Choose the Proper Capital Structure
From the corporation’s perspective, investing, debt, and equity all come back to the original question of how to fund its operations and how to properly balance the amount of debt or equity that is being used to raise capital. In other words, all this information is being used to manage the corporation’s capital structure.
The goal, in setting the corporation’s policies regarding capital structure, is to minimize the costs associated with raising capital. This means, when applicable, choosing the cheapest option for capital funding. If interest rates on debt will be too high, then issuing equity may be the cheaper method.
If issuing more equity will generate more tax burden (or decrease the tax advantages of incurring debt, either for the corporation or even for the shareholders in a manner that would cause the market value of shares to drop), generate greater dividend payments, or too greatly influence existing shares in a negative manner, then issuing more bonds may be the better choice.
Of course, a corporation takes and measures this decision within the appropriate context of the current value of the future cash flows anticipated in both choices. Of minimal consequence compared to other consideration, but still a consideration, is also the agency costs associated with each option.
Issuing a new IPO tends to be more expensive than taking out a business loan, for example, and this must be taken into account when deciding which method is best to raise capital. The increased number of shares can also dilute the value of each share of stock since total corporate value is distributed across all shares outstanding.
A wide number of variations on the basic calculations and variables are used for each of the equations. Some include the costs of potential bankruptcy when debt can’t be repaid. Others take into account the increased short-term liquidity requirements during the debt repayment period and the influence that such reserve requirements have on lost potential revenues possible from reinvesting that cash into longer term assets.
The Modigliani-Miller Theorem, for example, suggests that capital structure has no bearing on corporate value, though this is widely considered to be a purely theoretical model established as a foundation upon which more useful models can grow (similar to CAPM, in that respect).
The reality, though, is that American laws regarding corporate finance and the compensation (see: income) packages of corporate executives are such that, in the majority of cases, decisions regarding capital structure are going to be those that maximize the value of stock shares.
Maximizing the value of stock shares means making decisions that will increase earnings per share as much as possible, and, in some cases, taking on excessive amounts of risk through higher amounts of debt and acceptance of greater risk of loss in specific initiatives in order to preserve stock value and place a maximum amount of risk on debt.
This attitude toward capital structure has been cultivated by a combination of the “shareholder wealth maximization” model of corporate governance (which requires corporations to do what they can to increase the value of corporate shares), but also by executive incentive packages that include a large proportion of stock options as well as income based on the performance of the corporation’s stock value.