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Equity vs Debt

Equity vs Debt Financial Statement Information - Debt and Equity Holders  Debtholders and equityholders as claimants to a firm’s future cashflows are interested in assessing risk.  Debtholders are primarily interested in assessing whether the firm’s cashflow will be sufficient to make interest and principal payments on a timely basis  The lower the probability of a cash shortfall, the lower the risk to the debtholder  Debtholders therefore gather information about the firm’s liquidity, debt capacity and liquidation value of assets  Equityholders are residual claimants of the firm’s cashflows  Shareholders in effect, hold an option on the value of the firm’s assets, with the exercise price equal to the face value of the debt  It is well known that the option component of equity value increases with the variance of expected future cashflows – Black and Scholes (1973) and with the firm’s debt to equity ratio  Therefore, when equity has a large component of option-like characteristics, financial statement analysis focuses on assessing both the expected level and the variance of future cashflows when valuing equity  At extreme debt levels, the equity is a ‘deep in the money’ option and its valuation does not require the use of the option pricing model  More traditional valuation models suffice  Financial analysts are interested in assessing a firm’s Beta risk so that they can perform valuation of traded stocks, seasoned equity issues and public offerings.  Financial statement information is useful in assessing corporate and municipal bond risks  Wakeman (1981) argues that explanations offered by the ratings agencies, the timing of rating changes and ability of financial ratios to explain cross sectional variation suggest that ratings agencies use financial statement information  Hand, Holthausen and Leftwich (1992) found that unanticipated ratings changes are associated with significant bond and share price effects, especially when bonds are being downgraded.  Creditors and equity investors alike are interested in knowing the likelihood of a firm experiencing financial distress  A high probability of distress indicates both debt and equity are risky  Investors factor this information into portfolio decisions  Lenders use the financial information in lending decisions  Therefore bankruptcy prediction is useful in an efficient capital market  Beaver (1966) and Altman(1968) conducted early work on bankruptcy prediction  They found that economically intuitive ratios like leverage, earnings before interest and tax over assets and working capital over assets are useful indicators of financial distress  Altman’s models and his Zeta scores have been popular in the financial community due to their high degree of predictive accuracy  Ohison disagrees with these models arguing their predictive ability is over-rated due to sample issues  Altman and Spivack have compared the Zeta approach and the Value Line approach and conclude the models rank similarly  The most common measure of equity risk is the CAPM Beta  One way of estimating the expected rate of return on equity is to add the risk free rate to an allowance for the risk, equal to the Beta times the estimated risk premium  The limitation of market return and accounting Betas is that they are obtained using historical data and therefore may be less useful  Rosenberg and Guy (1976) give examples of macroeconomic events like energy crises, inflation, etc and their impacts on Beta  Lev (1974) shows that changes in a firm’s operating leverage should be positively associated with Beta risk changes  Ball, Kothari and Watts provide evidence that earnings changes are positively associated with Beta changes  Beaver and Morse (1978) analyse the usefulness of earnings yield as a measure of risk and earnings growth  They argue that earnings yield would be decreasing in the Beta risk of a stock  They also show that, perhaps better than as a risk measure, earnings yield forecasts earnings growth  CAPM used for over two decades as a determinant of the expected rate of return on equity  Recent studies provide evidence contradicting this  These studies show that firm size, earnings yield, dividend yield, leverage and book to market ratio explain cross sectional variation in average return that Beta cannot.  These studies are supported by research by Fama and French (1992). Bibliography:

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