Equity vs Debt
Financial Statement Information - Debt and Equity Holders
Debtholders and equityholders as claimants to a firm’s future cashflows are interested in assessing risk.
Debtholders are primarily interested in assessing whether the firm’s cashflow will be sufficient to make interest and principal payments on a timely basis
The lower the probability of a cash shortfall, the lower the risk to the debtholder
Debtholders therefore gather information about the firm’s liquidity, debt capacity and liquidation value of assets
Equityholders are residual claimants of the firm’s cashflows.
Shareholders in effect, hold an option on the value of the firm’s assets, with the exercise price equal to the face value of the debt.
It is well known that the option component of equity value increases with the variance of expected future cashflows – Black and Scholes (1973) and with the firm’s debt to equity ratio.
Therefore, when equity has a large component of option-like characteristics, financial statement analysis focuses on assessing both the expected level and the variance of future cashflows when valuing equity.
At extreme debt levels, the equity is a ‘deep in the money’ option and its valuation does not require the use of the option pricing model.
More traditional valuation models suffice.
Financial analysts are interested in assessing a firm’s Beta risk so that they can perform valuation of traded stocks, seasoned equity issues and public offerings.
Financial statement information is useful in assessing corporate and municipal bond risks.
Wakeman (1981) argues that explanations offered by the ratings agencies, the timing of rating changes and ability of financial ratios to explain cross sectional variation suggest that ratings agencies use financial statement information.
Hand, Holthausen and Leftwich (1992) found that unanticipated ratings changes are associated with significant bond and share price effects, especially when bonds are being downgraded.
Creditors and equity investors alike are interested in knowing the likelihood of a firm experiencing financial distress.
A high probability of distress indicates both debt and...