Wait a second!
More handpicked essays just for you.
More handpicked essays just for you.
Comparing debt and equity financing
Don’t take our word for it - see why 10 million students trust us with their essay needs.
Recommended: Comparing debt and equity financing
Introduction
Capital structure is a term used to refer to the fraction of debt and equity that make up a firm’s total capital. The cost of debt is the amount above the borrowed amount that lenders demand from the firm in form of interest.
There are benefits associated with each financing criteria. For instance, using debt to finance a project qualifies a firm for an interest tax shield. This means that, interest paid for debt is deducted from taxable income which serves to reduce the cost of financing as opposed to equity financing. The expenses incurred in issuing debt are fewer and the managers are pressured to allocate the funds to more profitable projects in a bid to protect their careers. However, using debt has a disadvantage of pushing the firm into financial distress by incurring extra costs to service the debt when the firm is experiencing tough financial times (Parrino, R. & Kidwell, D. S., 2009).
28 a). Assuming that the share price of IST will remain $13.50 after issuing equity and that:
i) The managers know the correct value of the shares is $12.50,
The firm needs $500 million to finance the project. If equity is issued to obtain the funds, then 37 million shares must be issued:
$500 million / $13.50 = 37 m.
However, the share price of $13.50 is inclusive of a $1 premium, therefore the total benefit to the firm due to share premium is 37m x $1 = $37 m. This is equivalent to $ 0.27 per share. This can be shown as,
12.50 x 100 + 500 = 12.77
100 + (500 /13.50)
The par value is $ 12.50, 12.77 – 12.50 = 0.27, which is the premium per share.
The borrowing cost is $20 m and the firm will compare the $20m borrowing cost with the $37 m benefit accruing from share issue at a premium.
The best choice is to ...
... middle of paper ...
...a benefit and managers would prefer it to debt financing. If the cost of borrowing is zero, and the shares can only be issued at a discount, managers will issue debt to evade the extra equity financing cost. However, investors seek to maximize their money value by buying at the least possible share price that the firm is willing to offer. With no benefit accruable from equity financing, the managers will use debt issue since it has no cost (Berk & Demarzo 2011).
References
Berk & Demarzo, 2011. P. 213-214. Financial distress, managerial incentives, and information...
Pearson Education, Inc publishing.
Ricardo N. Bebczuk, 2003. P. 37-52
Asymmetric information in financial markets: introduction and applications. Cambridge university press.
Xin Chang et al, 2011. P. 7. Capital Structure
http://www.bm.ust.hk/fina/staff/Dasgupta/Chang_Dasgupta_Hilary.pdf)
Therefore, the additional compensation cost $3 per share should be recognized in the 2017 by
Balance sheet lists assets, liabilities and owner’s equity. The assets listed on the balance sheet are acquired either by debt (liabilities) or equity. “Companies that use more debt than equity to finance assets have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and/or an aggressive capital structure can also lead
Based on the information in the case, Pepsi could invest US$360 million in exchange for 30% equity of Deltex. So we have to calculate the value of 30% equity of Deltex. First, we calculated the discount factor by using average unlevered beta of US independent bottlers, US 10 year Treasury bond as risk free rate and assuming market risk premium 10%. We came up with 9.83% of WACC. Next, we calculated Deltex free cash flow and terminal value and then converted them into US dollar value. Now with WACC and total cash flow, we had NPV of the company. So we deducted current debt from NPV and came up with the value of US$360M investment equal to 59.99% of Deltex equity. So the proposal to buy 30% of Deltex with US$360M is too expensive to PepsiCo and not attractive to PepsiCo.
We defined several criteria to determine our choice – return, risks and other quantitative and qualitative factors. Targeting a debt ratio of 40% will maximize the firm’s value. A higher earning’s per share and dividends per share will lead to a higher stock price in the future. Due to leveraging, return on equity is higher because debt is the major source of financing capital expenditures. To maintain the 40% debt ratio, no equity issues will be declared until 1985. DuPont will be financing the needed funds by debt. For 1986 onwards, minimum equity funds will be issued. It will be timed to take advantage of favorable market condition. The rest of the financing required will be acquired by issuing debt.
The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating.
Myers, S.C. 2001, "Capital Structure", The Journal of Economic Perspectives, vol. 15, no. 2, pp. 81-102.
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
In addition, we did the calculation for WACC to be 9.98 % after that we used the DCF analysis. In our analysis we assumed the share will be 20.5 per share. This tell us that the management price was overrated for the IPO and the price were 25 -26. This is will put the management to be under pressure because the price was higher than we estimated, it would cause the company sales in the future and putt the investors in embarrassing situation. Thus, they should recommended the price range 20 to
principle balance at 22.50% interest while paying $32.71 a week for 208 weeks (4 years) will cost a total amount of $6,803.68. That is over $2,000.00 in
The market value is not affected by the firm’s capital structure, that’s what the M&M first proposition stated; in proposition one it is stated that under certain conditions the firm’s debt equity has got no effect on the firm’s market value. This approach is based on the below:
Current cost of equity at 5.96% will be RE=RF+Beta (RM-RF); RE = 3.15% +0.18 (5%-3.15%) = 3.48%
easily pay for the sinking fund. In addition, by buying back bonds. annually, the interest expense is further decreased, thus creating less of a burden on the cash flow. In contrast, an equity-financed. acquisition would spread the net income out over 3 million more.
...ffer of $3,000,000/1 million shares = $3 per share. Compared to the current price per share of $2.50, this represents a 20% premium. The price per share of XYZ upon the announcement will therefore be $3, and the price per share of ABS upon the announcement will be $20 – 20% x $2.50 = $19.50.
The reason I select Masteel’ stock to analyse is because I have looked back the historical stock chart of Masteel from 2009 to 2015, it is a declining price movement. Masteel achived the highest RM1.5 price in 2011 but it reduced to RM0.4 price in 2015. This historical price of stock in Masteel made me curios on its current intrinsic value and are this stock is worth to invest now? Thus, I would like to analyse Masteel’s stock value through stock valuation in part B, to figure out whether Masteel is worth to invest now and expect the price will increase in future.
3. The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $113.10. Harry Davis would incur flotation costs of $2.00 per share on a new issue.