Running head: THE GREAT SERVICE CLEANING 1

Written Assignment Week 7

The Great Service Cleaning and Maintenance Company

BUS 5111 Financial Management

Term 4, 2018-2019

University of the People

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THE GREAT SERVICE CLEANING CASE STUDY

Raising capital for a business can be challenging. Private companies have many funding

options to raise capital such as borrowing from banks, private debt financing, private investors,

company mergers, and public investors through the issuance of corporate bonds and common

stocks. In the case study, The Great Service Cleaning and Maintenance Company, a corporation

with less than 50 stakeholders, requires an additional capital infusion of $200,000. The

alternatives available to the company will be discussed in this paper such as private debt

financing, private transfer of partial and entire ownership, public debt issuance, and public equity

offering.

Capital Structure

The overall composition of a company’s funding made up of equity and debt is called

capital structure (Kenton, 2018). Debt comes in the form of bonds, long-term payable notes, and

short-term debts while equity may be in the form of common stocks, preferred stocks, or retained

earnings (Kenton, 2018).

Cost of Capital

Cost of capital is the return a company needs in order to take on a capital project, which

typically includes the cost of both equity and debt (Kenton, 2019). Generally, the investment

decision should generate a return that exceeds the cost of capital used to finance the project

(Kenton, 2019). Cost of capital is weighted according to the company's existing capital structure,

known as the weighted-average cost of capital (WACC) (Kenton, 2019).

Equity and Debt

Two ways to raise capital for a business are equity and debt. A debt instrument promises

to pay the lender a certain amount or percentage as returns while equity returns are in the form of
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dividends (Kenton, 2018). Equity represents partial or full ownership of the company while debt

does not change the ownership of the business (Kenton, 2018). Many companies issue debts

instead of equity to take advantage of the tax shield (Kenton, 2018). A tax shield is an allowable

deduction from the taxable income from common expenses such as mortgage interest,

depreciation, interest payment, and amortization (CFI, 2019).

Private Debt

The term private debt refers to lending activities or debt investment carried out by entities

other than banks and not publicly issued or traded in an open market (PRI, 2019). Categorically

termed alternative debt or alternative credit, private debt is used interchangeably with direct

lending, private lending, or private credit (PRI, 2019).

Private debt impacts the structure and cost of capital in different ways. First, issuing debt

notes does not dilute ownership and lenders have no voting rights in the company (Investopedia,

2018). Second, a company can claim for tax shield since the interest expense on debt is tax

deductible (CFI, 2019), thus, interest payments on debt reduce the taxable income and cash flow

(Investopedia, 2018). Increasing debt causes leverage ratios such as debt-to-equity and debt-to-

total capital to rise, thus, leading to higher growth rates (Investopedia, 2018).

Private Transfer of Partial Ownership

A company seeking capital infusion may choose to sell partial ownership of the company

to investors who would be willing to share ownership. This may be referred to as private equity

recapitalization where private entities additional capital for growth is obtained while allowing the

owner to remain in control of the business and position it for future sale at a higher price (Nead,

n.d.).
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In private equity capitalization, a positive item in the cash flows is created from financing

activities section, subsequently increasing the common stock at par value on the balance sheet

(Investopedia, 2018). There is no obligation to pay interests compared to private debt, and

dividend payment is not mandatory (Kenton, 2018). The cost of capital is not affected by equity

increase but the major impact is on the ownership and management of the company (Kenton,

2018). Private equity can dilute the existing shareholders’ ownership and the company’s net

income is divided into a larger number of shareholders (Investopedia, 2018). The existing owner

may lose control of the company if the majority of shares are sold, and in many cases, the private

investors are given executive posts in the company, thereby influencing decisions (Simpson,

2018).

Private Transfer of Entire Ownership or Buyout

In a private transfer of entire ownership, investors will infuse additional funds to the

business by buying 100% stake of the company (Hartman, n.d.). It can be in the form of

acquisition by another company, leveraged buyout, or management buyout (Hartman, n.d.). In

this case, the major impact is on the management structure where existing shareholders lose

control over the company unless there is an employment or consulting contract between the

previous and new owner (Simpson, 2018). On the financial aspect, the owner’s equity on the

balance sheet will change as this represents ownership of the company (Investopedia, 2019).

Public Debt or Corporate Bonds

An alternative to raising capital is to issue corporate bonds or public debt instruments.

