Question

CFO of Graham Del plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. What affect it can have on the company’s financial statements. Discuss.

Answer 1

When a firm raises money by selling new shares of stock is called equity financing. Also when proceeds of this is used for paying off company's outstanding bonds, it will have following impact on company's financial statement:

1. Profitability(Net income)– Company's EBIT will remain same. However Net income will increase. Hence dividend to shareholders will also increase.

2. Also raising more equity can dilute existing shareholders' holdings, because the company's net income is divided among a larger number of shares.

3. When a company raises funds through equity financing, there is a positive item in the cash flows from financing activities section and an increase of common stock at par value on the balance sheet.

4. WACC- The weighted average cost of capital (WACC) measures the total cost of capital to a firm. Assuming that the cost of debt is not equal to the cost of equity capital, the WACC is altered by a change in capital structure. The cost of equity is typically higher than the cost of debt, so increasing equity financing usually increases WACC.

5. Leverage ratio- Equity and debt are the two sources of financing accessible in capital markets. The term capital structure refers to the overall composition of a company's funding. Alterations to capital structure can impact the cost of capital, the net income, the leverage ratios and the liabilities of publicly traded firms.