When you are setting up a business or want to finance a project, you either finance it from your savings; savings of relations or through issuance of common stock as an equity stake in the business or you borrow. So invariably, you have debt financing, equity financing or mixture of the two, which is known as capital structure. The decision to borrow or not involves many factors, including how much debt the company already has, the predictability of the company’s cash flow and how comfortable the management or owners of the firm are in working with outsiders, especially if equity financing is being considered. Whether debt-financing or equity-financing, each has its inherent merits and demerits.
Equity financing means issuing more shares, especially for listed companies or seeking new partners. With equity financing, you have less risk, because there is no fixed loan repayments. Also, it has no impact on a company’s profitability, but can dilute existing shareholders’ holding/interest, thus reducing the earnings per share; because the company’s net income is divided among a larger number of shares. Financing using equity also increases the par value of stock.
On the other hand, debt financing, does not dilute ownership, but interest payments reduce net income and cash flow, though the reduction in net income represents a tax benefit. Also, debt financing comes with covenants as such the firm must meet certain conditions such as interest coverage and debt-level requirements and more of it can lead to bankruptcy.
Therefore, one, when looking for funds to finance a business or a project, has to carefully consider the advantages and disadvantages inherent, (as explained above), the impact of each of them will have and/or the mix (capital structure) on profitability, market value of the firm/project and the expected return. Before doing that, let us draw reference from some theorists on this:
The Irrelevance Capital Structure theorist, believes, that in a perfect market, the financing decision or the capital structure does not matter and so irrelevant; and as such does not affect the firm’s operating income, the total market value of the securities/firm/project or the expected return. They assert that a firm value is determined by the real asset of the firm, that is, the expected return on asset (rA) is the proportion of debt multiplied by expected return on debt plus proportion of equity multiplied by expected return on equity, while expected return on equity is rE = rA + D/E (rA – rD) or EPS/MPS.
On the other hand, the Proposition II theorist believes that expected return on the common stock of a levered firm increases as the debt-equity ratio increases. And that the rate of increase depends on the spread between return on asset and return on debt. As a firm borrows more, the risk of default increases and the firm is required to pay higher rates of interests. The more debt the firm has, the less sensitive, return on equity is to further borrowing. This is so, because as a firm borrows, more of the risk is transferred from equity holders to creditors, which invariably will increase expected rate of return.
Typically, cost of equity, is often higher than the cost of debt, because equity financing poses greater risk to investors than is debt financing to the lender. Expected return on equity increases linearly with the debt-equity ratio, so long as debt is risk-free, otherwise, whatever decrease in expected return is offset by an increase in risk and therefore in shareholders’ required rate of return, hence the indifference in using debt to finance projects or expand business? Therefore, debt increases both the expected return on equity and risk of equity as investors require higher return on levered equity to simply match the increases risk.
Notwithstanding the foregoing, what is important in determining a firm’s optimal capital structure is the cost of capital or WACC that will give a net present value (NPV) that would not change the business risk of the firm. The WACC comprises of cost of equity and cost of debt, expressed either as a percentage or as a Naira amount depending on the situation. Typically, the cost of equity is higher than the cost of debt, as such increasing equity financing usually increases cost of capital (Weighted average cost of capital – WACC). On one hand, it is believed that a financing decision cardinal objective is not to maximize overall market value but to minimize WACC while some believe that maximization or maximizing a company’s overall market value is cardinal.
WACC being the expected rate of return on the market value of all the firm’s securities, so anything that increases the value of the firm should as well reduce the WACC if operating income is stable. But the warning is that shareholders are more interested in getting rich that is increasing the value of the firm than reducing the WACC.
Either way, the important thing is that the return expected from the project should exceed the return from a risk-free asset investment. Therefore, the cost of capital is primarily dependent upon the use of funds not the source.