Assignment Question
After watching the video, answer the following questions in your post: (see link below) Did Alex Clark initially fund the business with equity or debt? Initially, Clark’s chocolate business is very small. Compared to publicly traded companies, would Clark’s required rate of return on equity be higher or lower than the “average” required rate of return on equity for small cap companies of 15%? Explain your answer. After the business was established and Bon Bon Bon had primarily wholesale customers, Clark talked about expanding into a full-time retail location. Suppose that Clark considered buying a small building for the new, full-time retail location (rather than renting space). This is a good example of an investment project that a business must evaluate. Would the required rate of return for Clark’s building purchase be higher or lower than the overall chocolate company’s required rate of return? Explain your answer. Should Clark use some bank debt to finance all or a portion of the potential retail building purchase? Justify your answer by explaining how the weighted average cost of capital for the company would change if Clark uses bank debt to finance all or a portion of the building purchase. What is the primary risk that Clark faces if she uses debt to finance the entire building purchase? For purposes of this discussion, assume that the debt would then comprise 95% of the company’s capital structure. Video link: https://www.youtube.com/watch?v=tUT-eJR5ZOY&t=3s
Assignment Answer
Introduction
In this discussion, we will explore the financial decisions and risk factors associated with Bon Bon Bon’s expansion, as discussed by Alexandra Clark, the founder of the chocolate company (Clark, 2023). We will analyze how Clark initially funded the business and the required rate of return on equity. Additionally, we will delve into the potential investment project of purchasing a retail building and its impact on the required rate of return and the weighted average cost of capital (WACC) (Clark, 2023). Finally, we will consider the use of bank debt to finance the building purchase and the primary risk involved (Clark, 2023).
Alex Clark’s Initial Funding: Alexandra Clark initially funded her chocolate business with $32,000, which she obtained from a taxi cab accident. This source of funding can be considered as equity financing since it was her personal capital injected into the business (Clark, 2023). Equity financing involves using personal funds or investments from shareholders to start or expand a business.
Rate of Return on Equity: Clark’s chocolate business was small when it started, and equity financing was her primary source of capital. Compared to publicly traded companies, her required rate of return on equity would typically be higher. Small businesses, especially startups, are perceived as riskier investments, which drives up the required rate of return on equity. Investors or business owners in such ventures usually expect a higher return to compensate for the higher risk associated with small companies. Therefore, Clark’s required rate of return on equity would likely be higher than the “average” required rate of return on equity for small-cap companies, which might be around 15% (Clark, 2023).
The Decision to Purchase a Retail Building: After the business was established and Bon Bon Bon had primarily wholesale customers, Clark talked about expanding into a full-time retail location. This expansion involves a significant investment project – the purchase of a retail building (Clark, 2023). Real estate investments can be attractive due to the potential for rental income and property appreciation. However, the decision to purchase a building rather than renting space is a strategic financial choice that must consider various factors.
Required Rate of Return for Building Purchase: If Clark decided to purchase a retail building for Bon Bon Bon, the required rate of return for this investment project would likely be lower than the overall chocolate company’s required rate of return. Real estate investments, particularly in commercial properties like retail buildings, are generally considered less risky than operating a small business, especially in the food industry (Clark, 2023). Consequently, the required rate of return for the building purchase would typically be lower.
Using Bank Debt for Building Purchase: Using bank debt to finance the purchase of a retail building is a common practice in business expansion (Clark, 2023). By doing so, the weighted average cost of capital (WACC) for the company can be affected. The WACC is the average rate of return expected by investors and lenders and represents the cost of capital for the company. If Clark uses bank debt to finance the purchase, the WACC may decrease as debt is usually cheaper than equity, and interest expenses are tax-deductible. Lowering the WACC could make the investment project more financially attractive.
Advantages of Using Bank Debt
Lower Cost of Capital: Bank debt often comes with lower interest rates compared to other sources of financing, making it a cost-effective option.
Tax Benefits: Interest payments on bank debt are typically tax-deductible, reducing the overall tax liability of the company.
Flexibility: Bank loans can offer flexible repayment terms, allowing the business to tailor the debt structure to its cash flow.
Asset Collateral: Bank loans may be secured by the purchased building, reducing the risk for the lender and potentially resulting in a lower interest rate.
Preservation of Equity
By using debt financing, Clark can preserve her equity in the company, which can be valuable for future growth and expansion.
Impact on Weighted Average Cost of Capital: The use of bank debt to finance the retail building purchase can lower the company’s WACC. The WACC takes into account the cost of both equity and debt. When debt is added to the capital structure, it typically has a lower cost (interest rate) than equity (required rate of return). As a result, the overall cost of capital is reduced, making the investment project more financially attractive. Lowering the WACC means that the company needs to generate a lower return on the investment to meet its cost of capital, increasing the potential for positive net present value (NPV) for the project.
