Essay on Debt financing and Equity financing: FedEx Corporation

Introduction

One of the key decisions for new projects is the choice of financing. There exist two major forms of financing: debt financing and equity financing. Equity financing means attracting investors and providing them a part in the business in exchange for their money. Debt financing means lending money using a certain interest rate (personal or business loans). Both forms of financing have its advantages and disadvantages, depending on the company’s situation, plans of the company owners, and key macroeconomic variables such as interest rates, availability of tax benefits and bankruptcy costs. The purpose of this paper is to analyze the advantages and disadvantages of using debt as the source of financing for the new project of FedEx Corporation in Canada, considered in the previous assignments.

1. Operating cash flows for new project

First of all, it is necessary to determine operating cash flows for the new project, and to find out whether there would be a need for external financing. Table 1 contains supplementary data and calculations for determining operating cash flow for FedEx Corporation (currency conversion based on the results of the previous assignments).

Table 1. Operating cash flows for the new project of FedEx Corporation in Canada

Operating cash flows indicate that during the first three years external financing will be required, because in addition to operating costs, investments into machinery and equipment will be needed ($8,000 during year 0, $8,000 during year 1, and $4,000 during year 2). Operating cash flows cannot provide enough resources for such investments, and, therefore, FedEx Corporation will have to choose between equity or debt financing, or a mix of both financing options.

2. Comparison of debt and equity financing

The main advantage of debt financing is that it allows to retain business ownership and keep control over the company’s development. Other advantage of debt financing is the availability of tax deductions ”“ interest and principal payments for business debt are deducted from income tax payments, and consequent lowering of interest rate (Banks, 2010). However, the disadvantage of debt financing is that debt should be repaid during a predetermined period of time, and additional interest should be paid. High interest rates and changes of interest rates might also make debt financing a significant burden for the company. Excessive debt financing can also affect the company’s credit rating. Moreover, there are significant risks associated with bankruptcy in case of debt financing: the lender can request a collateral for significant loans (Banks, 2010), and in case of defaulting on the payments, the company might have to lose ownership of some assets. Therefore, debt financing is an effective form of financing, but it should be used with caution.

An alternative to debt financing is equity financing. The advantage of equity is that there is no need to repay the funds back, and the associated disadvantage is the need to give a portion of the business to the investors. In addition to this, issuing new equity is more costly than debt financing of the same value (Banks, 2010), and there are many administrative issues involved in equity financing. Depending on the combination of economic variables in the country, on the industry figures and the company’s preferences, the choice in favor of debt or equity should be done individually in each particular case.

3. Economic situation in Canada

Corporate income tax and deductible interest and business loan payments exist both in the USA and in Canada. With regard to the cost of capital, debt financing is more cost-effective than equity financing both in the USA and in Canada, but the difference between the effectiveness of these forms of financing is smaller in Canada (Shoven & Walley, 1992). Several economic variables which contribute to this difference are higher personal taxes, dividend tax credit system and effective capital gains rates lower than in the US (Shoven & Walley, 1992). Overall, although financial systems and conditions in both countries are rather close, in Canada it is slightly more favorable to use equity as a source of financing compared to debt financing: in fact, in Canada the advantages and disadvantages of using debt financing outweigh each other.

In Canada, FedEx Corporation can use the following sources of financing: government grants, financing using private sector options, finance the business using personal assets (which might not be a reasonable option for FedEx though), financing from non-governmental organizations and equity financing (Shoven & Walley, 1992). In logistics services, debt to equity ratio is expected to be about 1.3-1.5 worldwide (YCharts.com, 2012), so it is recommended for FedEx to use both debt and equity financing for the new project.

Conclusion

There are both advantages and disadvantages of using debt or equity financing for FedEx Corporation. According to previous market estimates, in the US FedEx Corporation used 71% of equity financing, and 29% of debt financing, while in worldwide logistics services the proportion is different, and the percentage of debt financing is expected to be around 60% (YCharts.com, 2012). It was determined that in Canada equity financing is slightly more favorable than in the US, so it can be recommended for FedEx to pursue its strategy of equity financing, and maintain either a 50-50 balance, or retain the same proportion which was chosen in the US. The company should balance equity and debt financing depending on its current financial situation and on the project perspectives.