Course: Corporate Finance Part II
CHAPTER 14: Evaluating Equity and Debt Financing: Key Considerations for
Raising Funds
To raise funds, rms have to decide what type of security they will sell to investors.
What considerations are important?
Dan Harris, Chief Financial O cer of Electronic Business Services (EBS), has plans for
a major expansion. EBS plans to raise $50 million from outside investors.
One possibility is selling shares of EBS stocks. Due to the rm’s risk, Dan estimates
that equity investors will require a 10% risk premium over the 5% risk-free interest rate.
So the company’s equity cost of capital is 15%.
Some senior executives at EBS, however, have argued that they should consider
borrowing $50 million instead. EBS has not borrowed previously and, given its strong
balance sheet, it should be able to borrow at a 6% interest rate.
Does the low interest rate of debt make borrowing a better choice of nancing for
EBS? If EBS does borrow, will this choice a ect the NPV of the expansion, and
therefore change the value of the rm and its share price?
Equity vs Debt Financing
The relative proportions of debt, equity, and other securities that a rm has outstanding
constitute its capital structure. When corporations raise funds from outside investors,
they must choose which type of security to issue. The most common choices are
nancing through equity alone and nancing through a combination of debt and equity.
Capital structure ➝ the relative proportion of debt, equity and other securities that a
rm has outstanding
Does the choice of capital structure a ect the value of the rm?
Law of One Price ➝ If equivalent investment opportunities trade simultaneously in
di erent competitive markets, then they must trade for the same price in all markets.
One useful consequence of the law of one price is that when evaluating costs and
bene ts to compute a net present value, we can use any competitive price to
determine a cash value, without checking the price in all possible markets.
In perfect markets, securities are fairly priced, there are no taxes or transaction costs,
cash ow is not a ected by type of nancing.
In real life, markets are not perfect and CF is a ected by market imperfections:
• Taxes and debt
• Costs of nancial distress
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, Course: Corporate Finance Part II
• Changes in managerial incentives
• Dividends or stock repurchases
Financing a Firm with Equity
You are considering an investment opportunity. For an initial investment of $800 this
year, the project will generate cash ows of either $1400 or $900 next year, depending
on whether the economy is strong or weak, respectively. Both scenarios are equally
likely.
The project cash ows depend on the overall economy and thus contain market risk.
As a result, you demand a 10% risk premium over the current risk-free interest rate of
5% to invest in this project.
What is the NPV of this investment opportunity?
Cost of capital = 10% + 5% = 15%
Expected CF = 0.5 (1400) + 0.5 (900) = 1150
Because probability of strong and weak economy are both equally likely
$1150
NPV = -$800 + = -$800 + $1000 = $200.
1.15
We discount the expected CF using the cost of capital. We also take into account the
initial investment.
Thus, the investment has a positive NPV.
NPV > 0 ➝ the project is expected to result in pro ts for the company
NPV < 0 ➝ the project is expected to result in losses for the company
NPV = 0 ➝ the project is not expected to result in any signi cant gain or loss for the
company.
If this project is nanced using equity alone, how much would investors be willing to
pay for the rm’s shares?
$1150
PV (equity cash flows) = = $1000
1.15
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, Course: Corporate Finance Part II
Since the rm has no other liabilities (the project is all equity- nanced), the equity
holders will receive all of the cash ows generated by the project on that date.
In the absence of arbitrage, the price of a security equals the present value of its cash
ows.
If you can raise $1000 by selling equity in the rm, after paying the investment cost of
$800, you can keep the remaining $200, the NPV of the project NPV, as a pro t. In this
case, the project NPV represents the value to the initial owners of the rm created by
the project.
Equity in a rm with no debt is called unlevered equity
Unlevered equity ➝ equity in a rm with no debt
Because there is no debt, the cash ows of the unlevered equity are equal to those of
the project.
Given equity’s initial value of $1000, shareholders’ returns are either 40% or -10%
The strong and weak economy outcomes are equally likely, so the expected return on
the unlevered equity is 0.5 (40%) + 0.5 (-10%) = 15%.
Because the risk of unlevered equity equals the risk of the project, shareholders are
earning an appropriate return for the risk they are taking.
