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Benefits and implication of the use of debt

Introduction

For decades, the theoreticians have been entangled in the decision of an optimal capital structure and divided into various groups of theory in terms of the structure. Among them, Franco Modigliani and Merton Miller (1958, 1963) proposed a famous theorem which forms the basis for contemporary thinking as for the capital structure, although such a theory is generally seen as a purely theoretical view since there are many important factors missing from it in the capital structure decision. The view basically states that in a perfect market where there is no transaction or bankruptcy cost and there is perfect information, a company’s value is independent of how the company is financed. However, in a real world, imperfections and all those important factors assumed away exist, especially taxes. Many theoreticians hold views that under a classical tax system, the tax deductibility of interest makes debt financing valuable, that is, when a company raises capital by taking on debt, it can write the debt payments off of their income taxes, so the cost of capital decreases as the proportion of debt in the capital structure increases. As a result, it would be easy to predict that an optimal capital structure would be to have virtually no equity at all. To avoid this extreme prediction, offsetting costs of debt are needed to achieve a realistic optimal leverage level. There is clear evidence to show that leverage exists in all kinds of companies. This paper expresses some of my understanding about implication of debt fianancing.

Literature Review

The most well-known theory in terms of debt financing is Trade-off theory (Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe, 2002), which describes that the companies are generally financed by both debt and equity, and a decision maker running a company evaluates the various costs and benefits of alternative leverage plans.

The theory primarily deals with the two concepts – cost of financial distress and agency cost. The first concept states that although there is a benefit to finance with debt, there are financial risks always associated with debt financing. While financial risks cover various forms, the financial distress is a common form of financial risks when we talk about the debt financing. A company experiences financial distress if it is unable to cope with the debt holders' obligations. If the company continues to fail in making payments to the debt holders, it can even be insolvent. The fact, that bankruptcy is generally a costly process in itself and not only a transfer of ownership, implies that these costs negatively affect the total value of the company. These costs can be thought of as a financial cost, in the sense that the cost of financing increases because the probability of bankruptcy increases. When a company goes bankrupt investors holding its debt are likely to lose part or all of their investment, and therefore investors require a higher rate of return when investing money in the company that can easily go bankrupt. This implies that an increase in debt which ends up increasing a company's bankruptcy probability causes an increase in these bankruptcy costs of debt. The second concept of the theory is the agency cost. When a company has debt, the company may often experience a dispute of interests among the management of the companies, debt holders and shareholders. Debt holders typically value a risk-averse strategy since that will increase the chances of getting their investment back, while stockholders on the other hand are willing to take on very risky projects. If the risky projects succeed they will get all of the profits themselves, whereas if the projects fail the risk is shared with the debt holders. Debt holders know this of course, so they will have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects should they arise, or they will simply raise the interest rate which in turn increases the cost of capital for the company. These disputes generally give birth to agency problems that in turn give rise to the agency costs. Therefore the agency costs may affect a company’s value and thus its the capital structure. Such an opinion is also employed in the agency theoretical models (Stewart Myers, 1977).

Despite of the two concepts, the Trade-off theory particularly points out that there is an advantage to financing with debt, the tax benefits of debt. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. It refers to the fact that from a tax perspective it is cheaper for companies and investors to finance with debt than with equity. Under majority income taxation systems around the world, income tax creates a benefit for debt in that it serves to shield earnings from taxes.

With these main elements of the theory, the following analysis explains the implication of debt financing to a company’s capital structure.

Analysis and Discussion

In a real competitive market, market imperfection exists, which means investment decisions are truly affected by financing decisions. Companies operating on debts can effectively lower the weighted average cost of capital (Stephen A. Ross, Randolph W. Westerfield, Jeffrey Jaffe, 2002). Such effect can be reflected in two ways. For one thing, because the debt yield is fixed, usually the debt holders can call in the capital at maturity unless the company is insolvent or bankrupted. Therefore the debt holders bear lower risks in credit than those in equity and receive lower rate of return accordingly. For another thing, companies financed with debts can benefit from tax shield (based on the methodology of Graham (1996a)), which can be defined as the reduction in income taxes that results from taking an allowable deduction from taxable income. Because interest on debt is a tax-deductible expense, taking on debt creates a tax shield. Since a tax shield is a way to save cash flows it increases the value of the companies, and it is an important aspect of company valuation. For instance, if a company, financed with all equity, that earns $1000 dollars in profits would have to pay $300 dollars in taxes, assuming the corporate income tax rate is 30%. It distributes these profits to its owners as dividends, and then the owners in turn pay taxes on this income, say $200 on the $700 dollars of dividends as personal income tax. The $1000 dollars of profits turned into $500 dollars of investor income. If, instead the company finances with debt, then, assuming the company owes $1000 dollars of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $300 dollars. This implies for $1000 dollars of profits before taxes, investors got $700 dollars. The numerical example tells us that interest payment is deductible from profit before tax while the dividend is paid after tax.

Then does that mean a company should finance 100% with debts and can enjoy tax benefit unlimitedly? The answer is No. In reality, there is no such a company financed fully with debts, although it might be pointed out that during the late 1980s there was a considerable amount of substitution of debt for equity among companies, particularly in the case of leveraged buyouts. However, many of those companies subsequently failed, Unocal as an example. The Trade-off theory proves the existence of optimal debt/equity ratio, also known as the leverage, which all companies should seek for. Let’s formulize the theory to explain why the extreme case of full debt financing is not possible in real business environment: V(a) = Vu + TD(a) - C(a). Among the formula, V stands for the value of a leveraged company, Vu for the value of unleveraged company, TD for the taxation of the leveraged company, C for bankruptcy cost, and a for the debt/equity ratio. According to the theory, Vu is a constant, while both TD and C are the increasing function of a. When a bears small value, the value of TD increases faster than that of C does, which means tax benefit exceeds bankruptcy cost and it’s good for the company to increase proportion of the debt. As a increases, there will be an equilibrium point where TD’s increment is equal to C’s. If a continually increases, tax benefit will not outweigh the cost of bankruptcy and the company is probably facing insolvency. The following graph can represent the equation (A. Kraus and R.H. Litzenberger 1973):

From the graph we can see the relation between the company’s value and the leverage is not a pure linear relation. When marginal benefit of tax shield equals to the marginal cost, a company’s value reaches the peak and at this point, the debt/equity ratio is optimal choice for the capital structure.

Conclusion

As we have observed a simple model of debt financing in which the major forces affecting companies’ financing decisions are corporate tax and bankruptcy, it’s not difficult for us to see that debt financing is “cheap” in the sense that required rates of return on equity will always be higher than the interest rate on debt, but while we may use cheap debt to finance a project, the increased risk to shareholders from increasing our financial leverage results in an increase in the cost of equity. The average cost of capital reflects both the cost of debt as well as the cost of equity and thus reflecting the increased cost of equity associated with the use of more debt financing. This is one reason that using the average cost of capital in valuing a company’s value is more appropriate sometimes, even if we intend to borrow all of the money to finance it.

By focusing on the trade off between tax shield and financial distress, I don’t mean to underestimate the importance of other factors. Rather, my analysis just shows that the simple trade-off framework actually does much better at predicting typical leverage levels than is generally recognized. Actually it would be interesting to determine the contribution of debt financing to company value after accounting for other factors.

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