Equity and Debt slp Assignment Example | Topics and Well Written Essays - 750 words

Equity and Debt slp - Assignment Example How this is important can be understood from the following example. While considering a small project needing investment of $10 million, the company ABC has several alternatives beforehand. It has been forecast that the project is likely to generate operating profit of $3 million in a year excluding interest charge against debt portion of the capital. The company has two alternatives to fund the required investment. The company may choose 100% equity means all money will be provided by the shareholders. The company may issue 10 million shares to its shareholders each having a par value of $1. In another alternative, the company may choose 50% equity and 50% debt to fund the investment. Debt is available to the company at 10% interest rates to be paid annually. It will be interesting to see how the earnings per share of the company are affected in both situations. It is amply clear from the above chart that by incorporating debt to funding the project the firm has been able to enhance its earnings per share resulting into higher valuation in market place. By applying the same P/E multiple, the company’s equity valuation is higher by 66% when the project is funded with the debt equity ratio of 1:1 instead of 100% equity. But this does not mean that debt can be raised to any level to enhance the company valuation. The higher the debt means the higher interest burden on the company. This also means that if the project is not able to pay its interest costs as usually happens in severe recession then the project will be in jeopardy due to higher interest burden. This also means that project must choose an appropriate mix of debt and equity depending upon its profitability and industry norms. Considering an investment project of $150m that is capable of generating 5m and 10m of operating profits before interest payments in its first two years of operations is likely to suffer from liquidity issues when it adopts its funding