This website uses cookies to ensure you have the best experience. Learn more

Evaluating The Risks Involved In Equity And Debt Financing

2053 words - 9 pages

Firms around the world rise funds in the capital markets to finance their expansion, acquisitions and other operations. This is usually done through equity and/or debt financing. Equity financing is the process in which a firm raises capital through the sale of shares. Debt financing involves the firm borrowing through, for example by issuing bonds.
The firm‘s decision on how to rise capital influences its capital structure and as a result may affect the value of the firm. It is therefore important that the firm must take into account the risks involved in both equity and debt financing. In order to be able to make an optimal decision, a firm that uses the combination of both equity and debt ...view middle of the document...

e. at a risk free interest rate;
• There are no taxes; and
• There are no bankruptcy costs

According to Modigliani and Miller, the value of the firm is determined by the net operating income earned on its physical assets or its cash flow. The value of leveraged firm is the same as the value of unleveraged firm, i.e. the value of the firm with debt is the same with the value of the firm without debt.
Modigliani and Miller‘s argument does not hold in the real world where financial decisions of the firm are influenced by a variety of factors. For example, in a real world, tax plays a critical role in the financing decision of the firm which is in contrast with Modigliani and Miller assumption that there is no tax. This includes corporate tax and personal income tax.
Taking corporate tax into account, it can be concluded that the debt-equity ratio affects the value of the firm and therefore is relevant. Corporate tax affects the net operating income of the firm and therefore the value of the firm. In this regard the decision of the firm‘s capital structure must be such that the effect of corporate tax on the value of the firm is minimized.
In a firm with all equity capital structure, corporate tax reduces the value of the firm more than the leveraged firm or firm with debt. Corporate tax can create a tax shield if the firm is partly financed by debt.
Company X will pay less tax if it replaces 50 percent equity with debt than if it remains all equity company. This is because the government or tax authorities treat the interest differently from the way the treat earnings to shareholders. Interest is able to avoid tax while earnings after interest but before corporate taxes are taxed at the corporate rate. Therefore, based on the information provided for company X, the increase in the debt- equity ratio will increase the value of the company:
Table 1
All equity firm Firm with 50% debt
Earning before tax £1 million £1 million
Interest 0 £30 000 @ 3%
Pretax income £1 million £970 000
Tax @30% £300 000 £291 000
Net cash flow £700 000 £679 000

Tax shield gives the firm with high amount of debt, a higher market value than the one with a lower level of debt. The total value of the firm is calculated as follows:
Firm value = Value of all equity firm +tax shield
= £700 000 + £30 000
= £730 000
Because the firm deduct interest payments on debt as an expense and dividend payment to shareholders are not tax deductible. Debt has a benefit to firm. The value of the firm increases by raising the debt-equity ratio if the present value of the corporate tax shield is greater than the extra cost of marginal investor would have to bear in the form increases tax.
Modigliani and Miller also argued that the firm‘s capital structure does not affect the cost of capital and therefore the change in debt-equity ratio does not affect the cost of the firm. As the debt-equity ratio increases, the expected return on equity increase, expected return on debt does not...

Find Another Essay On Evaluating The Risks Involved in Equity and Debt Financing

Risks Involved in the Game of Netball

884 words - 4 pages Risks Involved in the Game of Netball All sporting activities carry some risk. We can reduce the risk and help to prevent injury by preparing for sport properly, and take part with the right attitude. Netball is a fast, exiting team sport. It is played in many countries throughout the world. It is an easy game to pay, but at a higher level becomes very tactical game that needs great skill. Warm up/Cool down

"Employee Privacy": The risks and complications involved on the issue of employee privacy in the workplace

1364 words - 5 pages harmful to the company? This essay will examine this issue in detail and focus on the possible affects that could result from a company that removes employee privacy by monitoring their use of the Internet. Disregarding whether it should be legal or not, is it morally acceptable for the employer to monitor the employee?Moral Dilemma.This can be a tricky question to answer because of all the variables involved. There are many people who would say

Determining the Debt-Equity Mix

686 words - 3 pages structure?The Scenario and the Recommended SolutionScenario One: El Café is challenged to raise adequate financing for two additional shops. The objective was to select a debt-equity mix that minimized the WACC. The recommended solution is to obtain a debt-equity mix of 70 - 30% which achieved the lowest possible WACC of 8.65%.Scenario Two: After four good years, El Café has decided to expand into other cities to accelerate growth

Using Debt and Equity to Raise Capital

1015 words - 5 pages sale ownership interest (stock) in the business to raise funds/capital. There are several ways to start off a business using equity but the disadvantages are: 1. Financing entirely out of pocket means you take the total loss if the business fails. 2. If you’re seeking investors, it is difficult to find the right people willing to invest. 3. If you sell ownership interest, you could lose part of the ownership in your business and the new partial

