The equity issue scenario will give the company a price/earnings ratio of 48.44 times and the debt issue scenario will give the company a price/earnings ratio of 41.66 times.
The price/earnings ratio under the equity issue scenario is higher because the earnings per share is lower. The earnings have remained unchanged in both scenarios, but the number of outstanding shares has changed between the two scenarios.
Under the equity issue scenario, each share will have a lesser amount of the company's earnings ascribed to it. This is because the firm's capital structure is entirely weighted to equity, with no debt component. The use of debt can help a company's shareholders, because the amount of income for each share is going to be higher. In this situation, the earnings per share was higher in the debt issue scenario.
The price/earnings ratio is not necessarily of significance to the company in terms of its capital budgeting decisions, but does reflect to some degree how the market evaluates the firm's growth prospects. In this situation, the use of debt leads to a higher earnings per share but a lower price/earnings ratio. This reflects that the company's use of debt hampers to at least some degree its growth prospects. This is because a lesser amount of the company's income goes into equity. Typically, a firm's earnings per share can either be dispersed to the shareholders...
With debt, however, that debt must be repaid so not all of the earnings can be reinvested. Thus, the lower price/earnings ratio reflects the degree to which the use of debt hampers future growth prospects.
As this example illustrates, the decision between the use of debt and the use of equity for a project has specific ramifications to the shareholders. Perfect capital markets were assumed, but in many real world cases, an additional debt issue will result in dilution of value of existing shares. Debt also has its costs, in the form of interest charges that reduce earnings. By stripping away these ancillary impacts of the decision, this example shows the most basic and direct impacts on earnings and the price/earnings ratio as a result of the decision between debt and equity. The use of debt allows for higher earnings per share figures, but if the share price remains static then the price/earnings ratio will be reduced. The use of equity gives a lower earnings per share figure, but this in turn makes for a higher price/earnings ratio.
It is important that the company always examine the impacts of new share issues or new debt issues on its capital structure and its current shareholders. The firm needs to be able to continue to attract capital, so understanding the ways in which new project financing impacts the current owners…
