Debt capital inexpensive relative to equity

So, what is the cost of the equity that is currently being raised to replace debt? Using the Capital Asset Pricing Model it is not hard to work out what it is in normal market conditions. During the week, one commentator put the current cost of equity at bank bills plus 12 per cent, which may be right, but for those currently rushing to raise equity the cost may be even greater.

Last week we saw a rush of companies falling over themselves to issue shares at deeply discounted levels. The total value of shares issued since the beginning of the year has been put at $10.5 billion, with more than half of this volume being issued last week.

If this equity is being raised to rebuild damaged balance sheets, then fair enough; but if it is being raised simply to replace debt, then shareholders have ample reasons to question the massive dilution that is being thrust upon them.

Moreover, these raisings are pushing the Australian equity market back towards the lowest levels that have yet been seen in this crisis, as institutional investors ditch other holdings to participate in the new issues. This only serves to further erode the current market value of equity.

There may be justifiable arguments over the appropriate mix of debt and equity. But are corporate treasurers and chief financial officers seriously saying that they cannot raise any debt, at anything less than bank bills plus 12 per cent?

As already pointed out, corporate bond markets, domestic and international, currently look like viable sources of debt funding, though they may not remain so for long.

One challenge to be faced is the massive amount of government bond issuance that is coming, to fund the various rescue packages that have been, and will be, put in place around the world.

Australia's government announced only last week that it will issue $22 billion to $24 billion of bonds before the end of June 2008. Issuance started on Friday with the sale of $600 million of six-year bonds. The government also plans to lift the cap on bond issuance to $125 billion during the week, from the level of $75 billion proposed to parliament only recently.

The bonds that the government wants to issue before the end of June will fill the hole left by kangaroo issuers this year, all by themselves. This assumes that they will all be sold to domestic investors and they might be, when it is considered that European and American governments are expected to issue US$3 trillion of bonds this year - three times their level of issuance in 2008.

Government bond issuance does pose a crowding out and cost of debt problem for corporate borrowers: yields will undoubtedly move much higher.