Equity Recap

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Assets = Liabilities + Equity. This is the basis for the Balance Sheet and thus one of the important factors an investor uses to value a company. Generally the more Assets a company has while keeping its Liabilities low is a good thing, thus increasing its Equity. These partial shares of Equity are what investors are trying to price, and if an investor is long they want Equity to be as high as possible. Still there are important factors in determining how well a company has done in funding its operations, or its Capital Structure, and thus the value of its stock. Capital Structure is the right side of the Balance Sheet equation, and how the two are put together does matter a good deal to the market.

The leading theory in Capital Structure is the Modigliani-Miller Theorem. The Theorem says that in the absence of taxes, bankruptcy costs, transaction costs and that corporations and individuals can borrow at the same rate, that the Capital Structure of a firm does not matter. All of those assumptions though exist in the real world, thus the Capital Structure of a firm does matter.

Two of the bigger assumptions of the MMI Theorem are taxes and bankruptcy cost. Tax laws allow for the payment of interest to be deducted from income. Thus in a firm’s Capital Structure the more in Debt that operations are financed the larger the savings that can be realized. But if bankruptcy is considered then the more Debt a firm borrows the higher rate a rate they will have to borrow at (all other things remaining constant). So there is a trade-off between taking on more Debt and the higher interest that the firm will have to pay to do so.

There is generally not considered to be an optimal level of Debt/Equity trade-off to make a firm’s Capital Structure perfect. A firm may want to make itself highly leveraged (take on a lot of Debt) in order to rapidly expand operations or acquisitions, thereby growing the true value of the firm. On the flip side a firm may be forced to take on more Debt because it has no other way of continuing its operations, simply to sustain rather than grow. A more conservative firm may choose rather to finance its operations through internal financing which is cheaper but takes longer. Higher leverage can be a great tool is used by a firm that has solid earnings and operations to begin with, but also magnify problems in firms that are operating poorly. Conservative investors will probably like firms which have less Debt on their Balance Sheet, while aggressive investors might desire more Debt for potential growth. Either way Debt simply magnifies whether a company is operating well or poorly. A good way to measure this is the DuPont Ratio. Profit Margins and Asset Turnover measure how well a firm is operating and the Equity Multiplier measures a firm’s leverage and compounds on their operating record. This Ratio is used well across industry competitors, as well as the Debt/Equity Ratio.