This paper examines the capital budgeting decision facing a firm that must choose between debt and equity financing for a $1,000,000 project. Using a firm with 5,000,000 shares outstanding at $1.25 per share as a base case, the analysis calculates earnings per share and price/earnings ratios under each financing scenario, assuming perfect capital markets with no arbitrage or dilution. The paper demonstrates that debt financing produces a higher EPS ($0.03) but a lower P/E ratio (41.66×), while equity financing produces a lower EPS ($0.0258) but a higher P/E ratio (48.44×), and explains what these outcomes mean for shareholders and future growth prospects.
A firm is faced with the decision of how to finance a new project. The project will cost $1,000,000. The current capital structure of the firm consists of 5,000,000 shares at a price of $1.25 per share, for a total equity value of $6,250,000. If the company issues equity, the share price will remain the same but more shares will be issued, increasing the total equity in the firm. If debt is issued, the equity remains unchanged but $1,000,000 in debt will be added. The decision will therefore affect the firm's capital structure and its earnings per share. This paper analyzes how earnings per share in particular is affected by the capital budgeting decision.
Given perfect capital markets, it is assumed that the company will issue new shares at the same price as the current shares — $1.25 per share. There will be no arbitrage opportunities and no dilution in this example. Financing the $1,000,000 project through a share issue would require the company to sell 800,000 shares, as shown below:
$1,000,000 ÷ $1.25 = 800,000 shares
The new total number of shares outstanding will be the current total plus the newly issued shares:
5,000,000 + 800,000 = 5,800,000 shares
The earnings per share next year will reflect expected earnings of $150,000 divided by the total shares outstanding of 5,800,000:
$150,000 ÷ 5,800,000 = $0.0258 per share
The firm's price/earnings ratio will reflect the share price divided by the expected earnings per share. With a share price of $1.25 and expected earnings per share of $0.0258, the forward P/E ratio under the equity financing scenario is:
$1.25 ÷ $0.0258 = 48.44 times
If the firm issues debt instead, the forward price/earnings ratio is calculated in the same manner but with different figures. The expected share price remains $1.25. Since no new shares are issued, the equity of the firm is still 5,000,000 shares × $1.25 = $6,250,000, and the share price is unchanged.
The earnings per share, however, will differ. Because no new shares have been issued, the number of outstanding shares remains at 5,000,000. The EPS calculation for the debt financing scenario is therefore:
"Interprets differences in P/E and growth prospects"
The P/E ratio is not necessarily the primary determinant in a capital budgeting decision, but it 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 EPS but a lower P/E ratio. This reflects the fact that debt use can hamper growth prospects to at least some degree, because a portion of the firm's income must be directed toward debt repayment rather than being reinvested in the business. Typically, a firm's earnings per share can either be distributed to shareholders as dividends or retained and reinvested. With debt, however, debt service obligations mean that not all earnings can be reinvested. The lower P/E ratio under the debt scenario thus captures the degree to which the use of debt constrains future growth potential.
As this example illustrates, the decision between debt and equity financing has specific ramifications for shareholders. Perfect capital markets were assumed, but in many real-world cases, an additional debt issue will result in dilution of the value of existing shares. Debt also carries costs in the form of interest charges that reduce earnings. By stripping away these ancillary effects, this example isolates the most basic and direct impacts on earnings and the P/E ratio arising from the choice between debt and equity.
The use of debt allows for higher earnings per share figures, but if the share price remains static, the P/E ratio will be reduced. The use of equity produces a lower earnings per share figure, which in turn yields a higher P/E ratio. It is important that a company always examine the impacts of new share issues or new debt issues on its capital structure and its current shareholders. The firm must be able to continue attracting capital, so understanding how new project financing affects existing owners is imperative. In summary: debt issues increase EPS while decreasing the P/E ratio, and equity issues decrease EPS while increasing the P/E ratio.
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