OK, I will come right out and say it. I am doing a take-home final for my corp finance class and have this one question that involves calculating WACC. I did that, no problem. One part of the question asks what the pros and cons are for issuing debt and equity to raise capital. Below are some ideas I have so far. I am just looking for some other ideas, not flat out specific answers. I just want to kick ass on this final.

Here are some of my thoughts so far. For this company, I calcluated that cost of equity is about 9.8% via the CAPM model. We were given that this company can issue long-term debt at a rate of 6.5%. So from purely a numbers standpoint, it would be cheaper to issue additional debt than equity, assuming the company is not highly levered right now. Turns out debt is about 25% of their total capital structure, so not really that high.

If this company issued an additional $100 million of debt, their WACC drops about 0.1% and debt makes up about 35% of their total capital.

So my take is that wrt this company, they are better off issuing debt as long as they can secure it at 6.5%.

In general, the pros of issuing equity is that the company may be highly levered and cannot issue anymore debt, which is not the case here. So debt covenants must be preserved which at times force companies to issue more equity to raise capital. Cons of equity would be that the cost of equity is almost always greater than the cost of debt. So unless you simply cannot issue more debt, it would seem like debt is the better choice.

Cons of debt would be that the company could run the risk of breaking debt covenants which could result in higher rates or having to paydown loans in full, which could force them into bankruptcy. Also, issuing additional debt could add additional covenants that limited dividend payments even more, which could in turn affect stock price and make the cost of equity increase, thus making the option of issuing equity more difficult.

 

aaarrrggghhhh, flashbacks of finance class!!!!


my head hurts

 

I actually liked the material in this class, just not the instructor. I am cool with numbers in general, so this was not too bad.

 

Just do not issue too much debt as your risk increases and the 6.5% rate can bump up. The interest payments are a good tax shield too. A good balance of equity vs debt is always good for a company.

 

Out of curiosity, what kind of Company has a CoE of 9.8% but can only borrow debt at 6.5%?

 

One that does not have much debt issued I suppose. This 6.5% rate was merely an assumption given to us for this project for future year projections.

 

Right, that relates to optimal capital structure. I was talking with a colleague and he had some good points, such the more worthy the project that need financing, the more likely a bank is to finance it because there is a greater chance of getting their money back on the investment. Also, if the company's market value for its stock is undervalued, then they might not want to issue at that time.

 

When their stock is undervalued what they can do is buy back stock with money the company has. Demand and supply makes wonders; the stock price has a chance to go up, so they can sell it again. A study requires to be done in order to see if taking a loan from the bank in order to buy back stock can give a better ROI, and thus payback the loan when issuing stock later.

 

Thanks dude, that is good stuff!

 

I didn't read your entire post so this may be a repeat. Generally issuing debt is seen as a stronger financial sign by rating agencies then equity. There is no financial obligation associated with equity issues (dividends are not required). However, when issuing debt whether it be bonds, commercial paper, etc companies are tied to those instruments via their obligations on interest payments. One pro of debt financing is that interest payments are tax deductable. In the event of bankruptcy, debt holders get paid before equity or shareholders do. Most of that is pretty basic, if you need anything more in depth let me know.