Debt vs. Equity Tutorial: How to Advise Companies on Financing (2024)

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.