Under the two circumstances presented, I recommend that Harriet Burns and Richard Irvine should finance the purchase of Harmonic Hearing Co. through the deal proposed by the private equity firm, Comet Capital. This proposal best aligns with Burns and Irvine’s goal to select an option that offers the “best combination of cost, expected return of their ownership interest and financial flexibility.” To evaluate the two alternatives, a comparison based on IRR was assessed. Harrison Price’s proposal, which relies almost entirely on debt financing, offers an IRR of 215.5% (Appendix A). On the other hand, Joe Fowler’s proposal, which consists of equity financing, offers an IRR of 402.5% and also fulfills Comet Capital’s required rate of return of 27% (Appendix B). The main advantage of equity financing over debt financing, displayed in this case and in the real world, is the financial freedom and stability offered by the private equity firm. Burns and Irvine do not have to deal with the large burden of paying back debt. This report will compare the two financing alternatives proposed and highlight the pros and cons of each scenario. In addition, potential risks will be addressed and possible scenarios that may affect the valuation in the future will be looked at.
Harrison Price’s Proposal (Debt)
The proposal put forth by Harrison Price used a combination of the individual alternatives identified by Burns and Irvine. The heavy majority of the financing would come through debt, which would allow the duo to “retain 100% ownership of Harmonic.” This is a significant advantage of this proposal as Burns and Irvine will not have to worry about keeping investors happy and will also have full control of the operations and direction of the company. Another advantage of debt financing presented in this case is the reduced income tax. The interest being paid on the loans is tax-deductible meaning that part of the business income is shielded from taxes and therefore lowers the tax liability. This really is a double edged sword as there is no interest expense at all in the equity alternative. A drawback of the proposal is the overall burden of debt. The greatest risk this proposal entails is the possibility that Burns and Irvine are unable to keep up a sufficient cash flow and ultimately will have to give up the company to their creditors. Another drawback, being particular to Harmonic Hearing Co., is that the lack of sufficient internal cash would cause the release of their new hearing aid to be delayed by one year. This one year delay would “reduce their market share when it entered the market” and ultimately lead to lower gross profit margins. Furthermore, when comparing the two alternatives, the increased financial burden is heavily apparent when looking at the income statement. The fixed lease and rent payments greatly impact the net income as they slash the operating income by about 20% each year. In comparison, the interest expensed in the equity scenario usually only cut into the operating income by about 6 or 7%.
Subsequently, there are a number of very realistic scenarios that would put a lot of pressure on Burns and Irvine if they were to unfold. Firstly, an interest rate hike would cause many problems. In order to make up for the rise in interest rates, their investor may decide to transfer the burden down the chain to them. This may cause higher rent payments or higher interest rates on their personal guarantee. Another realistic risk is the possibility of a real estate boom. The property had “significantly appreciated in value” since Otis Wren has purchased the land and building and if that were to happen again in a short amount of time; the IRR would be greatly reduced. For example, if the land and building were to double in market value, the IRR would drop to a mere 3% (Appendix C). A third scenario would be if Burns and Irvine...