Debt vs. Equity Analysis: How to Advise Companies on Financing
Debt vs. Equity Analysis: How to Advise Companies on Financing
In this tutorial, you’ll learn how to analyze Debt vs. Equity financing options for a company, evaluate the credit stats and ratios in different operational cases, and make a recommendation based on both qualitative and quantitative factors.
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Table of Contents:
0:50 The Short, Simple Answer
3:54 The Longer Answer – Central Japan Railway Example
12:31 Recap and Summary
If you have an upcoming case study where you have to analyze a company’s financial statements and recommend Debt or Equity, how should you do it?
SHORT ANSWER:
All else being equal, companies want the cheapest possible financing. Since Debt is almost always cheaper than Equity, Debt is almost always the answer.
Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders).
The risk and potential returns of Debt are both lower.
But there are also constraints and limitations on Debt – the company might not be able to exceed a certain Debt / EBITDA, or it might have to keep its EBITDA / Interest above a certain level.
So, you have to test these constraints first and see how much Debt a company can raise, or if it has to use Equity or a mix of Debt and Equity.
The Step-by-Step Process
Step 1: Create different operational scenarios for the company – these can be simple, such as lower revenue growth and margins in the Downside case.
Step 2: “Stress test” the company and see if it can meet the required credit stats, ratios, and other requirements in the Downside cases.
Step 3: If not, try alternative Debt structures (e.g., no principal repayments but higher interest rates) and see if they work.
Step 4: If not, consider using Equity for some or all of the company’s financing needs.
Real-Life Example – Central Japan Railway
The company needs to raise ¥1.6 trillion ($16 billion USD) of capital to finance a new railroad line.
Option #1: Additional Equity funding (would represent 43% of its current Market Cap).
Option #2: Term Loans with 10-year maturities, 5% amortization, ~4% interest, 50% cash flow sweep, and maintenance covenants.
Option #3: Subordinated Notes with 10-year maturities, no amortization, ~8% interest rates, no early repayments, and only a Debt Service Coverage Ratio (DSCR) covenant.
We start by evaluating the Term Loans since they’re the cheapest form of financing.
Even in the Base Case, it would be almost impossible for the company to comply with the minimum DSCR covenant, and it looks far worse in the Downside cases
Next, we try the Subordinated Notes instead – the lack of principal repayment will make it easier for the company to comply with the DSCR.
The DSCR numbers are better, but there are still issues in the Downside and Extreme Downside cases.
So, we decide to try some amount of Equity as well. We start with 25% or 50% Equity, which we can simulate by setting the EBITDA multiple for Debt to 1.5x or 1.0x instead.
The DSCR compliance is much better in these scenarios, but we still run into problems in Year 4.
Overall, though, 50% Subordinated Notes / 50% Equity is better if we strongly believe in the Extreme Downside case; 75% / 25% is better if the normal Downside case is more plausible.
Qualitative factors also support our conclusions.
For example, the company has extremely high EBITDA margins, low revenue growth, and stable cash flows due to its near-monopoly in the center of Japan, so it’s an ideal candidate for Debt.
Also, there’s limited downside risk in the next 5-10 years; population decline in Japan is more of a concern over the next several decades.
RESOURCES:
https://youtube-breakingintowallstreet-com.s3.amazonaws.com/Debt-vs-Equity-Analysis-Slides.pdf
Thank you… please more videos and more simple basics .. and explanation of terminology
which package can i buy this model form
Thanks a lot for the video, quick clarification – can you clarify why do you reduce the EBITDA in order to present the equity funding option? why is its reduced by 50% when the funding is based on 50% equity?
(after tax) Cost of equity < (after tax) cost of debt when P/E ratio is very high. Please can you explain the reason for this?
Have a question that is sort of related to this. But if this was an ADR, how would you arrive at Enterprise Value. I tried to reconcile metrics for NYSE: VLRS. Would you still quote figures like EV/EBIT and EV/Sales off of the different shares in other markets? I have been searching like crazy for this because I keep seeing different metrics quoted for an ADR on market cap, EV, EV/EBIT, P/E. I also see that in P/E the earnings being reported in the countries currency so it distorts the ratio. Is this typical? Thanks if you see this. ( Oh, I have already factored in the ADR share conversion).
ich will have an AC at a local IB, just found this video really helpful for the case study preparation! Thanks a lot!
In which course(s) do you find the case study?
Great Work!
Hey guys. Can someone please explain: does 5% amortization for term loans mean that amortization term is 20 years? Or how does it work? Thank you in advance.
If the acquirer has cash wouldn’t it use that first before considering debt?
Any chance you can provide a download link for the spreadsheet? Great video.
Thank you for all the great content you provide ! (from France)
Another great video. Have you done any videos on shortcuts in excel that are essential to valuations/modelling? Would really appreciate a video that covers shortcuts for powerpoint/excel/word in reference to financial modelling or other work carried out by analysts.
Once again thanks for all the videos so far; they’ve helped me land an assessment centre and wouldn’t have been able to do it without this useful content from your channel!
Hi, possible to share the excel working file?
I have homework similar to this scenario, the firm is entrepreneurial in nature. Its total worth is $1.3 Million and sales are only $150000 in the current year. Its revenues are expected to reach $20.5 Million after 8 years and currently, cash flows are negative. They need $10 to $15 million in the short-term. Which options they should choose to finance their business. ?
Your earlier kind of help would be fruitful for me to complete my homework on time.
Very well explained (From India)