Having the appropriate debt-equity mix is very important to the financial success of any business. One must give careful consideration to the mix of debt and equity capital which your organization is to have. Although debt finance is cheaper, obtaining such finance depends on your ability to repay. It may also require significant security. One must also ensure that your organization is not too leveraged (i.e., the ratio of debt to equity is not too high).
I recently completed a simulation exercise for FIN/325 titled Determining the Debt-Equity Mix. During the simulation I was given the role of owner of a coffee shop and was taken through the various stages of the evolving business. During the different stages I was presented with situations where I had to evaluate different proportions and costs of debt and equity components so that I could make investment decisions. The goal was to optimize the Weighted Average Cost of Capital (WACC) for the business so that I could lead the business to success.
Following are the situations that I encountered and the decisions that I made as well as the reasons why I made those decisions.
The first portion of the simulation presented me with the challenge of expanding the business in a very competitive market. In order to be successful at expansion I needed to use WACC as a benchmark to decide the optimal debt-equity mix. Finding the right mix would help me minimize the WACC.
I chose 70% debt to 30% equity mix which helped me achieve the lowest possible WACC of 8.65 percent. Choosing a higher equity percentage would have increased the WACC considerably and a higher debt would have over-leveraged the business. Being over-leveraged would have possibly caused lenders to seek a higher rate of return due to the increased risk.