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Critically evaluate the potential impact on shareholder wealth on the decision to introduce debt into the capital structure of a company and consider whether the alternative decision to finance investment using equity finance would be more beneficial to the shareholder.

This question deals with the complex relationship of debt versus equity in a firm’s capital structure. There is no simple answer to the statement. In fact, the amount or degree of debt usage/ percentage in the capital structure can be either positive or negative towards shareholder wealth. Besides, the amount usage of debt will also dependent on the shareholder’s preference. For example, if shareholders prefer a low leverage company, introduction of more dent into the capital; structure will be perceived as risky and thus could depress the stock prices and reduce shareholder’s wealth. Also, the introduction of debt into the capital structure also needs to consider the industry the company is operating in. Example, in a pharmaceutical company, which is often considered as a growth industry by many investors, an introduction of debt into the capital structure may even improve the prospect of growth expectation on the company, and thus improve its stock prices. Conversely, if a company is operating in a mature industry, an increase in the debt level in capital structure may invoke uncertainties in the future prospect of the company. Analysts and investors may be led to believe that something hanky panky is going in the company (particularly in mature company such as Coca Cola or BAT which often viewed as cash cow for investors). Else, people may also speculate if the company is really in terrible issues which need debt to raise fund to settle problems. Whatever the speculation may be, an increase in debt level for a mature cash cow company will likely to make investors anxious and depress the stock prices. From a theoretical point of view, there is an optimum usage of debt level in a company. The main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn’t it thus make sense to maximize your debt load? The answer is no. With an increased debt load the following occurs: Interest expense rises and cash flow needs to cover the interest expense also rise. Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing. Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all. This can be best illustrated with an example: The following is Newco’s cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.

Newco’s cost of debt at various capital structures

At each level of debt, calculate Newco’s WACC, assuming the CAPM model is used to calculate the cost of equity.

At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29 (maximized)
The minimum WACC is the level where stock price is maximized. As such, our optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits - as indicated in the example.

To finance investment with equity can have its advantages or disadvantages. However, most likely, the announcement of financing an investment with equity, i.e., by issuing right issues in Malaysia will depress stock prices. This practical observation may sound contradicting with the theory as mentioned above, but it is not without good reasons. Firstly, the stockholder expects a company to generate money for them, but not to demand money from shareholders. Usually, it is also observed that those companies that cannot get borrowing from banks or bondholders will tend to issue right issues to ‘cheat’ money from shareholders, as the company has already no choice to do so in raising capital. Besides, shareholders also tend to be very skeptical about how the management uses their money. Acquisition project particularly, if proposed to be undertaken with equity, will often send the stock prices down deeply. Shareholders often are careful if the management wants to use their money for the sake of empire building or go for stupid diversification projects. Shareholders tend to prefer a company that concentrate ion its competitive advantage. Nonetheless, there are simply no hard rules in finance. Example, management with remarkable reputation for brilliant management, wanted to undertake a profitable project by issuing equity may send the stock prices up and thus increase shareholder value. Generally speaking, however, unless the company has no other options, they should not choose issuing equity to finance a new project as equity has a greater cost of capital than debt.

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