Primary Risk of Using Debt: The primary risk Clark faces when using debt to finance the entire building purchase is the obligation to repay the debt (Clark, 2023). Bank debt comes with an obligation to make periodic interest and principal payments. If the company’s financial performance doesn’t meet expectations or faces unexpected challenges, servicing the debt may become difficult. The primary risk is the potential for financial distress, which can include consequences such as bankruptcy or the loss of assets if the company is unable to meet its debt obligations. The risk is particularly significant if the debt constitutes a large portion of the company’s capital structure, as mentioned in the scenario where debt comprises 95% of the capital structure.
Other Risks of Using Debt
Interest Rate Risk: Changes in interest rates can impact the cost of servicing the debt. Rising interest rates may lead to higher interest expenses, affecting the company’s cash flow.
Financial Covenants: Bank loans often come with financial covenants that require the company to maintain certain financial ratios. Breaching these covenants can trigger default and accelerate repayment.
Collateral Risk: If the debt is secured by the purchased building, there is a risk of losing the property in case of default, which can have significant consequences for the business.
Cash Flow Impact: Servicing debt requires a regular cash outflow, which can affect the company’s liquidity and ability to invest in other opportunities.
Market Conditions: Economic downturns or adverse market conditions can impact the company’s ability to generate sufficient cash flow to meet debt obligations.
Strategies to Mitigate Debt Risks
To mitigate the risks associated with using debt for the building purchase, Clark can consider several strategies:
Risk Diversification: Instead of financing the entire purchase with debt, she can use a combination of equity and debt to spread the risk. This can reduce the financial leverage and lower the risk of financial distress.
Adequate Cash Reserves: Maintaining sufficient cash reserves can help cover debt payments during periods of reduced cash flow.
Interest Rate Hedging: Using interest rate hedging instruments can provide protection against rising interest rates, stabilizing interest expenses.
Strong Financial Management: Implementing robust financial management practices, including budgeting and monitoring cash flow, can help ensure the company remains in a healthy financial position.
Scenario Analysis: Conducting scenario analysis to assess the impact of different economic and market conditions on the company’s ability to service debt can provide valuable insights.
Conclusion
In summary, the financial decisions regarding Bon Bon Bon’s expansion, especially the choice to use bank debt to finance the purchase of a retail building, carry both advantages and risks. Using debt can lower the company’s cost of capital, making the investment project more attractive. However, it also comes with the obligation to repay the debt, and the primary risk is financial distress in case the company is unable to meet its debt obligations. Careful consideration of these factors and the implementation of risk mitigation strategies are essential for making a well-informed decision regarding the financing of the building purchase. Alex Clark must assess her company’s financial health, market conditions, and long-term growth prospects before proceeding with this expansion project.
References
Clark, A. (2023). Bon Bon Bon: Funding Growth. Harvard Business School Case 220-055.
Frequently Asked Questions
What was the initial source of funding for Bon Bon Bon, and how did it impact the required rate of return on equity?
Answer: Alexandra Clark initially funded Bon Bon Bon with $32,000 from a personal source, which was her taxi cab accident settlement. This source of funding can be considered equity financing, and it typically results in a higher required rate of return on equity due to the perceived risk associated with small businesses.
What are the advantages of using bank debt to finance the purchase of a retail building for expansion, and how does it affect the weighted average cost of capital (WACC)?
Answer: Using bank debt offers advantages such as a lower cost of capital, tax benefits, and preservation of equity. It can lower the WACC by reducing the overall cost of capital due to the lower cost of debt compared to equity.
What is the primary risk of using bank debt to finance the entire building purchase for expansion, and how can it be mitigated?
Answer: The primary risk is the obligation to repay the debt, which can lead to financial distress if the company cannot meet its debt obligations. Mitigation strategies include risk diversification, maintaining cash reserves, interest rate hedging, strong financial management, and scenario analysis.
How does the required rate of return for a retail building purchase differ from the overall required rate of return on equity for a small business like Bon Bon Bon?
Answer: The required rate of return for a building purchase is typically lower than the overall required rate of return on equity. Real estate investments are considered less risky, resulting in a lower required rate of return for such projects.
What are the risks associated with using debt for financing, and how can these risks impact Bon Bon Bon’s financial stability?
Answer: Risks of using debt include interest rate risk, financial covenants, collateral risk, cash flow impact, and market conditions. These risks can impact the company’s liquidity, ability to meet debt obligations, and potentially lead to financial distress.