Risk of unlevered equity = risk of the project ➝ shareholders are earning an appropriate
return for the risk they are taking
Financing a Firm with Debt and Equity
Suppose you decide to borrow $500 initially, in addition to selling equity. Because the
project’s cash ow will always be enough to repay the debt, the debt is risk free, and
you can borrow at the risk-free interest rate of 5%. You will owe the debt holders $500
× 1.05 = $525 in one year.
Amounted due to debt holders = amount borrowed x (1+ rf)
Levered equity ➝ equity in a rm with debt outstanding
Promised payments to debt holders must be made before any payments to equity
holders are distributed. So, given the rm’s $525 debt obligation, shareholders will
receive:
• $875 ($1400 – $525 = $875) ➝ strong economy
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, Course: Corporate Finance Part II
• $375 ($900 – $525 = $375) ➝ weak economy
What price E should the levered equity sell for? Which is the best capital structure for
the company?
Modigliani and Miller proposed an answer to this question. They argued that with
perfect capital markets, the total value of a rm should not depend on its capital
structure. They reasoned that the rm’s total cash ows would still equal the cash
ows of the project and, therefore, have the same present value of $1000 calculated
earlier.
Modigliani Miller ➝ in perfect capital markets, the total value of the rm does not
depend on its capital structure
Because the cash ows of the debt and equity sum to the cash ows of the project, by
the Law of One Price the combined values of debt and equity must be $1000.
Therefore, if the value of the debt is $500, the value of the levered equity must be $500.
E = $1000 – $500 = $500.
Because the cash ows of levered equity are smaller than those of unlevered equity,
levered equity will sell for a lower price ($500 versus $1000). However, the fact that
equity is less valuable with leverage does not make you worse o . You will still raise a
total of $1000 by issuing both debt and levered equity. Consequently, you would be
indi erent between these two choices for the rm’s capital structure.
The E ect of Leverage on Risk and Return
Leverage increases the risk of the equity of a rm.
Therefore, it is inappropriate to discount the cash ows of levered equity at the same
discount rate of 15% that you used for unlevered equity. Investors in levered equity
will require a higher expected return to compensate for the increased risk.
Levered equity is more risky than unlevered equity and will thus require a higher
expected return.
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CHAPTER 14: Evaluating Equity and Debt Financing: Key Considerations for
Raising Funds
To raise funds, rms have to decide what type of security they will sell to investors.
What considerations are important?
Dan Harris, Chief Financial O cer of Electronic Business Services (EBS), has plans for
a major expansion. EBS plans to raise $50 million from outside investors.
One possibility is selling shares of EBS stocks. Due to the rm’s risk, Dan estimates
that equity investors will require a 10% risk premium over the 5% risk-free interest rate.
So the company’s equity cost of capital is 15%.
Some senior executives at EBS, however, have argued that they should consider
borrowing $50 million instead. EBS has not borrowed previously and, given its strong
balance sheet, it should be able to borrow at a 6% interest rate.
Does the low interest rate of debt make borrowing a better choice of nancing for
EBS? If EBS does borrow, will this choice a ect the NPV of the expansion, and
therefore change the value of the rm and its share price?
Equity vs Debt Financing
The relative proportions of debt, equity, and other securities that a rm has outstanding
constitute its capital structure. When corporations raise funds from outside investors,
they must choose which type of security to issue. The most common choices are
nancing through equity alone and nancing through a combination of debt and equity.
Capital structure ➝ the relative proportion of debt, equity and other securities that a
rm has outstanding
Does the choice of capital structure a ect the value of the rm?
Law of One Price ➝ If equivalent investment opportunities trade simultaneously in
di erent competitive markets, then they must trade for the same price in all markets.
One useful consequence of the law of one price is that when evaluating costs and
bene ts to compute a net present value, we can use any competitive price to
determine a cash value, without checking the price in all possible markets.
In perfect markets, securities are fairly priced, there are no taxes or transaction costs,
cash ow is not a ected by type of nancing.
In real life, markets are not perfect and CF is a ected by market imperfections:
• Taxes and debt
• Costs of nancial distress
fi ff fifl fi fi ff ffi fi fifi ff ff ff fi fi fi
, Course: Corporate Finance Part II
• Changes in managerial incentives
• Dividends or stock repurchases
Financing a Firm with Equity
You are considering an investment opportunity. For an initial investment of $800 this
year, the project will generate cash ows of either $1400 or $900 next year, depending
on whether the economy is strong or weak, respectively. Both scenarios are equally
likely.
