To: The Board of Directors – Badejo Limited
From: Accountant
Date: May 18, 2016
Subject: Debt Financing Considerations for Capital Investment

Dear Members of the Board,

I have prepared a report addressing the key considerations for the financing of the company’s upcoming capital investment project. Specifically, I will focus on:

(a) The factors to be considered in deciding the appropriate mix of short, medium, or long-term finance.
(b) Practical factors that may restrict the amount of debt the company can raise.

(a) Factors to Consider When Deciding the Appropriate Mix of Short, Medium, or Long-Term Finance

1. Term of Finance
   The term of the finance should align with the lifespan of the asset being financed. Generally, long-term assets should be financed with long-term debt, while short-term finance should be used for meeting temporary working capital requirements or managing fluctuations in cash flow.
2. Flexibility
   Short-term debt offers greater flexibility compared to long-term debt. It is typically easier to adjust or renew, while long-term debt can carry penalties if repaid early. Furthermore, long-term debt locks the company into a fixed interest rate, which can be disadvantageous if interest rates decline.
3. Repayment Terms
   The company must have sufficient liquidity to meet repayment schedules. Short-term debt, which is often repayable on demand or at short notice, is risky for financing long-term investments, as it can place pressure on the company’s cash flow if repayment is suddenly required.
4. Availability
   Short-term finance may be difficult to renew, especially if the company’s financial situation worsens or there are adverse changes in the economic environment. This makes short-term financing less reliable for funding long-term projects.
5. Cost
   Short-term debt generally has a lower interest rate than long-term debt. However, if short-term loans need to be frequently renewed, the associated costs may rise. Additionally, the administrative costs of issuing and renewing short-term debt can increase its overall cost.
6. Effect on Gearing
   Certain types of short-term debt (e.g., bank overdrafts or increased trade credit) are usually excluded from gearing calculations, which can make the company appear less leveraged. However, high gearing can signal increased financial risk, potentially leading to higher borrowing costs, more restrictive loan terms, or difficulty obtaining additional financing.

(b) Factors That May Restrict the Amount of Debt the Company Can Raise

1. Restrictions in the Company’s Memorandum and Articles of Association
   The company should carefully review its legal documents to ensure there are no restrictions on the amount of debt it is permitted to raise or for what purposes it can be used. These legal constraints can limit the company’s borrowing capacity.
2. Previous Financial Records
   If the company or its directors have a low credit rating or poor borrowing history, this can make it difficult to secure loans. Lenders may be reluctant to issue debt or may offer unfavorable terms if they perceive the company as a high-risk borrower.
3. Current Borrowing Restrictions
   Existing loan agreements may contain covenants that limit the company’s ability to raise additional debt. These covenants could include restrictions on the amount of debt the company can incur or on specific terms of new borrowing.
4. Uncertainty Regarding the Project
   If the capital investment project carries significant risk or uncertainty, lenders may hesitate to provide financing. The success of the project, and consequently the company’s ability to repay the debt, may be unclear, leading to reluctance from potential creditors.
5. Security Requirements
   Lenders often require security for the debt they issue. If the company is unable to provide adequate collateral—especially when its assets are already encumbered by existing debt—this can significantly limit the amount of debt it can raise.

Please feel free to reach out for any further clarifications. I look forward to discussing these points at the upcoming meeting.

Signed,
ACCOUNTANT