Cost of Capital: Debt or Equity?

1) What your opinion on JUSTIN's ANSWER to the question below?

JUSTIN's ANSWER: The pecking order theory addresses how companies will choose to finance in a certain order if given the option. (Frank & Goyal, 2007) First, they will choose to finance with internal funds. Next, they will choose debt financing, and finally, they will resort to equity financing. By choosing this order companies are trying to first avoid a disadvantage of debt financing (paying off interest on a loan) and next the disadvantage of equity financing (essentially giving up ownership of the company) (Peavler, 2012)

Frank and Goyal demonstrate that pecking order theory may be an indicator of stock price. A common argument regarding pecking theory is that a manager should know the most about his company and that if they are resorting to equity financing that most likely means they are trying to take advantage of a companies over valuation.

1. Frank, M.Z., & Goyal, V.K. (2007, December 11). Trade-off and pecking order theories of debt. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=670543

2. Peavler, R. (2012). Debt and equity financing. Retrieved June 2014 from http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm

A corporation's cost of debt is typically lower than a corporation's cost of equity. A reason for this is because corporations get a tax deduction from using debt financing. Therefore, assuming a positive tax rate, a firm's after-tax cost of debt financing is lower than a firm's before-tax cost of debt financing. The cost of debt financing is equal to the yield to maturity on the company's bonds. The cost of equity financing can be determined with the Capital Asset Pricing Model or through the dividend yield plus growth rate approach. Beta, a measure of systematic risk, is an input in the CAPM. The higher the stock's beta, as is usually the case with technology companies, the higher the cost of equity financing.

Even though the cost of debt financing is lower than the cost of equity financing, it doesn't mean that the company should have an excessive amount of debt in its capital structure, particularly for cyclical companies. The company pays interest to bondholders; during a recession, the company may not generate enough money to pay the bondholders. This may cause the company to eventually file for bankruptcy. On the other hand, there's no requirement to pay dividends to common stockholders.

References:

Fama, E.F, & French, K.R. (1997, February 1). Taxes, financing decision, and firm value. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1871

Frank, M.Z., & Goyal, V.K. (2007, December 11). Trade-off and pecking order theories of debt. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=670543

Required:

Below are some questions for discussion.

1. What signals are provided to investors when a company obtains debt financing? What signals are provided to investors when a company obtains equity financing?

2. Explain and critique the pecking-order theory.

3. Preferred stock is another financing option for companies. What's preferred stock? How's the cost of preferred stock financing determined? Name and describe three publicly-traded companies that have preferred stock in their capital structure.

You must answer one of the above questions. You do not need to answer all three questions. You must also respond to at least two peers' posts over two separate days. Please try to add information not previously discussed by others. Please provide factual information (not merely opinions) backed up by details or examples. Your comments should be in your own words and include references in APA format.

2) What is your opinion on MATT's ANSWER to the question above?

MATT's ANSWER: In finance, the pecking order theory is based on the noted observance that companies tend to lean more towards financial investments that have retained earlings and when outside financial funding becomes necessary, a severe debt should be issued instead of relying on equity. Pecking order, in theory is all about hierarchy much as the name suggests. In finance, this means debt to equity issuance. In this theory, internal funding does have a lower transaction cost compared to debt issuance. It is noted that new equitey is not a preferred source of determination in this theory which may make for inaccuracies at best.

Pinder, S. (June 2007). Financing Decisions. University of Melbourne Financial Management (333-641) lecture notes online.