A CFO is proposing that his company issues equity to reduce leverage because the company's current leverage ratio is 40% and the CFO believes that lower leverage will increase company value. However, a board member, who is a CFO of a different company, said that despite having a high leverage ratio, the company is mature and highly profitable, and has an investment-grade credit rating (rating of A-). The board member is arguing that the company doesn’t need to issue equity to reduce debt.
Question: Who is right (the CFO or the board member)?
Explain your answer.
Both the CFO and the board member could be right, depending on the specific circumstances of the company and its industry. Lowering leverage by issuing equity can increase a company's value in several ways. For instance, it can reduce the company's cost of capital by improving its creditworthiness and reducing its interest expenses. Additionally, issuing equity can also improve the company's liquidity and financial flexibility, which can enable it to pursue growth opportunities, such as acquisitions or investments in research and development. However, the board member's argument that a company with high leverage can still be mature, profitable, and have an investment-grade credit rating is also valid. High leverage is not always a sign of financial distress or poor management, especially if the company generates enough cash flow to service its debt and has a diversified revenue stream. In some cases, a company may prefer to maintain its leverage to preserve its tax shield or to fund its growth plans without diluting its existing shareholders. Therefore, the CFO and the board member should evaluate the company's specific circumstances and goals before deciding whether to issue equity to reduce leverage or not. They should consider factors such as the company's industry, growth prospects, competitive position, cash flow, capital expenditures, dividend policy, and risk tolerance. A thorough analysis of these factors can help them determine whether lowering leverage through equity issuance would create value or if maintaining high leverage would be more beneficial for the company.