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From the borrowing viewpoint, if a high probable profit is thought to be likely by increasing assets held through financing, then whether it is better to finance by issuing shares, or by increasing long term borrowings. In the first, the downside is dilution of control and dilution of earnings per share, and in the latter, the downside is increased defaulting risk, decreased liquidity ratios.
- given A= assets, L = liabilities , P = gross profit before tax of 't'% and additional interest, S the current issued shares, if an increase in assets 'a' results in a increase in
gross profits 'p' ,is it better to increase by 'a' by issuing 's' shares at 'a'/'s' per share, or borrowing 'a' at an annual interest rate of 'i'% , where an annual interest of 'i' % times
'a' will be incurred ?
- in the first , net profit after tax is P + p * (100 - t) % , giving an earnings per share of ( P + p * (100 - t)/100) / (S + s) , and a debt ratio of L / (A + a)
- in the second, net profit after tax and interest is ( P + p (100 - i) / 100 ) * ( 100 - t) / 100 , giving an EPS of (P + p (1 - i/100) * (1-t/100) / S , and a debt ratio of (L + a) / (A + a)
Rough steps in financing:
- budget and forecast increase profit and increase in assets required. May require lots of management accounting.
- Model results of increasing liability , increasing equity or a combination of both, in order to increase assets.
- analyse consequences of possible different actions.
- choose, lead action
- review results and learn
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