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Debt vs.

equity financing is one of the most important decisions facing managers who need
capital to fund their business operations. Debt and equity are the two main sources of capital
available to businesses, and each offers both advantages and disadvantages.

DEBT FINANCING

Debt financing takes the form of loans that must be repaid over time, usually with interest.
Businesses can borrow money over the short term (less than one year) or long term (more than
one year)

However, debt financing also has its disadvantages. New businesses sometimes find it difficult
to make regular loan payments when they have irregular cash flow. In this way, debt financing
can leave businesses vulnerable to economic downturns or interest rate hikes

EQUITY FINANCING

Equity financing takes the form of money obtained from investors in exchange for an
ownership share in the business. Such funds may come from friends and family members of
the business owner, wealthy "angel" investors, or venture capital firms. The main advantage to
equity financing is that the business is not obligated to repay the money. Instead, the investors
hope to reclaim their investment out of future profits

The main disadvantage to equity financing is that the investors become part-owners of the
business, and thus gain a say in business decisions. "Equity investors are looking for a partner
as well as an investment, or else they would be lenders," venture capitalist Bill Richardson
explained in Pacific Business News (Jefferson, 2001). As ownership interests become diluted,
managers face a possible loss of autonomy or control. In addition, an excessive reliance on
equity financing may indicate that a business is not using its capital in the most productive
manner.

ADVANTAGES OF DEBT COMPARED TO EQUITY

Because the lender does not have a claim to equity in the business, debt does not dilute the
owner's ownership interest in the company.
If the company is successful, the owners reap a larger portion of the rewards than they would if
they had sold stock in the company to investors in order to finance the growth.

Interest on the debt can be deducted on the company's tax return, lowering the actual cost of
the loan to the company.

Raising debt capital is less complicated because the company is not required to comply with
state and federal securities laws and regulations.

DISADVANTAGES OF DEBT COMPARED TO EQUITY

Unlike equity, debt must at some point be repaid.

Interest is a fixed cost which raises the company's break-even point. High interest costs during
difficult financial periods can increase the risk of insolvency. Companies that are too highly
leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow
because of the high cost of servicing the debt.

Debt instruments often contain restrictions on the company's activities, preventing


management from pursuing alternative financing options and non-core business opportunities.

The larger a company's debt-equity ratio, the more risky the company is considered by lenders
and investors. Accordingly, a business is limited as to the amount of debt it can carry.

The three assumptions under perfect capital market:

1. Investors and firms can trade the securities at competitive market prices equal to the
present value of their future cash flows.

2. There are no taxes and transaction cost associated with security trading.
3. A firms financing decision do not effect cash flows generated by their investment.

Under these conditions, Modigliani and Miller proposed their proposition.

Proposition 1

In a perfect capital market, the total value of firm should not depend on its capital structure.
Changing the capital structure does not change the total cash flows. Therefore the total value of
the assets that give ownership of these cash flows should not change.

Regardless of how firms choose to finance its decision, the total value will still be the same.
The firm cash flow will still be $1000 regardless of how firm chose to finance it.

However, it is possible for investors to have their preferred capital structure with their
homemade leverage. With this method, although the firm’s value is not affected by its choice
of capital structure, an investor can borrow and add leverage to his or her own portfolio as
long as it’s at the same interest rate level as the firm.

For example, if an investor would prefer a company to be more highly geared this can be
stimulated by buying shares and borrowing against them.

Useful device of MM proposition 1 is the market value balance sheet. It’s argued that value is
created by the choice of assets and investments. However, the choice of capital structure does
not change the value of the firm. Instead, it merely divides the value of firm into different
securities.

Market value of equity = Market value of assets – market value of debt and liabilities

Hence, one can choose to have more debt and the market value would still stay the same.
MM 1 also proposed that a leverage recapitalization will not change the share price. This
occurs when firm borrow money (issue debt) and repurchase shares (or pay dividend). Since the
transaction consist of zero NPV, benefits = costs, thus, does not change the value for
shareholders.

Proposition 2

The cost of capital levered equity increases with the debt-equity ratio. While debt itself may be
cheap, it increases the risk and therefore the cost capital of firm’s equity.