The project cash ows depend on the overall economy and thus contain market risk.
As a result, you demand a 10% risk premium over the current risk-free interest rate of
5% to invest in this project.
What is the NPV of this investment opportunity?
Cost of capital = 10% + 5% = 15%
Expected CF = 0.5 (1400) + 0.5 (900) = 1150
Because probability of strong and weak economy are both equally likely
$1150
NPV = -$800 + = -$800 + $1000 = $200.
1.15
We discount the expected CF using the cost of capital. We also take into account the
initial investment.
Thus, the investment has a positive NPV.
NPV > 0 ➝ the project is expected to result in pro ts for the company
NPV < 0 ➝ the project is expected to result in losses for the company
NPV = 0 ➝ the project is not expected to result in any signi cant gain or loss for the
company.
If this project is nanced using equity alone, how much would investors be willing to
pay for the rm’s shares?
$1150
PV (equity cash flows) = = $1000
1.15
fi fi fl fl fi fi
, Course: Corporate Finance Part II
Since the rm has no other liabilities (the project is all equity- nanced), the equity
holders will receive all of the cash ows generated by the project on that date.
In the absence of arbitrage, the price of a security equals the present value of its cash
ows.
If you can raise $1000 by selling equity in the rm, after paying the investment cost of
$800, you can keep the remaining $200, the NPV of the project NPV, as a pro t. In this
case, the project NPV represents the value to the initial owners of the rm created by
the project.
Equity in a rm with no debt is called unlevered equity
Unlevered equity ➝ equity in a rm with no debt
Because there is no debt, the cash ows of the unlevered equity are equal to those of
the project.
Given equity’s initial value of $1000, shareholders’ returns are either 40% or -10%
The strong and weak economy outcomes are equally likely, so the expected return on
the unlevered equity is 0.5 (40%) + 0.5 (-10%) = 15%.
Because the risk of unlevered equity equals the risk of the project, shareholders are
earning an appropriate return for the risk they are taking.
Risk of unlevered equity = risk of the project ➝ shareholders are earning an appropriate
return for the risk they are taking
Financing a Firm with Debt and Equity
Suppose you decide to borrow $500 initially, in addition to selling equity. Because the
project’s cash ow will always be enough to repay the debt, the debt is risk free, and
you can borrow at the risk-free interest rate of 5%. You will owe the debt holders $500
× 1.05 = $525 in one year.
Amounted due to debt holders = amount borrowed x (1+ rf)
Levered equity ➝ equity in a rm with debt outstanding
Promised payments to debt holders must be made before any payments to equity
holders are distributed. So, given the rm’s $525 debt obligation, shareholders will
receive:
• $875 ($1400 – $525 = $875) ➝ strong economy
fl fifi fl fi fi flfl fi fi fi fi fi
, Course: Corporate Finance Part II
• $375 ($900 – $525 = $375) ➝ weak economy
What price E should the levered equity sell for? Which is the best capital structure for
the company?
Modigliani and Miller proposed an answer to this question. They argued that with
perfect capital markets, the total value of a rm should not depend on its capital
structure. They reasoned that the rm’s total cash ows would still equal the cash
ows of the project and, therefore, have the same present value of $1000 calculated
earlier.
Modigliani Miller ➝ in perfect capital markets, the total value of the rm does not
depend on its capital structure
Because the cash ows of the debt and equity sum to the cash ows of the project, by
the Law of One Price the combined values of debt and equity must be $1000.
Therefore, if the value of the debt is $500, the value of the levered equity must be $500.
E = $1000 – $500 = $500.
Because the cash ows of levered equity are smaller than those of unlevered equity,
levered equity will sell for a lower price ($500 versus $1000). However, the fact that
equity is less valuable with leverage does not make you worse o . You will still raise a
total of $1000 by issuing both debt and levered equity. Consequently, you would be
indi erent between these two choices for the rm’s capital structure.
The E ect of Leverage on Risk and Return
Leverage increases the risk of the equity of a rm.
Therefore, it is inappropriate to discount the cash ows of levered equity at the same
discount rate of 15% that you used for unlevered equity. Investors in levered equity
will require a higher expected return to compensate for the increased risk.
Levered equity is more risky than unlevered equity and will thus require a higher
expected return.
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