Question

You work as a financial analyst at a large automobile corporation that occasionally makes acquisitions of smaller companies that specialize in the production and assembly of small component parts. In order to achieve vertical integration of its newest sports sedan model, the company is evaluating a few manufacturing companies that have experienced strong financial performance in the past few years. These companies would make excellent acquisitions due to the nature and quality of the product and the anticipated ease of transition. You have been tasked to evaluate these companies from a financial perspective and choose one. To do this, you need to brush up on a few concepts by addressing the following topics:

The firm will need to raise funds immediately for the acquisition, and debt will be used. Why?

Should the firm borrow on a long-term or short-term basis? Why? Explain the effect, if any, inflation rates will have on the purchase? How significant is this factor?

Answer 1

If a company is an asset-heavy business and it is investing heavily on the project then it should use debt financing because debt financing is the cheapest source of long term capital.
Example: if an automobile company investing heavily on a plant then it should be using debt financing for its growth in its capital structure.

If a company is an asset-light business like a software company or internet company then it can use equity for its growth.

And also this large automobile corporation looks like a more stable company in its industry with strong financial performance.

A more stable business can use debt for its growth.

The firm should borrow for a long term basis because it is a heavy investment and requires many years to reap its benefits.

Short term debt financing is mainly for working capital uses and not for project investment or company acquisition.

Inflation will be having a major effect in debt financing because if the inflation rate is high then overall prices increases but the company still has to pay the same amount of interest and principal. So that financing becomes cheap during high inflation and vice versa.