When a firm faces new investment opportunities which have positive net present values, financing needs come along. The options range from using cash generated from operations to just simply forego the projects.
If the company wants to take its projects, the options to raise new funds -disregarding cash generated from operations- are issuing equity or debt financing. The combination of equity and debt which a company decides to use is known as its capital structure. This paper is about how a firm ought to establish its debt/equity ratio, focusing on the pros and cons of debt financing.The Capital Structure As stated before, the capital structure of a firm is the mix of equity and debt used. When referring to the capital structure of a firm, it is impossible to avoid Modigliani-Miller’s (MM) influential paper “The Cost of Capital, Corporation Finance and the Theory of Investment” (1958).
The main findings in this paper are that the firm’s value is invariable despite relative changes in its capital structure, which is also known as MM first proposition.The MM second proposition affirms that the use of debt for financing increase the expected future earnings, but this increase is coupled with an increase in the risk to equity holders, thus the discount rate used to value these future earnings also increases. In other words, the first proposition states that firm’s value does not depend on the capital structure’s mix. The second affirms that firm’s value is positively related with leverage (in a world without taxes).
But these hypotheses rely on a “perfect market” assumption.When imperfections are present into a certain market this hypothesis is misleading; changes in a firm’s capital structure could change the firm value. Related to this, Myers states that “firms’ debt policies may reflect imperfect or incomplete capital markets” (148). For example, the presence of market imperfections as taxes may lead to different choices, as the Internal Revenue Code (1963) allows interest payments to be deducted by an organization when determining its taxable income.
In this brief preliminary approach the idea that a firm’s value is positively related to the amount of debt chosen is introduced. The choice between equity and debt is object of many researches, and it is usually presented in a trade-off context, i. e. choosing the capital mix through balancing cost and benefits. In the next sections the effects of debt financing will be explored in order to shed some light on the issue stated in the introduction.
Debt Financing Unfortunately, MM propositions are not reflected in the “real world”. Many issues are associated with the use of debt.The basic idea, when choosing debt financing, is to determine the trade-off between the benefits and the costs associated with debt which, in turn, will lead to an optimum amount of debt. Benefits The main benefit comes from the fact that interest payments are deductible when determining taxable income.
This benefit is known as Interest Tax Shield, due to the fact that “interest expense shields income from taxation” (Fabozzi and Patterson 602). Taking account of the expression above, whatever the taxable income of a company is without debt, the taxable income is now less in an amount equal to the Tax Shield in the presence of debt.Jensen and Meckling propose that the agency relationship may lead to the manager “choose a set of activities for the firm such” (306) that will decrease the total value of the firm. They explain this fact as follows: “if both parties to the relationship are utility maximizers there is good reason to believe that the agent will not always act in the best interests of the principal.
”(308). Thus, the presence of debt can be seen as an instrument to commit managers to operate more efficiently, diminishing this way the agency costs.Myers points “managers avoid high debt ratios in an attempt to protect their jobs and stabilize their personal wealth” (148). Coupled with the paragraph above is the fact that lenders will be engaged to monitor the managers and the firm’s activities. However, Myers points “the theory should be able to explain why tax savings generated by debt do not lead firms to borrow as much as possible” (147), or the differences among firm’s borrowing amounts or the difference in the maturity chosen. This conducts to the idea of costs associated with debt financing.
Costs The main costs associated with debt financing are financial distress, personal taxes, agency costs and bankruptcy. Interest and principal payments are obligations, when not met, the firm faces the risk of financial distress or even bankruptcy. Financial distress bears costs: as levered firms may face financial distress; investors will reflect it requiring a higher return for the levered firm’s securities. The costs associated with financial distress are directly related to the probability and the costs linked if it occurs.These costs vary and depend on several certain items. Major issues are the conflicts that may appear among stockholders and bondholders, affecting the firm’s operations.
