Complete the Information for Scenario A and Scenario B for John's Company

Which option would you advise John to take: more debt or sell equity?

What is the risk if he follows your advice?

Answer:

Selling equity seems to be the more favorable option for John in terms of maintaining a healthy debt to equity ratio and avoiding increased financial risk. However, he should carefully consider the potential dilution of ownership before making a final decision.

Based on the information provided, I would advise John to sell equity and accept the investor's offer. Here's why:

1. Scenario A - Borrowing $250,000:

If John chooses to borrow the money, the company's debt will increase from $175,000 to $250,000. This will affect the debt to equity ratio, which is currently at 0.269. Increasing the debt will raise this ratio even higher, potentially indicating financial risk to creditors and investors.

2. Scenario B - Selling $250,000 in common stock:

By selling an additional 25% ownership in the business for $250,000, John will increase the company's common stock from $200,000 to $250,000. This option will not affect the debt to equity ratio, as it involves selling equity rather than increasing debt.

If John follows my advice and chooses to sell equity, the risk he faces is dilution of ownership. Currently, John owns 65% of the company, but selling a 25% stake to the investor will reduce his ownership to 40%. This means he will have less control and decision-making power in the company.

Now, let's address the bonus questions:

1. The actual cost of borrowing:

The information provided does not specify the actual cost of borrowing, so we cannot determine the exact interest rate or cost of borrowing in Scenario A.

2. What percentage of the business will John own if he chooses to sell equity:

If John chooses to sell equity, he will sell a 25% ownership stake to the investor. However, it is important to note that John's ownership percentage after selling equity will be 40% (since he currently owns 65% of the company).

By carefully considering the implications of each scenario and the potential risks involved, John can make an informed decision on whether to borrow or sell equity for his business expansion.