DEBT VERSUS EQUITY DECISION FORMAT

AN APPLICATION OF FINANCIAL STRUCTURE THEORY

BASIC FORMS OF CAPITAL

• INTERNAL - RETAINED EARNINGS

• EXTERNAL– DEBT– PREFERRED STOCK– COMMON STOCK

BASIC TRADEOFF

• FINANCIAL RISK AND RETURN BY USING RELATIVE AMOUNTS OF DEBT AND EQUITY SECURITIES

RISKS

• BUSINESS RISK - FUNCTION OF OPERATIONAL DECISIONS

• FINANCIAL RISK - DERIVED FROM FIXED FINANCING CHARGES

BUSINESS RISK(using cash flow format)

• DEMAND VARIABILITY

• SALES PRICE VARIABILITY

• INPUT PRICE VARIABILITY

• OPERATING REVENUES

• FIXED OPERATING COSTS (DOL)

BASIC CHARACTERISTICS OF THE FINANCING

OPTIONS

REVIEW TEXT PP. 101-102

FRICTO

• F - FLEXIBILITY

• R - RISK

• I - INCOME

• C - CONTROL

• T - TIMING

• O- OTHER

INCOME ANALYSIS

• MINIMAX COMPANY - TABLES 10.2, 3

• EBIT/EPS -MEASURE OF INCOME

• GRAPHICAL DESCRIPTION - FIGURE 10.1

• EPS EQUIVALENCE POINT - TABLE 10.4

“HIDDEN COSTS”

• BALANCES “EXPLICIT” INCOME EFFECT

• ALSO REFERRED TO AS JOINT COSTS– FLEXIBILITY– RISK– TIMING

FLEXIBILITY

• “ABILITY TO RESTRUCTURE INTERNAL FUNDS AND RAISE NEW FUNDS IN A CRISIS”

• “BUMP IN THE DARK”

• DEBT RATIOS CAN BE EMPLOYED TO QUANTIFY ACCEPTABLE FLEXIBILITY

TIMING

• TWO MAJOR QUESTIONS:

– 1. SEQUENCING OF DEBT AND EQUITY

– 2. FOR DEBT, WHETHER TO FINANCE WITH SHORT TERM OR LONG TERM DEBT

CONTROL

• TYPICALLY FAVORS DEBT FINANCING DUE TO VOTING RIGHTS ISSUE

• MUST RECOGNIZE ROLE OF COVENANTS AS CONTROL ISSUE IN DEBT FINANCING

• THRESHOLDS OF CONTROL