Stockholders may be “tempted to forsake the usual objective of maximizing the overall market value of the firm and to pursue narrower self-interest instead” (Brealey & Myers 503), leading to costs of financial distress. Bankruptcy costs are the costs of allowing creditors to take over the firm when it can not face its debt payments.This occurs when stockholders decide to default; due to limited liability, it is the creditors who should confront the problem. These costs are mainly legal and administrative.
But there are also some indirect costs which appear when creditors, suppliers or even customers are reluctant to operate with a firm that may disappear in foreseeable future. Myers states that “bankruptcy costs (the transaction costs of liquidation or reorganization) probably discourage borrowing” (148).The presence of personal income taxes can also decrease, or even eliminate, the advantage of corporate taxes associated with debt financing. Merton Miller proposed that, in presence of both, personal and corporate taxes, the decisions about capital structure of a firm were irrelevant.
Myers proposes another issue, relative to debt financing, that is sometimes ignored, affirming that “Firm with risky debt outstanding, and which acts in its stockholders’ interest, will follow a different decision rule than one which can issue risk-free debt or which issues no debt at all”(149).Also he states that firms financed with “Risky debt will, in some states of nature, pass up valuable investment opportunities - opportunities which could make a positive net contribution to the market value of the firm”. Therefore another cost appears, i. e. debt issuing may lead to a decrease in the market value of the firm by “by inducing a future strategy that is suboptimal” (Myers 149) Now it will be interesting to see whether these theories are reflected into reality. Brief Literature SurveyThe cost of debt and, particularly, capital structure decisions produced much theoretical work and researches.
Some of them will be now explored. Panteghini in a work about multinationals capital structure found that “optimal leverage is reached when the marginal benefit of debt financing (which is due to the deductibility of interest expenses) equates its marginal cost (which is related to the expected cost of default).A strategy used is “Income shifting” which “raises the tax benefit of debt financing, thereby stimulating debt financing, and delays default. (2) Verschueren research about Belgian companies strategies showed that “the hypothesis that firms for which the tax advantage of debt financing is higher have higher debt tax shielding ratios gets only meager support: more profitable firms have lower debt tax shielding ratios.
” She found “no indications that avoiding agency conflicts of any type plays a significant role in the determination of debt tax shielding. ” (22) She states that these results are quite close to international research also.Graham and Tucker found a similar result “firms that use tax shelters use less debt on average than do non-shelter firms. ” There is also a potential problem which is that “under-levered firms may have “off balance sheet” tax deductions that are not easily observable, and which are therefore often ignored in empirical analyses. ” (1) Irina Stefanescu arrives to a comparable conclusion “There is a general consensus that significant tax incentives are associated with corporate borrowing.
Nevertheless, many large and profitable companies with a low risk of financial distress have relatively low debt ratios. ” (2) Stewart Myers, explaining Miller’s paper “Debt and Taxes”, theorizes about why firms are not “awash in debt”. An interesting point he states is that Miller’s model “allow us to explain the dispersion of actual debt policies without having to introduce non-value-maximizing managers”. In the other hand he states also that “firms have good reasons to avoid having to finance real investment by issuing common stock or other risky securities.They do not want to run the risk of falling into the dilemma of either passing by positive NPV projects or issuing stock at a price they think is too low”.
(1980) Binsbergen, Graham and Yang found in their research that “large firms with tangible assets and few growth options tend to use a relatively large amount of debt” and “firms with high corporate tax rates also tend to have higher debt ratios and use more debt incrementally”(1).Conclusion The trade-off theory seems to be adequate still, and it is somehow reflected in reality also. Also, it is clear that is easier to measure the benefits from debt than to calculate the exact magnitude of numerous costs related with debt financing. Thus, the pros and cons of debt depend on many factors and the benefits should be contrasted with the costs associated for the specific firm.Referencesfinance.wharton.upenn.edu/department/Seminar/2007Spring/micro/graham-micro040507.pdfpapers.ssrn.com/sol3/papers.cfm?abstract_id=676628
