Does financing affects the market value of a company?

Corporation tax offers a valuable tax shield that allows interest payments on corporate debts to be deductible for income tax purposes. It enhances the firm’s value by lowering the cost of debt, thus lowering WACC.

The difference can be seen between two companies with similar pre-tax operating cash flows but different capital structure will differ in tax payments as debt offers a tax shield. Thus, the value of a levered company is higher than the unlevered company, which makes debt financing attractive.

Although Modigliani and Miller (Berk, 2011) argued that the market value of a company is not affected by the way it finance its investment, but debt finances increases bankruptcy risk thus causing financial distress. Therefore managers may choose to limit taking on too much debt finance. In the long run, investment and operating decisions are the main drivers in enhancing a firm’s market value. This implies the importance of maintaining a healthy liquidity to secure good investment opportunities

Should you use NPV or IRR to choose between the two projects?

Both NPV and IRR are widely used in capital budgeting to analyse profitability of an investment or project. Both of them are discounted cash flow models and can reach similar conclusions about a single project. They are easy to understand in terms of decision criteria i.e. Accept project if positive NPV or vice versa, accept the project with the higher IRR.

Unlike IRR, NPV considers different discount rates and takes into account cost of capital. Thus may involve a lot of calculation work. IRR would always give the same recommendation even if the discount rates change.This may be favourable among non-financial managers as it involves less work, less confusing and easier understanding by expressing in percentage terms.

IRR is limited and could not be use in the event of changing cash flows i.e. Negative and positive cashflows in between periods.Whereas NPV can be calculated in the event of changing cash flows.

There are however limitations to the assumptions for NPV where it assumes that the discount rate is stable over the life of a project.

Academic suggest that NPV is preferred over IRR as it calculates additional wealth while IRR does not.

Debt Financing and Equity Financing

A firm’s capital structure consists of proportions of debt and equity. It could finance itself through equity only or a combination of both debt and equity. The decision to finance from equity or debt has major implications on its long term sustainability and may affect the value of the firm.

Debt Financing

Advantages:

·         Tax advantage as interest is deductible for income tax purposes, thus cheaper to obtain compared to equity.

·         Motivates manager to borrow more

·         It does not dilute the ownership of the business

Disadvantages:

·         The risk and cost of financial distress increases with the increase in debt i.e. capital and interest payment is made regardless of business performance. (increase in financial risk)

·         In the event of bankruptcy, debt holders are secured and they will be paid first.

Equity Financing

Advantages:

·         Investors may offer valuable business assistance i.e. skills, contacts and experience, especially in early days of a new firm.

·         No need to keep up with cost of servicing bank loans or debt finance, allowing capital to be used solely for business activities. Investors do not expect returns immediately.

·         Investors are often prepared to provide follow-up funding as the business grows.

·         If the business fails, investors will not get their money back. Thus investors have a vested interest in the business success i.e. its growth, profitability and increase in value.

Disadvantages:

·         Raising equity finance is demanding, costly and time consuming, and may take management focus away from the core business.

·         It dilutes business ownership, thus may lead to loss of control of managing the business.

·         Investors expect a share of profits, compared to deft finance, lenders only expect their loans repaid.

·         Prepared to invest time to provide regular information for investors to monitor.