Examine your firm’s current financing choices, categorizing them into debt (borrowings) and equity, and assess the trade-off between debt and equity for your firm

Chapter 7. Analyzing a Firm’s Current Financing Choices

Objective: Examine your firm’s current financing choices, categorizing them into debt (borrowings) and equity, and assess the trade-off between debt and equity for your firm. Key

Steps: 1. Examine how your firm is currently financed in both book value and market value terms and classify the financing into debt, equity, and hybrid choices.

2. Evaluate how much your firm’s needs in recent years have come from internal equity (retained earnings), external equity, and debt.

3. Examine in qualitative or quantitative terms the advantages and disadvantages to your company of using debt, as opposed to equity. Based on this assessment, make a qualitative judgment of how much debt the firm should be using.

Framework

For Analysis: 1. Current financing mix

a. Based upon the balance sheet (accounting), evaluate how much debt, equity, and hybrid financing your company is using to fund its assets (book value).

b. Based upon market values, evaluate how much debt, equity, and hybrid financing your company is using to fund its assets (market value).

2. Financing type

a. Examine the forms in which the company is raising equity. For a publicly traded company, you will start with common shares, but it can be supplemented with warrants and other equity-linked securities. For privately owned businesses, the equity may come from venture capitalists, private equity investors, and the owner(s) of the business.

b. Break down the debt of the firm, based upon when it comes due, what currency it is in, and any special features associated with it (fixed versus floating rate).

c. If you have any hybrid securities (convertible bonds and preferred stock), see if you can break down the hybrid financing into debt and equity components. If not, consider treating it as a separate cost of financing.

3. Financing trade-off

a. Evaluate the tax benefits of debt to your company by first estimating the marginal tax rate of the country in which it is incorporated and then following up by looking at marginal tax rates of countries where it operates. Make a judgment on where the company will benefit most from the tax deductibility of interest expenses and constraints on maximizing these benefits.

b. Consider whether there is a separation of management from ownership in your firm and the potential benefits of having more debt, as a disciplinary mechanism.

c. Based on your company’s earnings history and the business that it operates in, evaluate the uncertainty in future earnings and the potential for default risk from borrowing. Examine the costs (indirect bankruptcy costs) that may accrue to your business (in terms of revenues lost or higher operating expenses) from being perceived to be in financial trouble.

d. Examine whether lenders will feel secure about lending to your firm, in terms of being able to monitor how the money is spent and whether it is being used productively. Based on this assessment, estimate the costs and restrictions that your firm may face, if it tries to borrow money.

e. Make a judgment on the uncertainty faced by your firm in forecasting future investment needs and the benefits of maintaining financial flexibility (or excess debt capacity).

f. Based on this trade-off, determine how much (if at all) your firm will benefit from borrowing money and the financing mix that you would expect to see at the firm