The issue that must be settled in this paper is whether the company should proceed with the IPO as a mode equity financing in its planned acquisition of the production plant or should it lease the same if debt financing is used.
The plan of either to use equity financing or debt financing will surely affect the capital structure of the company. Capital structure will in effect determine whether the company has good financial leverage or whether it is highly leveraged.
A good financial leverage is a sign of long-term health since it would mean that the company is solvent or stable it has enough equity to match its long term debt (Ross et.
al, 1996). It is for the above reason that debt to equity ratio is the formula to measure the capital structure and the same time would tell about the level of financial leverage that the company has.
What is ideal capital structure that would give the investors the message that the company has a good financial leverage the industry average.
The industry average on debt of equity ratio includes the ratios of the players in the same industry and one company that has a debt-equity ratio outside the said average may be considered be risks to too risky depending on the extent of the difference from the average.
Equity vs. debt - Stocks and bonds - Finance & Capital Markets - Khan Academy
There is a trade-off between equity financing and debt financing. Equity financing which could be done by IPO will surely improve the capital structure of the company since the equity would be increased while leaving the long term debt unchanged. On the other hand resorting purely to debt financing will generally worsen the company’s capital structure.
There is however an advantage of using debt equity financing because of the tax shield provided by being able to deduct interest expenses for the debt in reducing cash outflows for tax purposes which cannot be done in the case of additional dividends due to equity financing (Brigham and Houston, 2002).
There is therefore the expected benefit of higher of profitability in debt financing but the higher profitability could result to higher risk for the company up to a level that it debt-to-equity ratio may get outside the industry average or simply very highly leveraged from the point normal investors.
The company’s decision to either use equity financing or debt financing must strike a balance by approximating its optimum cost of capital by having a target capital structure that would support the same (Brigham and Houston, 2002).
The company’s balance sheet would be impacted by debt financing rather using cash from IPO in terms higher financial leverage as expressed in debt-to-equity ratio since liabilities would increase while total equity would remain the same.
The company’s return on equity could however be increased by utilizing more debt up to a certain point that company is not too risky to invest with.
To conclude, before the company should decide to either choose IPO or debt financing, it must know how much is the amount of investment needed for the plant acquisition and what would be its effect in the debt to equity ratio of the company.
Using the IPO would increase only the equity while debt financing that would increase only the total liabilities (Ross et.
al, 1996). The resulting debt to equity ratio should then be compared with industry average, and the option that will have lower debt to equity than the industry average should be chosen.
If the resulting debt equity ratios for both options are equal or lower than industry average, then it is safe to choose either option since it would mean that similar companies are having more or less the same capital structure. However, in such a case, it is better to choose the debt financing because of higher return on equity.
If both options are above industry average, it would mean that company will have to defer plan for plant acquisition or it should increase its equity infusion to match those within the industry.
The equity infusion to acquire the plant should however be justified by the demand for company’s products which the company is presumed to have established or studied.
Making equity infusion by IPO at that point however may not be favourable since the company is just entering the capital market.
References: Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, US Ross et. al (1996) Essentials of Corporate Finance, IRWIN, London, UK