Debt Financing and Investment Value of Common Stock

Abstract

As a basic premise, it is assumed that debt or equity financing should be undertaken only when it is reasoned that existing shareholders will be better off with the financing than without. Investment value of common stock is taken to be the measure of the economic wellbeing of existing shareholders. This value is defined as the present worth of after taxes discounted at an annual percentage rate acceptable to investors where anticipated cash dividends include distributions received during the investment period and the representing the price at which the stock is eventually sold. Dividends to be received during the investment period are dependent upon the outlook for earnings and dividend payout. These in turn are functions of the assets available to the firm, the rate of return at which these assets are invested, the corporate capital structure and dividend policy. The final dividend or sales price depends, moreover, upon the price which other investors will be willing to pay for the stock sometime in the future. Investment value of common stock is consequently a function of the outlook for earnings and the rate of discount applied to these projections by both the existing shareholder and prospective investors.' Since investment value is dependent both upon the existing and prospective owners' outlook for the probable level and timing of earnings, and dividends and also upon their respective minimum acceptable rates of discount, management's decision to utilize debt should be determined not only by the estimate of improvement in earnings resulting from leverage but by the attendant risks and uncertainties which are likely to influence investors' rates of discount. Trading on equity is warranted, therefore, when it is believed that investors will be willing to pay more for the common stock; i.e., when the increase in the present value of ultimately available dividends arising out of the profitable investment of the borrowed money is expected to be greater than the reduction in present value of all dividends arising out of application of a higher minimum discount rate by investors.