Section C

MedTech Innovators

MedTech Innovators is a rapidly growing technology startup specializing in medical devices. The company currently has annual credit sales of $18,000,000.

Current Receivables Policy:

• Average collection period: 60 days.
• Bad debts: 2% of credit sales.
• Administration costs of the sales ledger: $150,000 per year.
• MedTech finances its receivables using a short-term bank overdraft at an interest rate of 8% per year.

Proposed Factoring Arrangement:
A factoring company has offered to take over the administration of MedTech's sales ledger on a non-recourse basis (meaning the factor assumes all bad debt risk).

• The factor will charge an administration fee of 1.5% of credit sales.
• The factor will advance 80% of the invoiced amounts immediately at an interest rate of 10% per year.
• The remaining 20% will be paid to MedTech when the customers pay the factor.
• The factor guarantees to reduce the average collection period to 40 days.
• If MedTech accepts the offer, it will save the $150,000 internal administration costs and eliminate bad debts.

Assume a 365-day year.

Required:

(a) Evaluate whether MedTech Innovators should accept the factoring offer. Support your answer with a detailed financial calculation showing the net benefit or cost of the proposal. (12 marks)

(b) MedTech is considering raising $5,000,000 for a new factory. The board is debating between issuing new equity or taking out a long-term bank loan. Discuss the factors the board should consider when choosing between debt and equity finance, making specific reference to MedTech's status as a rapidly growing startup. (8 marks)

**Part (a) Evaluation of Factoring Offer** *Current Policy Costs:* 1. Current Receivables = $18,000,000 * (60 / 365) = $2,958,904 2. Finance cost of receivables = $2,958,904 * 8% = $236,712 3. Bad debts = $18,000,000 * 2% = $360,000 4. Admin costs = $150,000 Total Current Costs = 236,712 + 360,000 + 150,000 = $746,712 *Proposed Factoring Costs:* 1. Proposed Receivables = $18,000,000 * (40 / 365) = $1,972,603 2. Factor Admin Fee = $18,000,000 * 1.5% = $270,000 3. Finance cost of advance (80%) = ($1,972,603 * 80%) * 10% = $1,578,082 * 10% = $157,808 4. Finance cost of balance (20%) = ($1,972,603 * 20%) * 8% = $394,521 * 8% = $31,562 Total Proposed Costs = 270,000 + 157,808 + 31,562 = $459,370 *Net Benefit:* Net Savings = Current Costs ($746,712) - Proposed Costs ($459,370) = $287,342. Conclusion: MedTech should accept the factoring offer as it results in a net financial benefit of $287,342 per year, largely driven by the elimination of high bad debts. **Part (b) Debt vs Equity for a Startup** When choosing between debt and equity, MedTech's board must consider: 1. **Cost:** Debt is generally cheaper than equity because it is lower risk for the investor (secured, prior claim on assets) and interest payments are tax-deductible. Equity requires a higher return to compensate for higher risk. 2. **Financial Risk (Gearing):** Debt introduces mandatory interest payments and capital repayments. As a rapidly growing tech startup, MedTech's cash flows may be volatile or negative. High gearing increases the risk of bankruptcy if cash flows fall short. Equity does not require mandatory dividends, preserving cash. 3. **Control:** Issuing new equity to external investors will dilute the founders' ownership and control. Debt providers do not take voting rights, though they may impose restrictive covenants. 4. **Availability/Security:** Startups often lack tangible assets to offer as security for long-term bank loans. If the new factory can be used as collateral, debt might be accessible; otherwise, equity (e.g., venture capital) might be the only viable option. Given MedTech is a startup, the flexibility of equity (no mandatory cash outflows) is often preferred despite its higher cost, unless the new factory provides sufficient collateral for a low-risk loan.