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:
D/(D+E) 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 2 D/E [1]/(1-[1]) 0,00% 11,11% 25,00% 42,86% 66,67% 100,00% 150,00% 233,33% 400,00% 900,00% 3 Debt [2]*[14] 0 4872,1111 10962,25 18792,43 29232,67 43849 65773,5 102314,3 175396 394641 4 EBIT (Op Inc.) from Intel's inc. st. 11.264 11.264 11.264 11.264 11.264 11.264...
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