Cost of capital of levered equity

Re = ru + D/E ( ru- rd )

M&M Proposition II states that the value of the firm depends on three things:

1) Required rate of return on the firm's assets (Ru)


2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

This equation reveals the effect of leverage on the return of the levered equity. The levered
equity return equals the unlevered return, plus and extra “kicks” due to leverage. The amount
of risk depends on the amount of leverage, measured by the debt-equity ratio.

MM on WACC

We can use the MM theory to understand the effect of leverage on the firms cost of capital for
new investment. If a firm is financed with both equity and debt, then the risk of its asset will
match the risk of its equity and debt since

rwacc = E/E+D re + D/E+D rD.

That is, with a perfect capital market, a firms’ WACC is independent of its capital structure and
therefore, is equal to its cost of capital for equity and its cost of capital of debt. As firm borrow
at a low cost of capital for debt, its equity rises. The net effect is that a firm WACC remains
unchanged.
Although both equity and debt rise when leverage is high, because more weight is put on the
lower cost debt, WACC remain constant. Although debt has a lower cost of capital, it does not
lower a firm’s WACC. These allow us to conclude that the enterprise value of a firm does not
depend on its financing choices.

Weighted Average Cost of Capital (WACC) does not have any relationship with the
Debt/Equity ratio. This is the basic identity of M&M Proposition I and II, that the capital
structure of the firm does not affect its total value. This implies that the cost of equity must
rise as financial risk increases.

Proposition 3

The third proposition establishes that firm market value is independent of its dividend policy.
Bhattacharya (1979) and others however, show that firm dividend policy can be a costly
device to signal a firm’s state. Taxes are another important friction which effect dividend policy.

Capital structure fallacies

Alternative to MM, many researchers turned their attention to market ‘imperfections’ that
might make firm’s value dependable on their capital structure. The main reasons were:

Tax that encourages debt

Expected costs of financial distress that increases with increasing amount of debt

In 1970s, there’s also a discussion on “signaling” effects, such as the tendency for stock prices to
fall in response to new equity issues and to rise on the news of stock buyback. These effects
confirm the existence of large ‘information cost’ that could influence financing choices in
predictable ways.

Although MM proposition 1 and 2 states that with perfect capital markets, leverage has no
effect on firm’s value or the firm’s cost of capital, there have been some arguments against this
theory.
Leverage can increase a firms expected earnings per share.

Example, LVI is an all equity industry; it expects to generate earnings before taxes (EBIT) of $10
million. Currently, LVI has 10 million outstanding shares trading for $7.50 per share. LVI is
considering changing the structure by borrowing $15million at an interest of 8% and using the
proceeds to purchase 2 million shares at $7.50 per share.

Considering, LVI in a perfect market with no debt. Since LVI pay no interest, and in perfect
capital market there is no such thing as taxes, LVI earnings would equal its EBIT. Thus,

EPS= Earnings/ number of shares

= $10 million/ 10 million = $1

The new debt will oblige LVI to make interest payment of each year of

$15million * 8% interest/year = $1.2 million/year

As a result, earnings would be = EBIT- interest

= $10 million- $1.2 million = $8.8 million, hence

EPS= $8.8million/8million = $1.10

**8million shares is due to the share repurchase

So, evidently, EPS increases with leverage. This increase might appear to make shareholder
better off and could potentially lead to an increase in stock price. When earnings are low,
leverage will cause EPS to fall even further than it otherwise would.

Trade-off theory

Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to
financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with
debt.

The trade-off theory predicts that firms with safe, tangible assets and lots of tangible income to
shield should have higher debt ratios. On the other hand, unprofitable firms with risky,
intangible assets should rely more on equity financing and have low debt ratios.
Clifford Smith summarizes his research by concluding that all leverage-increasing transactions
are good news and leverage-decreasing transactions are bad news.

Myers stated in his article “Searching for Optimal Capital Structure”, announcement of stock
issues drive down stock price, but repurchases pushes them up.

Pecking order theory

Myers observed that most US public companies appeared to follow a financing “pecking order”.
He suggested that pecking order maximized firm value by maximizing expected information
costs. By using this method of financing, firm uses their retained earnings as a source of capital
first and if needed they’ll issue debt first than equity.

Pecking order theory predicts that most profitable firms have less need for external funds and,
therefore, borrow less. On the other hand, less profitable firms issue debt because they do not
have sufficient funds for their capital investment programs and because debt is first in the
pecking order for external financing