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 extant 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 $ 600

Earnings per share $ .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 $500 (i.e. an NPV of 100), and which will increase total earnings by $60 per year. If it is financed with equity, the $400 will require approximately 200 shares, thus bringing the total shares outstanding to 1200. The new earnings will be $660, and earnings per share will fall to $.55. The president of the firm argues that the project should be delayed 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 market index improves, the market value of equity will exceed the book value and equity financing will no longer reduce earnings per share. Critique the president’s logic.

Explanation / Answer

While the president's logic regarding the cost of debt (argument 1) is correct, the other 2 arguments don't appear to be logical. Inclusion of more debt in the capital structure would increase the risk profile of the company because of its fixed obligation to pay interest. Further, it would result in a decline in the bond rating which again is not a favorable proposition as it can affect the overall market value of the company.

While the acceptance of new project may reduce the value of EPS initially, it would produce positive results in the near future as it is expected to generate a positive NPV (Net Present Value) which would result in an increase in net income. Also, considering EPS as the only peformance measure is not correct. A project with a positive NPV would indicate that a company is able to earn a rate of return higher than its cost of capital indicating a favorable situation for the company. Projects with positive NPVs are generally accepted as they enhance the market value of the firm and add value to the shareholder's wealth. It is, therefore, essential for the company to determine the project's NPV and evaluate its benefits over a longer period rather than immediate impact on EPS. Even if the project produces a zero NPV, the company should consider the project as it will improve the overall value of the firm as the market improves.

While the equity markets are currently depressed, the company cannot afford to delay the acceptance of the project as such an opportunity may not be available later on. If the project is expected to produce a positive or zero NPV, the company will in no case lose money and will be able to recover its investment with increase in shareholder's value over a period of time. As market improves, the company's market value will increase with this project.

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