DEBT VERSUS EQUITY DECISION FORMAT

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DEBT VERSUS EQUITY DECISION FORMAT

• AN APPLICATION OF FINANCIAL STRUCTURE THEORY

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BASIC FORMS OF CAPITAL

• INTERNAL - RETAINED EARNINGS
• EXTERNAL
• DEBT
• PREFERRED STOCK
• COMMON STOCK

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BASIC TRADEOFF

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

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RISKS

• BUSINESS RISK - FUNCTION OF OPERATIONAL DECISIONS
• FINANCIAL RISK - DERIVED FROM FIXED FINANCING
  CHARGES

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BUSINESS RISK(using cash flow format)

• DEMAND VARIABILITY
• SALES PRICE VARIABILITY
• INPUT PRICE VARIABILITY
• OPERATING REVENUES
• FIXED OPERATING COSTS (DOL)

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BASIC CHARACTERISTICS OF THE FINANCING
OPTIONSREVIEW TEXT PP. 101-102
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FRICTO

• F - FLEXIBILITY
• R - RISK
• I - INCOME

• C - CONTROL
• T - TIMING
• O- OTHER

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INCOME ANALYSIS

• MINIMAX COMPANY - TABLES 10.2, 3
• EBIT/EPS -MEASURE OF INCOME
• GRAPHICAL DESCRIPTION - FIGURE 10.1
• EPS EQUIVALENCE POINT - TABLE 10.4

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HIDDEN COSTS

• BALANCES EXPLICIT INCOME EFFECT
• ALSO REFERRED TO AS JOINT COSTS
• FLEXIBILITY
• RISK
• TIMING

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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

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TIMING

• TWO MAJOR QUESTIONS
• 1. SEQUENCING OF DEBT AND EQUITY
• 2. FOR DEBT, WHETHER TO FINANCE WITH SHORT TERM
  OR LONG TERM DEBT

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CONTROL

• TYPICALLY FAVORS DEBT FINANCING DUE TO VOTING
  RIGHTS ISSUE
• MUST RECOGNIZE ROLE OF COVENANTS AS CONTROL ISSUE
  IN DEBT FINANCING
• THRESHOLDS OF CONTROL