Ebook Finance - Capital Markets, Financial Management, and Investment Management: Part 2

Ebook Finance - Capital Markets, Financial Management, and Investment Management: Part 2 presents the following content: The Corporate Financing Decision; Financial Engineering, Asset Securitization, and Project Financing; Capital Budgeting: Process and Cash Flow Estimation;...Please refer to the documentation for more details.
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Ebook Finance - Capital Markets, Financial Management, and Investment Management: Part 2 CHAPTER 11 The Corporate Financing Decision business invests in new plant and equipment to generate additional A revenues and income—the basis for its growth. One way to pay for investments is to generate capital from the company’s operations. Earnings generated by the company belong to the owners and can either be paid to them—in the form of cash dividends—or plowed back into the company. The owners’ investment in the company is referred to as owners’ equity or, simply, equity. If earnings are plowed back into the company, the owners expect it to be invested in projects that will enhance the value of the com- pany and, hence, enhance the value of their equity. But earnings may not be sufficient to support all profitable investment opportunities. In that case management is faced with a decision: Forego profitable investment oppor- tunities or raise additional capital. New capital can be raised by either bor- rowing or selling additional ownership interests or both. The decision about how the company should be financed, whether with debt or equity, is referred to as the capital structure decision. In this chapter, we discuss the capital structure decision. There are different theories about how the firm should be financed and we review these theories in this chapter. In the appendix to this chapter, we present a theory about the capital struc- ture proposed by Franco Modigliani and Merton Miller. DEBT VS. EQUITY The capital structure of a company is some mix of the three sources of capi- tal: debt, internally generated equity, and new equity. But what is the right mixture? The best capital structure depends on several factors. If a company finances its activities with debt, the creditors expect the interest and prin- cipal—fixed, legal commitments—to be paid back as promised. Failure to pay may result in legal actions by the creditors. If the company finances its activities with equity, the owners expect a return in terms of cash dividends, an appreciation of the value of the equity interest, or, as is most likely, some combination of both. 375 376 FINANCIAL MANAGEMENT Suppose a company borrows $100 million and promises to repay the $100 million plus $5 million in one year. Consider what may happen when the $100 is invested: ■ If the $100 million is invested in a project that produces $120 million, the company pays the lender the $105 million the company owes and keeps the $15 million profit. ■ If the project produces $105 million, the company pays the lender $105 million and keeps nothing. ■ If the project produces $100 million, the company pays the lender $105 million, with $5 million coming out of company funds. So if the company reinvests the funds and gets a return more than the $5 million (the cost of the funds), the company keeps all the profits. But if the project returns $5 million or less, the lender still gets her or his $5 million. This is the basic idea behind financial leverage—the use of financing that has fixed, but limited payments. If the company has abundant earnings, the owners reap all that remains of the earnings after the creditors have been paid. If earnings are low, the creditors still must be paid what they are due, leaving the owners nothing out of the earnings. Failure to pay interest or principal as promised may result in financial distress. Financial distress is the condition where a com- pany makes decisions under pressure to satisfy its legal obligations to its creditors. These decisions may not be in the best interests of the owners of the company. With equity financing there is no obligation. Though the company may choose to distribute funds to the owners in the form of cash dividends, there is no legal requirement to do so. Furthermore, interest paid on debt is deduct- ible for tax purposes, whereas dividend payments are not tax deductible. One measure of the extent debt is used to finance a company is the debt ratio, the ratio of debt to equity: Debt Debt ratio = Equity This is relative measure of debt to equity. The greater the debt ratio, the greater the use of debt for financing operations, relative to equity financing. Another measure is the debt-to-assets ratio, which is the extent to which the assets of the company are financed with debt: Debt Debt-to-assets ratio = Total assets The Corporate Financing Decision 377 This is the proportion of debt in a company’s capital structure, measured using the book, or carrying value of the debt and assets. It is often useful to focus on the long-term capital of a company when evaluating the capital structure of a company, looking at the interest-bear- ing debt of the company in comparison with the company’s equity or with its capital. The capital of a company is the sum of its interest-bearing debt and its equity. The debt ratio can be restated as the ratio of the interest-bear- ing debt of the company to the equity: Interest-bearing debt Debt-equity ratio = Equity and the debt-to-assets can be restated as the proportion of interest-bearing debt of the company’s capital: Interest-bearing debt Debt-to-capital ratio = ...