In MikesBikes, funding large investment options such as purchasing additional plant capacity and development projects may require additional capital. Raising Debt or Equity are ways companies can raise additional funds to finance these large projects or investments. In deciding whether to increase Debt, issue Shares or a combination of both; companies should assess their current situation and the impact of each financial decision.
Note: If your company is insolvent you will not be able to raise long-term debt.
What is the initial impact of each option on the company’s Shareholder Value (SHV)?
In the first rollover, the initial impact on issuing shares and raising debt is near identical. However, each option has its own pros and cons in subsequent rollovers.
What is the long-term effect on SHV for each option?
Raising Long-Term Debt:
- As long as the company remains solvent, there is no limit on long-term debt repayments, so you can repay in full at any time.
- Long-term debt carries interest payments at a rate of 8% to more than 20% p/a if the Debt to Equity Ratio (D/E) increases. This may not be significant for small loans, but can quickly cause problems if their debt levels are significant.
- This option has a greater impact on D/E Ratio.
- Issues and repurchases will occur at current market prices with underwriting and merchant banking fees also being incurred. There is a 5% issue premium on equity repurchased, and a 5% issue discount on equity raised. This effectively means that the cost of repurchasing or issuing equity is 5% of the value.
- There is a limit on the number of shares which can be repurchased in a single year (10% of the market equity). So, it may take multiple years for your company to buy back all of the previously issued shares, which would have a longer negative impact on SHV.
- This option has a lesser impact on D/E Ratio.
Debt to Equity Ratio (D/E) – A higher D/E ratio means higher risk, which results in a lower share price. A lower D/E ratio means lower risk, which results in a higher share price.
It is ideal for firms to be able to fund large investments through their current cash reserves. Debt or Equity are popular external funding options if additional cash is required.
When making these decisions, firms must realize that both options will have an impact on their SHV but this may be negated if the additional expenditure provides a greater return over the course of the simulation.