Investment Banking: How a Company Chooses Debt or Equity - dummies

Investment Banking: How a Company Chooses Debt or Equity

By Matt Krantz, Robert R. Johnson

Both debt and equity are issued by companies who need funds to expand their operations. This is good information for an investment banker to know. The factors that management considers are numerous, but the goal is always to raise capital in a cost-efficient manner.

Just as an investor wants to buy undervalued assets and sell overvalued assets, companies choose between debt and equity based on the relative cost of the capital source.

If a firm’s management believes that interest rates are low and likely to rise in the future, they often choose to issue long-term debt at a fixed rate. If interest rates do indeed rise, the market value of the debt will decline. Because that debt is a liability of the firm and the liability declines in value, the firm wins.

A prime example of this was in May 2013 when Warren Buffett’s Berkshire Hathaway issued $1 billion in corporate debt. The Oracle of Omaha was on record as saying that he believed that interest rates were historically low and would increase in the future. Issuing debt was a way of selling what he believed was an overvalued asset. (Betting against Mr. Buffett has been a losing proposition for several decades.)

If a firm’s management believes that interest rates are high and are likely to decline in the future, they’ll choose to issue shorter-term debt, callable debt, or perhaps debt with a floating interest rate. That way, they aren’t locked into paying a high interest rate for an extended period of time, and they have the flexibility to refinance when rates fall.

Companies generally don’t like to issue equity if they believe that their stock is undervalued. This form of financing is expensive and dilutes the ownership of the current stockholders.

If the equity is undervalued but debt financing appears to be expensive, companies may choose to issue convertible bonds. That way, if the value of the equity rises, the bondholders will convert and extinguish the debt. In addition, the conversion price is generally set at a substantial premium above the market price of the equity at the time the bond is issued.

If things work out the way the firm would like, the value of the stock will rise, bondholders will convert, and the firm will have effectively issued stock at a price that is above what it could have received in a straight equity offering.

Companies can also increase their leverage without issuing debt. They can buy back (or repurchase) company stock in the open market, thereby increasing their debt-to-equity ratio. A firm will buy back stock when it has excess cash and the management believes that the market undervalues that stock.

Stock buybacks tend to bolster the stock price of the firm, because the percentage of the company that any individual stockholder owns effectively increases after a buyback. Buybacks are often preferred to cash dividends, because only the shareholders who want to sell the stock back will incur a tax liability.