Unlike private debt, public debt is issued and traded in the market publicly, subject to the rules

and regulations of the Securities and Exchange Commission (PRI, 2019). The returns generated

is in the form of interest which will be paid at a certain period (PRI, 2019). The ownership of the
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company does not change and the lender will not have voting rights or cannot influence the

company decisions (PRI, 2019). Public debt, similar to private debt, benefits the company by

lowering the net taxable income through the tax shield on from interest payments (PRI, 2019).

Public Equity or Common Stocks

Public offering is the sale of equity shares to raise funds but as the term implies, traded to

the public in the stock market (Chen, 2018). The major effect of public equity, similar to private

equity recapitalization, public equity represents ownership of the company wherein investors will

have voting rights that can influence the decisions in the company (Chen, 2018). Moreover, there

is a risk of losing control of the company if the majority of stakes are sold (Chen, 2018). Since

payment of dividends is not mandatory, the cost of capital is not affected by equity increase

(Investopedia, 2018). However, an increase in equity implies that the company’s net income will

be divided into a larger number of shareholders (Investopedia, 2018).

Impact of $200,000 Capital Infusion on the Financial Statements

An increase in the capital can affect the financial statements and will reflect when ratio

analyses are performed. For instance, if the company decides to issue debt instruments, it will

increase the debt-to-equity (D/E) ratio which shows how much of the company’s debt is used to

finance the company in relation to the amount of equity used. Based on the company’s balance

sheet, the D/E are 2.70 and 1.72 in 2013 and 2014 respectively. Should an additional $200,000

will be infused as debt, the D/E will become 1.81 using the formula D/E = Total

Liabilities/Shareholder’s Equity (Investopedia, n.d.). On the contrary, if common stocks will be

issued, the D/E will be reduced to 1.59.

As mentioned earlier, if the company issues a debt instrument, it will have a positive

effect on the income statement through the tax shield which will lower the taxable income due to
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an increase in interest payment, thus, increasing the net income of the company. Equity, on the

other hand, will not have an impact on the income statement.

In conclusion, the preceding alternatives considered by the company can impact its

financial position and management structure differently. If the decision will be based on the

company’s performance as can be gleaned from its financial statements, then the company would

be better off issuing debt instruments. The company’s revenue trend is increasing and could

further be improved with the infusion of $200,000 additional capital, hence, the company will be

in a better position to repay the principal and interest on a specific period. At the same time, the

company will benefit from lower tax income, thus increasing the net income that can be used to

pay dividends among a smaller number of shareholders.

There are many financial analysis tools available in order to evaluate the company’s

financial situation and make a sound decision, especially in this case. The data provided for in

this case study is limited and should not be enough basis to be used in making big decisions.

Therefore, the owners of Great Service Cleaning and Maintenance Company must exert more

effort and perform deep analysis of the situation, requirements, and alternatives based on

complete information.
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References

Chen, J. (2018, March 10). Public offering. Retrieved from

https://www.investopedia.com/terms/p/publicoffering.asp

Corporate Financial Institute (CFI). (2019). What is a tax shield. Retrieved from

https://corporatefinanceinstitute.com/resources/knowledge/valuation/tax-shield/

Hartman, D. (n.d.). Buyout options for a business owner. Retrieved from

http://smallbusiness.chron.com/buyout-options-business-owner-13593.html

Investopedia. (n.d.). Debt ratios: Debt-equity ratio. Retrieved from

https://www.investopedia.com/university/ratios/debt/ratio3.asp

Investopedia. (2018, August 31). How do equity financing and debt financing affect a company's

financials? Retrieved from https://www.investopedia.com/ask/answers/051315/how-

does-equity-financing-affect-companys-financials-compared-effects-debt-financing.asp

Kenton, W. (2018, May 4). Capital structure. Retrieved from

https://www.investopedia.com/terms/c/capitalstructure.asp

Kenton, W. (2019, May 15). Cost of capital definition. Retrieved from

https://www.investopedia.com/terms/c/costofcapital.asp

Nead, N. (n.d.). Ownership transfer alternatives: 5 options for your business exit. Retrieved from

https://investmentbank.com/ownership-transfer-alternatives-5-options-for-your-business-

exit/

Prestige Funds. (2019). Private debt. Retrieved from

http://www.prestigefunds.com/know/private-debt/
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Principle for Responsible Investment (PRI). (2019, February 11). Private debt overview.

Retrieved from https://www.unpri.org/private-debt/an-overview-of-private-

debt/4057.article

Simpson, S. (2018, May 29). How to sell stock in your company. Retrieved from

https://www.investopedia.com/articles/stocks/12/how-to-sell-company-stock.asp