The decision as to how to organize the debt structure of a company is very important. The choice between equity and bonds as a form of debt is perhaps the most important decision a large company can make. ABC Golf Equipment is no longer a growing company but rather an established company with fairly secure profits. The decision to use profits buy back stocks and issue bonds really depends highly on the interest rates paid to equity shareholders and to bonds holders. Given the increase in risk due to debt now being owed to bond holders the interest payment to shareholders will increase. The question really becomes: is this increase offset by a decrease in costs given lower interest payments to bond holders. It is clear that in this instance the final cost on interest will increase if the company moves to 25% funding through the sale of Bonds. Thus it is highly recommended that the company does not change the current capital structure.
The Value of the Company
The overall value of the company will decrease by roughly 1% given the overall cost in terms of interest expenses will increase from 11% to 12%. The increase in cost of equity will not be offset by the lower payments that will be made to bond holders. Thus in this instance it is not in the best interest of the company to restructure capital.
Earnings Per Share
The Earnings per Share will rise as the company has increased risk. The shareholders will need to be compensated for taking on more risk given that bond holders will have to be paid back regardless of the financial scenario of the company. Take the 5% chance that the company as a EBIT of -1 000 000$. In this case the company will have to sell off assets to repay the bond holders. Given the company will still have a net worth above this loss the company will not be bankrupt and thus will be required to pay back the bond holders. Given this is a serious risk to equity holders they will have to be compensated by a higher dividend per share.
The New Stock Price
The company’s stock will drop by roughly 1%. This we know since the stock price will reflect the accounting value of the company. We know the accounting value of the company will drop by 1% given that the cost in terms of interest will rise by 1%. Again this move is not recommended. If the company was growing, then the stock price might rise on the expectation of higher future profits. However, this is not the case.
There are many reasons a company would consider moving from equity debt to debt to bond holders. The key reason is that companies have to pay taxes on all dividends and capital gains however they do not have to pay tax on interest payments on bonds . The key decision then hinges on whether or not over all costs will increase of decrease and how much revenues will increase and decrease by after the capital restructuring.
Advantages of Equity Financing
A key advantage to equity financing are that you use all available cash from the sale of stocks. You can start the business without the problem of debt. Shareholders are owners so you simply continue with business as usual with a different make up of owners. The second key advantage to equity is that it is less risky to the shareholders. That is, you don’t have to explain to any one that debt needs to be paid back.
Disadvantages to Equity Financing
The big disadvantage is that you no longer will have ownership of the company. Equity is ownership. Thus you will not necessarily be able to control the company after equity. Since others own a piece of your business you will be responsible to them. You will still want to grow the company as clearly any equity holder will want the stocks to be values as high as possible. However, you may no longer be able to grow the company exactly how you wanted.
Advantages to Debt Financing
The big advantage to financing through debt is you will maintain ownership of the company. You do not have to listen to equity shareholders. Rather you can direct the capital of the company as you see fit. Another key advantage is that the interest payments to bond holders is tax deductible. This can result in major savings depending on the size of your company.
Disadvantages to Debt Financing
The major disadvantage is that you need to pay back the debt to the bond holders. This can be easy if the company grows a great deal but it could end up being very difficult. All profits of the company can only be considered after you have taken off the repayments to the bond holders. Even if the company is losing money you still need to pay back the bond holders. This can be a major burden and is a serious source of increased risk.
The decision to finance through debt of through equity really comes down to the size and goals of the company. The bottom line is that if the company is growing and the owners want to maintaining complete control then financing through debt is a much better option. This will allow the owner to grow the company as they see fit. On the other hand, if equity holders will not change the direction of the company and re payment of debt is a serious rick then equity ownership is the best. The bottom line is in either situation you will have to be responsible to someone. In the case of debt, it will be to the bond holders, you will need to make a profit to pay them back. In the case of equity, it will be to the shareholders. Thus it really depends on how much you value control of a given company and how much you are worried about the repayment of debt.
Answers from Excel
1. The key to understanding the value of the company after the recapitalization is to look at the interest expenses. Since the company is not expecting to earn any more profit this is the key variable. Before the recapitalization the cost of equity was 11%. Since the company had no debt this is the entire interest cost. After the company switches to 25% debt financed it will then have a weighted interest expense. That is it will be: .25x.09 + .75x.13 = .12, or 12%. The bottom line is revenues will remain the same while profits cost increase by 1% given the increased interest payment. Thus the overall value of the company will decrease by 1%.
2. The formula for Earnings per Share can be calculated by multiplying 13% by the new stock price. The new Stock price will be 1% lower given the company will earn less. WE know this because the Market value of the firm is the same as the book value. The original Earning per share was 27x.11 = 2.97$. This will rise to .13×26.73 = 3.47$.
3. As discussed we know the market value of the company is the same as the book value. The book value will fall by 1% given an increase in costs of 1%. Thus the stock price will fall by 1% to 26.73$.
4. The EBIT is determined as the expected value. The expected value is the summation of the probability of each event times the EBIT given that event. Thus it is .05x-1000000 + .25×2300000 + .4×4000000 + .25×5800000 + .05×6100000 = 3880000. This represents the most likely outcome. Not that in the real world the EBIT will not be 3 880 000, it will be a different number, however this is the expected value given different outcomes are possible.
5. The formula for the times interest eared ratio is:
For each scenario that calculation is as follows.
-1000000/.12 = -83 333 333
2300000/.12 = 19 166 666
4000000/.12 = 33 333 333
5 800 000/.12 = 48 333 333
6100000/.12 = 50 833 333