Question

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From a corporations point of view, list 3 considerations when deciding whether to issue debt or equity for financing needs. How does this differ when you consider the investors point of view?

Answer 1

An optimal capital structure is a crucial decision for any management and it plays a key role in maximising the wealth of shareholders. The most important part of an optimal capital structure is to decide the debt to equity ratio.

The cost of debt is lower than the cost of equity which makes it an attractive alternative, but it increases the financing risk in the business/project due to which it's a crucial decision for the management and must be taken carefully. The 3 most important factors/considerations that the management must analyze when deciding whether to issue debt or equity or equity for financing are as follows:

1. Return on investment (ROI): The return on investment in the business/project for which the financing is required forms the most important factor when deciding the source of financing. If the expected ROI from the project is high and there is enough margin of safety to tackle the hard times (bearish business cycles), the management may decide to choose debt over equity as it has lower cost of capital
2. Cost of debt Vs Cost of equity: The quantum of difference between cost of debt and cost of equity depends on factors such as tax rates, prevailing interest rates, capital markets, company's credit ratings, existing debt to equity ratios. The management must compare the cost of the two alternatives when deciding which one to choose for the new project. Though cost of debt is lower than the cost of equity, the quantum of difference between the two is very crucial to analyze before making a decision. If the cost of debt is substantially lower than the cost of equity, the management should choose debt and if the quantum is not much, the management may not be comfortable increasing the financing risk
3. Operating risk in the business/project: Another factor that is very crucial is the operating risk in the project/business for which the financing is required. Some businesses (E.g. FMCG) have lower operating risks and not impacted too much by recessions, bearish business cycles whereas some businesses (e.g. Steel, Auto) have high operating risk. For businesses that have low operating risk, debt could be a preferred source of financing as cash flows are more certain and mandatory interest/capital repayments wouldn't be an issue. On the contrary, equity might be a preferred financing source for projects with high operating risk so that interest payments don't become an issue in tough times when the business might by generating losses
4. Existing debt to equity ratio: Another crucial factor is the existing debt to equity ratio. If the existing leverage is too high, the company may rather prefer equity for additional financing and vice versa

Investors point of view:-

Management is also appointed by the shareholders/investors and therefore they must take decisions for the benefit of shareholders, i.e. to maximize the wealth of shareholders. The above factors that we have discussed are considered by management for the benefit of shareholders only and hence, there ideally shouldn't be any difference between management/corporation point of view and shareholders point of view.

However, it may be possible that few investors are more risk averse or risk favourable than others. While management may always try to take financing decisions in a purely rational manner, some investors might be more risk averse and prefer to finance through equity despite debt being a viable option. On the contrary, some investors may be very risk favourable and choose debt over equity despite the financing risk being too high.