During recent years your company has made considerable use of debt financing, to

Question

During recent years your company has made considerable use of debt financing, to the extent that it is generally agreed that the percent debt in the firm's capital structure is too high. Further use of debt will likely lead to a drop in the firm's bond rating. You would like to recommend that the next major investment be financed with a new equity issue Unfortunately, the firm has not been doing very well recently (nor has the market). In fact, the rate of return on investment has just been equal to the cost of capital. As shown below, the market value of equity is less than book value Total market value of equity 2,000 Number of shares outstanding 1,000 Price per share $ 2.00 Book value per share $4.00 Total earnings for the year S 600 Earnings per share S.60 This means that even a profitable project will decrease earnings per share if it is financed with new equity. For example, the firm is considering a project which costs $400 but has a value of S500 (i.e. an NPV of 100), and which will increase total earnings by $60 per year. Ifit is financed with equity, the S400 will require approximately 200 shares, thus bringing the total shares outstanding to 1200 The new earnings will be S660, and earnings per share will fall to S.55. The president of the firm argues that the project should be delaved for three reasons. a) It is too expensive for the firm to issue new debt. b) Financing the project with new equity will reduce Earnings Per Share because the market value of equity is less than book value. c) Equity markets are currently depressed. If the firm waits until the marke will exceed the book value and equity financing will no longer reduce Earnings Per Share. t index improves, the market value of equity Critique the president's logic.

Explanation / Answer

While the president's logic with respect to inclusion of debt appears to be correct, his opinion regarding reduction in EPS because of issue of new equity to undertake expansion/new project doesn't seem to be correct. More debt inclusion, in the given case, will result in a decrease in bond ratings (for the company) which in turn will affect the company's market value in an adverse way. Not only this, higher debt in the capital structure increases the financial risk for the company (because of fixed interest obligation). Therefore, the company should use equity as the only means to finance any new project/investment.

While the inclusion of new equity may affect the current EPS (because of book value being less than market value), the company can realise the benefits of the new project/investment over a longer period of time, provided it generates a positive NPV for the company. Expansion/New projects are generally viewed favorably by the investors as such projects may increase the overall value of the company and may result in capital appreciation for the shareholders (resulting from increase in company's share price). This in turn is likely to increase the EPS. Therefore, the focus shouldn't be on the immediate effect of accepting a new project/investment. Further, it is essential to understand that an opportunity available now may not be available in the future. If the company continues to wait for the market situation to improve, it may lose a potential profitable investment which can affect its long term growth prospects. Therefore, the company should raise capital through equity and accept the new project, if it is expected to provide positive results in the long run.

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