All equity vs debt-equity firm
hey guys,
just wondering: if you have two identical firms with different asset structures - one is all equity whereas the other has both debt and equity, which one would you invest in and why?
my answer:
in good times, invest in the debt-equity firm because your upside is unlimited and once the cheap debt is serviced, the remaining profit will be divided amongst fewer shareholders.
in bad times, invest in all equity firms since they don't have to worry about going bankrupt due to interest payments.
am not very confident of my answer.....any advice would help!
You can't really answer that question without more information, but for the sake of giving you an answer I'll say all equity.
Since I have no idea what the credit worthiness of the firm is, the prudent thing to do is invest in the all equity firm. Actually, the prudent thing to do is sit on cash.
I had that very same question one year ago from Credit Suisse IBD. My answer was since the cost of debt is lower than the cost of equity, the firm with some debt and and some equity will have a higher value because of lower WACC etc. Also profit is divided amongst fewer shareholders. Your answer is acceptable.
There's a lot of different ways to answer this question depending on the details. I can't think of any for sure answer based just on the information you've given.
I am tempted to say that I would invest in the all equity firm though because they are most likely to raise debt to finance expansion whereas the all debt/equity firm is more likely to raise capital through an equity offering and that can lead to shareholder dilution when they issue new stock.
Indian-banker's answer is very good from the perspective he's looking at it from. In fact, his answer may be the most appropriate.
Personally, if I see a company with positive cash flow and without any debt I tend to think it's a healthier company than a company with debt. They have a lot more room to raise capital by adding debt to their capital structure, and they can add said debt cheaply compared to a company who already has senior notes in place. This means they can expand very quickly and cheaply compared to the comapny with a d/e structure, and they can weather business cycle fluctuations and cash shortages easier.
I am inclined to believe that this is a question with no right or wrong answer as long as you can properly justify whatever answer you give.
This question has a very simple answer.
Any firm with debt is levered. An increase in firm value goes disproportionately to the equity and ditto for the decrease. If you're looking to make high returns on an equity investment and are comfortable that you can service and refinance the debt with future cashflows, then of course go for the levered firm. The implicit costs of investing in a levered entity are covenant issues and bankruptcy costs. If you know you can avoid both and both firms have the same cashflow profile, then investing in a firm with both debt and equity is a no-brainer. I haven't added in the benefit of the tax shield.
There is no such thing as a 'healthier' company if it has no debt.
sbmerchant: that makes very little sense. A company with more debt can simply issue more equity to finance positive-NPV projects, getting it to the same capital structure as a company that is all equity that issues debt. Enterprise value, in the absence of tax distortions, does not change due to capital structure. Given a certain cashflow profile, you can adjust the capital structure any which way.
In sum, if cashflows can cover interest payments and the company does not break covenants, then always go with the firm that has debt. If you need to refi, you'll issue equity and get your capital structure to that of an all-equity firm, while in the meantime reaping the benefits of a tax shield and leverage.
Curiosmonkey is absolutely right. I think in this case, what's most important to remember is that when you're buying a stock in a company, you're buying a cash flow (going back to the fundamentals of finance. So you basically try and choose the best cash flow.
Well, I wrote up a nice long response to defend my position, but I just deleted it.
Curiousmonkey is likely correct in his answer. There is another way to look at the problem, but in order to justify it you need some more details. In general, a leveraged company will provide a greater return to it's investors over a company financed with all equity. There's some assumptions we're making to be able to say that, and I don't like to make assumptions, but they're fairly reasonable considering the context of the question. So I'll just leave it at that.
I'm pretty sure that if the companies are completely identical except for their capital structure's, the theoretical classroom answer would be that it would not matter which company you invest in due to homemade leverage.
If you invest in the all-equity company, you could just borrow money and lever your investment up, and if you invest in the debt-equity company, you could lend out money and negate the leverage of the company.
Of course this is all theoretical, assuming you could borrow money at the same interest rate which you can lend at..but I'm pretty sure this would be solution in a classroom example.
Ya that's why I think this question depends on how well you can justify your answer.
what are examples of all equity firms?
Modigliani and Miller's (MM's) famous debt irrelevance proposition states that firm value can't be increased by changing capital structure. Therefore, the proportions of debt and equity financing don't matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off.
Modigliani and Miller's (MM's) famous debt irrelevance proposition states that firm value can't be increased by changing capital structure. Therefore, the proportions of debt and equity financing don't matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off.
Modigliani and Miller's (MM's) famous debt irrelevance proposition states that firm value can't be increased by changing capital structure. Therefore, the proportions of debt and equity financing don't matter. Financial leverage does increase the expected rate of return to shareholders, but the risk of their shares increases proportionally. MM show that the extra return and extra risk balance out, leaving shareholders no better or worse off.
Et molestias soluta aut eius aut. Rerum repellendus voluptas placeat incidunt odio. Est iste nemo corporis placeat vitae nihil ipsum. Excepturi ea vero ut blanditiis quo. Architecto unde modi occaecati id consequuntur voluptates.
Saepe sit corporis adipisci. Et rem rerum adipisci vel nemo. Porro provident laboriosam tempora. Delectus atque quod est suscipit. Eligendi autem facere nihil eum itaque.
Non adipisci incidunt ut dolores dolorem. Qui rerum ipsam doloremque aliquam commodi perspiciatis. Soluta suscipit ab vero est.
Omnis reprehenderit iure perferendis non perspiciatis nemo. At inventore qui vel quod magnam dolores. Numquam neque vel nesciunt. Excepturi inventore porro doloribus praesentium. Maxime temporibus et soluta non et veniam a accusamus.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...