Chapter 2 - Financing Capacity & Deal Structuring Considerations

Question 1

What are the Two components of Capital Structure?

Answer 1

1) Equity Capital - money invested and owned by shareholders

2) Debt Capital - Borrowed money deployed in business

Question 2

What are the two types of Equity Capital? (explain)

Answer 2

1) Contributed Capital: Money originally invested in business for shares of stock or ownership
2) Retained Earnings: Profits from past years kept by the company to strengthen the balance sheet.

Question 3

Provide 3 examples of Capital Structure (explain)

Answer 3

1) Under-Levered - Higher WACC, equity financing
2) Over-levered - business has chapter debt, increases risk profile
3) Optimal Structure - Appropriate level of debt

Question 4

What are the 4 Life Cycle Stages of a Business?

Answer 4

1) Startup/early stage
2) Growth or Expansion
3) Mature
4) Financially Distressed

Question 5

What are the three most prominent forms of Equity?

Answer 5

1) Common Shares - Rights, securities, cost of equity is high
2) Preferred Shares - Sit above common shares, below all forms of debt in security of business.
3) Convertible Securities (Options, Warrants) - considered equity, gives the holder the right but not obligation to purchase shares for a set price, where warrants are a potential source of capital (differ in vesting terms) based on operational or financial performance

Question 6

What are 3 key Potential Investor Considerations regarding Financial Statements?

Answer 6

1) Return on Investment to Investors - what is the ROI? For any equity investor, this can include income distributions and capital appreciation. Review cash flow, debt service requirements, future investments
2) Available Security - while equity owner is inherently subordinate to debt holders, this does not mean that an equity holder would not assess the security available to them in the event of a liquidation event.
3) Impact on Covenants - Potential investors consider the impact that existing loan covenants have on the business. Overly restrictive covenants could deter an investor.

Question 7

What are two common Market Constraints of Deal Structuring?

Answer 7

1) Optimal Capital Structure vs. Available Capital Sources

2) Impact of Market Conditions

Question 8

What are two common Operational Constraints in Deal Structuring?

Answer 8

1) Shareholders Agreements & other Internal Agreements

2) Lack of Internal Resources and Incremental Costs

Question 9

What are 4 Tax Considerations of Deal Structuring?

Answer 9

1) Tax Deductibility of Interest - debt issuance will be significantly more cost effective to the company (interest payments are tax deductible, dividends are not)
2) Tax to Investors on Dividends Vs. Interest Income - Company must be mindful of what potential investors would prefer - investors may prefer to receive dividends rather than interest income
3) Corporations with Large Tax Pools Available - May prefer to benefit from deducting interest payments as a company which is currently cash taxable - this all depends on the cash position of the corporation
4) Flow Through Shares - use of flow-through shares is common in mining and O&G industries in Canada, where financing is structured such that tax deduction of expenditures related to financing are granted to the investor and not the company. This creates a situation where company’s assets will have little to no tax basis in the future