Key takeaways
- There is no capital structure that is cheapest for every company. There is only a structure whose cash burden the company's cash flow can carry and whose terms the owner can accept.
- Compare three things at the same time: the true cost, the annual cash burden, and what you must give up, such as collateral, refinancing risk or shares.
- In the example, a full THB 500m bank loan leaves the DSCR at 1.18x, while a mix of THB 300m debt and THB 200m equity gives a DSCR of 1.66x, with the owner giving up 9.09% of the shares.
A company decides to invest in a new project and needs to raise THB 500 million. A bank offers a low interest rate but asks for additional collateral. An adviser proposes a bond with no principal amortisation, and an investor offers capital in return for part of the shares. All three offers sound good in different ways. Choosing a funding source is like choosing shoes: free shoes in the wrong size are no use for walking. So the question is not which option is cheapest, but which one fits the business on the day the numbers do not go to plan.
Comparing the three options with the same questions
| Issue | Bank loan | Bonds | Private Equity |
|---|---|---|---|
| What you repay | Interest and principal according to a schedule | Interest, and usually a single bullet repayment of principal at maturity | No repayment schedule, but profit and value are shared at exit |
| What you must give up | Collateral, covenants, guarantees | Terms and rights provisions, disclosure requirements; some issues are secured | Shares, board seats, veto rights and exit conditions |
| Main risk | High principal repayments while revenue has not yet arrived | A large lump sum must be found at maturity | High hidden cost if the business does well, and possible disagreements with the investor |
| Suitable when | Cash flow is predictable and collateral is available | The company has sufficient reputation or size and a plan to repay at maturity | You need long-term capital, debt is already at its ceiling, or you want a partner |
What to know before considering a bond
Bonds are governed by the rules of the SEC, which are divided by type of buyer: institutional investors, a small limited group of investors (PP10), large investors, and offers to the general public. According to the summary of rules published by the SEC, offers to institutional investors and PP10 do not require prior approval for each offering, but must follow the stated conditions and submit the required documents. Offers to large investors and the general public require an application for approval and a disclosure document. Offers to the general public require a credit rating, and bonds that are unrated or rated below investment grade within the specified categories must include the words "High Risk" in their name.
These rules can change, and the issuer's status, such as a private limited company or a public limited company, affects the options available. Check the current announcements with a legal adviser before using them in your planning.
Example: calculating the outcome of each route
Hypothetical example A company has a constant CFADS of THB 170m a year and existing debt service of THB 40m a year. It needs THB 500m. Assume the year-5 enterprise value is the same under every option, at THB 5,000m, and the existing debt outstanding is THB 60m. Interest is tax-deductible at 20%, and no return on accumulated cash is counted.
| Unit: THB m | Bank 500 | Bond 500 | PE 500 | Bank 300 + PE 200 |
|---|---|---|---|---|
| Assumed terms | 6.5%, 7 years | 7.5%, 5 years | Pre-money 2,000 | 6.5%, 7 years; pre-money 2,000 |
| Arrangement costs | 5.0 | 7.5 | 0.0 | 3.0 |
| New debt service, year 1 | 103.93 | 37.50 | 0.00 | 62.36 |
| Year 1 DSCR (including existing debt) | 1.18x | 2.19x | 4.25x | 1.66x |
| New debt outstanding, year 5 | 142.86 | 500.00 | 0.00 | 85.71 |
| Equity stake sold | 0% | 0% | 20.00% | 9.09% |
| Owner's equity value, year 5 | 4,992.1 | 4,932.5 | 4,472.0 | 4,755.7 |
| Investor IRR | - | - | 17.46% | 18.92% |
Borrowing the whole amount from a bank gives the owner the highest value, but a DSCR of 1.18x is below the commonly seen threshold. Working back from a DSCR of 1.30x, this company could carry about THB 437m of debt on those terms. The bond shows an attractive DSCR, but in year 5 THB 500m must be repaid while accumulated cash is THB 492.5m. That leaves a shortfall of THB 7.5m before counting minimum cash, so there is refinancing risk. PE carries the cash burden best, but the owner's value is THB 520.1m lower than under the bank option if the business goes according to plan.
An important point is that the investor IRR in the table is the result of the year-5 value assumption, not an agreed rate. If the value is lower, the cost of capital falls too. This is the value of equity that debt cannot provide, because debt must be paid even when results are poor.
Decision sequence
- Find the debt ceiling from cash flow. Calculate it from the downside case, not the base case.
- Match the tenor of the funding to the life of what it is used for. Long-term funding should be used for long-term assets.
- Assess every maturity date. Pay particular attention to large debts that fall due in the same year.
- Define what you cannot give up. For example, control, rights over core assets, or personal guarantees.
- Open up competition. Ask every party to bid on the same assumptions, then compare total cost, not just the interest rate.
Next steps
- Prepare base-case and downside-case forecasts, with DSCR for each year
- Calculate the debt ceiling from a target DSCR that you set yourself
- Itemise all arrangement costs for each offer
- Prepare a debt maturity schedule for the whole group
- Check the restrictions in existing loan agreements before taking on new debt or raising equity
- Define unacceptable terms before negotiations begin
- Have legal and tax advisers review the chosen structure