If this investment was financed entirely with debt, the new capital structure would be 67.2% debt and 32.8% equity. If this investment was financed entirely with equity, the new capital structure would be 30.5% debt and 69.5% equity.
One rule of thumb for making such a decision is to match the asset type with the financing. Therefore, an asset that is expected to have a service life of five years would be financed with a five-year bond issue, so that the cash flows from the asset can be used to cover the costs of financing. In this case, the asset life is not known, so any financing type can be used.
Internal cash is not possible because the firm likely does not have $10 million in cash if it only has $17.2 million in assets and $17.5 million in annual revenues. A debt issue will leave the firm with a significantly higher degree of leverage, increasing the firm's risk level. In order to know if this risk level is acceptable, it is worth considering the industry norms. Canadian auto part supplier Magna carries a capital structure featuring 40.2% debt and 59.8% equity (MSN Moneycentral, 2010) so it appears that 67.2% debt is probably too high for our auto parts company.
If equity is to be used to finance this project, there are still a couple of different options, including common shares and preferred shares. In this case, there is the risk of using common shares that ownership could be diluted. This dilution can be eliminated by issue rights to the existing common shareholders, allowing them to maintain their current level of holding in the firm's equity.
Recommendations
The project has a positive net present value or it would not be considered. Assuming that it makes sense on a strategic level, the company should pursue the investment. Although this project will dramatically increase the size of the company, the decision needs to be made based on rational economic criteria. Thus, if the project can be financed and will result in a positive net present value for the firm, it should be pursued.
It should also be considered that at present the company only earns $5,000 in revenue per employee. This means that the company as currently constituted...
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