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Disadvantages Of Equity Financing

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 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 been equal to the cost of capital. As shown below, the market value of equity is less than book value.

Final market value of equity

$2000

Number of shares outstanding

1000

Price per share

$2.00

Book value per share

$4.00

Total Earnings for the year

$600

Earnings per share

$0.60

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 $0.55. 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 the 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.

You are required to critique the president’s logic.

 

Summary

The question belongs to Finance and it discusses about a firm which wants to take up equity financing to finance a new project and the disadvantages of it.

Total Word Count 510

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