Question

Imagining that you are the company, why would you want to sell stock vs. taking out a loan? Or why would you prefer to take out a loan instead of selling stock?In what situations is one better than the other? In general terms, how do you price what a stock is worth? (just in the abstract, no need for formulas)

Answer 1

This would be the leveraging decision.

Every firm has two options to bring in the Capital needed to run the business , it could be the Equity, or it could come in the form of Debt. Several measures are defined to measure a company's leverage just for this reason, such as the Debt Equity Ratio.

Fundamentally - Equity is Costlier than debt, because the return on investment expected by equity holders would be much higher than the return expected by Debt holders. Since Equity is a riskier investment. Debt would always get the first preference to be paid out of the EBIT (Operating Profit), and only from the residual Net profit, will Equity holders get a chance to take a part from the spoils, as Dividends.

Since Debt is less riskier, it would be priced much lower than the Equity.

Reasons why a Company Would want equity over debt:

1. A bootstrap company without any real assets.
2. A company which wants to maintain a healthy debt equity ration (low enough to not get into financial trouble)
3. Companies with minimal capital investments such as Boutique firms, Resaerch Firms, Small Tech Startups etc.

Reasons why a company would prefer debt over equity"

1. To lower the cost of capital overall (the WACC)
2. To invest for future growth.
3. Companies which are typically more capital intensive (traditional companies)

Pricing what a stock is worth:

We would need to perform the DCF to determine a stock's real worth (rather than just the book value)

1. Draw up the future projections of the company
2. Determine the Free Cash Flows generated
3. Determine the Cost of Capital using the CAPM formula
4. Discount the Cash flows to present value using the Cost of capital
5. Dividide the discounted present value of the firm over the no of shares outstanding, we get the price per share.