Question

How does the decision to finance with a greater percentage of debt versus stock impact:

a) shareholders’ earnings per share

b) company risk exposure

c) the WACC for the company

Answer 1

(a) While choosing between financing through debt or stock, EPS goes down in case of debt financing as increased debt servicing (interest) expense depresses net income. Net Income is the denominator of the EPS equation with the denominator of shareholder's equity remaining constant. In case of stock financing new stock are issued which increases the shareholder's equity keeping net income constant. This again depresses EPS.Anothe process is using debt to repurchase common stocks. Repurchase reduces the EPS denominator but increased debt might reduce the Net Income as well (EPS numerator). In such a case an increase/decrease in EPS is an interplay of reduction in Net Income and reduction in common stocks.

(b) Company's Risk Exposure goes up in case of debt financing owing to higher than before financial leverage. This financial leverage though adding interest tax shield benefits, also props up the firm's levered (equity) beta, thereby increasing the firm's cost of equity. Stock financing exposes the firm to increased risks of the market (stock market risk).

(c) The company's WACC initially goes down as debt increases in the capital structure owing to the benefits of interest tax shields. However, the benefits of interest tax shields is soon outmatched by the rising level debt which in turn increases financial leverage risk. Consequently, both cost of debt and cost of equity increases leading to a overall growth in WACC.