Corporate Finance Issues in Order

Corporate Finance Issues

In order to decide from which sources the company should obtain the required cash for financing this project, there are a few theoretical assertions that should be made. First of all, deciding the source of capital (equity, debt, preferred stock) has to be done according to the specific needs and characteristics of the project. In this case, Intel has to replace the defective motherboards. The project is definitely a short-term one, with a huge impact on the firm's credibility, so the company has to react swiftly. Additionally, the project is not cyclic.

The second issued that needs to be discussed is the hierarchy of financing. There are researchers who claim that companies follow a financing hierarchy, with retained earnings being the most preferred choice for financing, then followed by debt, while new equity is the least preferred choice. This hierarchy obviously has a rationale. The first reason for which retained earnings are the favorite source of financing is maintaining flexibility. Managers value this characteristic, so they will generally avoid using external financing, which reduces flexibility, and try to use internal financing whenever possible. The second cause of the hierarchy is control. Issuing new equity weakens control, since the structure of the company's shareholders can significantly change, while issuing debt creates bond covenants, which, in turn, lead to changes in the company's management technique.

According to a survey, this hierarchy looks as follows: Retained Earnings, Straight Debt, Convertible Debt, External Common Equity, Straight Preferred Stock and Convertible Preferred Stock. In Intel's particular case, we should assume that any retained earnings from the previous year are not available, since any cash, short-term investments and accounts receivable are already allocated to other projects. Therefore, the only solution for the company to raise the required $675 million is to issue new equity or debt.

There are several factors that influence the decision of a company in Intel's position. A short analysis of each one of them should prove useful, as certain aspects are applicable in Intel's case, while others aren't. Let's concentrate first on debt. There are certain benefits and costs associated to debt. The benefits include tax incentives and additional discipline to the management. The costs incurred are related to bankruptcy risks, agency costs and losses of future flexibility.

The Tax Benefits a company obtains by issuing debt are related to the fact that the interest on debt is tax deductible, while cashflows on equity (such as dividends) are not. That means that the tax rate applies to the (EBIT-Interest) value, while dividends are made available only after taxes have been calculated. The tax benefit each year is t r B. "t" is the tax rate, "r" is the return rate of a bond, and "B" is the total value of the bonds. Therefore, the after-tax interest rate of debt is (1-t) r.

This result is derived from the following formulae: Suppose "k" is the cost of equity (i.e., the required rate of return given the risk, inclusive of both dividend yield and price appreciation). Assume the company has to choose between issuing debt ("B") or equity ("K"). Obviously, K=B. If the firm chooses the debt option, than the net profit would have the following value:

Net profit = (1-t) (EBIT - r B) = (1-t) EBIT - (1-t) r B

By using the equity option, the Net profit would look as follows:

Net profit = (1-t) EBIT - k K

The conclusion is that the tax rate has a definite influence on a firm's net profit, since the amount the firm has to pay to creditors decreases as the tax rate increases. Therefore, at first glance, if a company's management is to be indifferent of the choice it makes in finding a source for financing, the (1-t) r B. should be equal to k K (the amount paid to stockholders. Since B=K, (1-t) r = k. Therefore, k is smaller, by definition, than r (except for a tax-free environment). However, stockholders desire to obtain a higher rate of return of their investments ("k") than they would normally get on the money market ("r"). As a conclusion, debt seems to be always more attractive than issuing new equity. It can be said that, other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure.

At first, it would seem that debt has more advantages than new equity. However, that is not always the case. The fact is that certain equilibrium between issuing debt and issuing equity has to be found. The cost of debt rises constantly, since the financial risk of a company grows together with the level of debt the company has to face. The cost of debt is the market interest rate that the firm has to pay on its borrowing and depends upon three components: the general level of interest rates, the default premium and the firm's tax rate. The cost of debt rises if the company has other debts, since the degree of risk a creditor takes increases. The company's beta indicator increases, so it does not have access to sources of financing as it once did. Therefore, issuing new equity becomes an interesting alternative.

What a company needs to do is to search for the lowest possible cost of capital. This costs depends upon the components of financing: Debt, Equity or Preferred stock, and the cost of each component. The formula for determining the cost of capital is WACC = ke (E/(D+E)) + kd (D/(D+E)). Basically, the cost of capital is the cost of each component weighted by its relative market value.

The Cost of Equity has to be estimated at different levels of debt. As equity becomes riskier, the beta will increase, so the Cost of Equity will increase. The Cost of Debt also has to be estimated at different levels of debt. Default risk will rise and bond ratings will go down as debt goes up, so the Cost of Debt will increase. Bond ratings may be estimated by using the interest coverage ratio (EBIT/Interest expense). The Cost of Capital at different levels of debt will then be determinable. The next step, eventually, is to calculate the effect on Firm Value and Stock Price, as we can assume that the Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital. Here is an estimation of the cost of debt: