© 2000 John Petroff
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© 2000 John Petroff |
1)- Review of benefits and detriments from using debt
Aside from the major justification for capital structure listed above, companies may want to gain any one of the benefits financial leverage provides, or on the contrary, avoid a detriment.
Let's review the benefits or using
debt:
1- Lower cost: because the lender is promised to be repaid, the
lender takes less risk than the equity owner, and therefore the
interest paid on debt is lower than the return that must be offered
to the equity owner (historically around 6% less, as shown in
Table T-2.1).
2- Tax deductibility: in virtually all countries, interest is
deductible from revenue when calculating earnings subject to corporate
income tax; this reduction of the cost of borrowing is significant
because most corporate tax rates are over 30%; by allowing the
tax deduction, the government in effect subsidizes borrowing;
but, naturally, the company must have earnings to benefit from
the tax saving.
3- Using debt only for the time needed: loans are taken out to
finance specific needs, either seasonal, short term, or long term;
each loan is repaid as soon as the project is completed and there
is no need to incur additional interest payments after that.
4- Matching low cost borrowing with low return assets: the discussion
of the yield curve in Chapter 2 reminds us that, most of the time,
the shorter the maturity, the lower the interest charged; it is
wise to use trade credit given by suppliers and short term credit
available from banks to finance working capital, because these
are somewhat cheaper than interest paid on bonds and a lot cheaper
than the rate of return expected by shareholders.
5- The lower cost of debt financing decreases the average cost
of capital and allows more profitable capital projects to be accepted,
thus, increasing company profits and maximizing the overall value
of the firm.
6- To the extent that fewer shares are issued by a company that
relies on debt, the earnings per share of the company are increased
(provided, however, that the level of debt is not beyond the optimal
point).
7- If earnings per share are increased (and as long as the added
risk to shareholder is not substantial) the wealth of shareholders
is maximized.
8- Less reliance of new stock issues also assures that control
over the corporation is not lost to outsiders; this is especially
important for closely held corporations.
The detriments of using debt:
1- Increased variability of earnings per share is observed even
when very little debt is used, and the variability becomes serious
as debt increases.
2- Potential for default forces lenders to impose restrictions
on company actions.
3- Potential for default raises the cost of borrowing.
4- Potential for default increases risk of bankruptcy.
5- Risk of bankruptcy scares most talented staff away.
6- Risk of bankruptcy lowers moral of remaining staff.
7- Risk of bankruptcy discourages customers from buying and force
company to sell its products at a rebate.
9- Risk of bankruptcy discourages suppliers from entering into
long term supplying arrangements.
10- Financial risk compounds operating risk by adding the fixed
cost of interest expense.
11- Financial risk may aggravate commercial risk if additional
sales expansion is necessary to cover interest cost.
12- Loss of control over company if bankruptcy is declared.
13- Loss of wealth for owners in case of dissolution because of
bankruptcy.
See review questions Q-11F1.1 through Q-11F1.3.
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