The Right Mix- Debt vs. Equity

754 words - 3 pages exploration of a possible citywide expansion followed by a multi-city expansion as well.The first step in the process was to generate financing. Understanding that the level of competition and the number of competitors had increased approximately $400,000.00 for every two stores would need to be raised. Students were tasked with trying to find suitable sources for capital while selecting a debt-equity mix that minimized the Weighted Average Cost of

Risks Involved in Rx-to-OTC Switching

1693 words - 7 pages Risks involved in Rx-to-OTC switching Apart from the benefits described above, a comprehensive analysis and evaluation of the Rx-to-OTC switch movement should also contain a critical examination of potential risks and disadvantages associated with the reclassification of drugs. Importantly, the usage of OTC drugs heavily depends and relies on consumers' ability to appropriately self-diagnose and self treat (Pawaskar 2007; Stitching AESGP

Determining the Debt-Equity Mix: El Caf

669 words - 3 pages structure?The Scenario and the Recommended SolutionScenario One: El Café is challenged to raise adequate financing for two additional shops. The objective is to select a debt-equity mix that minimized the WACC. The recommended solution is to obtain a debt-equity mix of 70 - 30% which achieved the lowest possible WACC of 8.65%.Scenario Two: After four good years, El Café has decided to expand into other cities to accelerate growth and

"Charity in the US" A paper discussing current trends of philanthropy in America and also the risks and scams involved in giving

2295 words - 9 pages as opposed to problematic ones is essential. Unfortunately, many Americans are uneducated about their giving; among the list of the top 15 consistently excellent charities, only one of them (Columbia University) is a top 50 recipient organization.Philanthropy plays a major role in the stability and equity of our economy by redistributing income. Therefore, it should be in the government's best interests to regulate and legislate giving. The

Global Financing and Exchange Rate Mechanisms Paper How it is used in global financing operations, and its importance in managing risks

791 words - 3 pages foreign exchange reserves. Countertrade is a common solution for these payment problems.CountertradeCountertrade is a term used to cover a wide range of reciprocal trade. Barter is the best-known example and others such as offset, buyback and switch trading have been developed to meet the needs of the world economy. These trade methods involve the exchange of goods or services in order to finance purchases rather than using cash. Reasons for

What Are Debt Covenants And Why Are The Debt Covenant Are Heavily Used In Private Debt?

712 words - 3 pages , Basingstoke, Hampshire ; New York: Palgrave Macmillan, 2010), p105.][3: Mariah Talavera, "What Lies Beneath: Understanding Debt Covenants and their Impact on your Company", accessed August 7, 2014,]Why are the debt covenant are heavily used in private debt? :The uses of these different types of covenants have underlying similar

Why Drug Trafficking Continues to Rise Despite the Risks Involved

1659 words - 7 pages , most of the supply originates from Central and South America. In Great Britain, cocaine amounts are also very high in trade and demand. According to Britain is Facing 'Emerging Threat' From Live Streaming of Sex Abuse, "almost half of organised crime groups are involved in some way in the drug trade, with 18 to 23 tonnes of heroin and around 30 tonnes of cocaine imported annually into Britain.” Great Britain is not the only country with a high

Similar Essays

Comparing Debt Financing And Equity Financing

1440 words - 6 pages There are two basic ways of financing for a business: Debt financing and equity financing. Debt financing is defined as 'borrowing money that is to be repaid over a period of time, usually with interest" (Financing Basics, 1). The lender does not gain any ownership in the business that is borrowing. Equity financing is described as "an exchange of money for a share of business ownership" (Financing Basics, 1). This form of financing allows

Debt Versus Equity Financing Paper

885 words - 4 pages ultimately to make money. The following questions ensue, what are debt and equity financing? and is one type of financing more advantageous than the other? Debt and equity financing will be examined in this paper as well as if one of the capital structures may be considered more advantageous than the other.Debt FinancingDebt financing occurs when a business raises money for working capital or capital expenditures by borrowing money from

Debt Versus Equity Financing Paper

751 words - 3 pages will revolve around debt and equity financing. These two commonly used forms of financing are important as they are both unique in how they are utilized. The author of this piece will address these two financing options while providing examples of each and addressing which capital structure is most advantageous.Debt FinancingDebt financing is the process of borrowing money from a lender such as a bank. These financings option comes in the forms

What Are The Advantages And Disadvantages For American Semiconductor To Forgo Their Debt Financing And Take On Equity Financing?

772 words - 3 pages , venture capitalist or any investors are considering giving money to any borrower, then the most important part of it will be the debt equity ratio, by which it can be determined, whether there is adequate money available for repayment in case there is any failure to pay and also reflects the amount of dependents of the business on outer sources.In summary, deciding the process of financing is not an easy task. A company must give thought on the