Debt vs Equity Financing
When skimming a balance sheet of a company you wish to potentially invest in, one of the first things people look at is the company’s debt-to-equity ratio.
The debt-to-equity ratio basically tells us how much of the business’s debt can be repaid with the equity in the business. Ideally, we would like to see a very low debt-to-equity ratio. This would mean that in a worst-case scenario, much of the equity that we, as investors, place into the business will come back to us if all of the debt is recalled. So, if having low debt levels is good for attracting investors, why do companies take on debt at all?
This question comes down to a concept called capital structure. In short, a firm’s capital structure is how much of the firm is financed with debt and how much is financed with equity. In reality, many companies don’t simply have debt and equity. Many companies have several tranches of debt with different terms, interest rates and amounts. This is all part of a firm’s capital structure.
Now, the important thing to note here is that there is a theoretical model for how capital structure affects things like stock price and returns, and how it works in practice. Many academics and practitioners debate this issue at length, and there really is no consensus.
One of the academic perspectives is that the capital structure should have no effect on the returns of a company’s stock, it just affects the stock price at which investors will purchase the stock. This is, of course, assuming a universe in which the market is completely efficient, and everything is completely disclosed. Of course, in some cases such an Enron, the capital structure is not completely made public.
Interest Tax Shield
One of the biggest reasons to take on debt is the interest tax shield. Understanding this means taking a look at the income statement. Businesses are taxed on their Net Earnings AFTER interest. This means that having interest payments can actually reduce the amount of tax that is paid. Now, of course it also includes an extra expense onto the income statement, so why is it an advantage?
The reason for this is actually quite simple. The goal of a company (theoretically) is to provide as much of the return as possible to all investors. Debt holders are investors. Therefore, the more a company pays out to investors, the better it is doing. This is best illustrated using numbers.
The above numbers show a firm with the same EBIT (Earnings before interest and tax) but different capital structures. When the firm is levered, we can see that the total available to all investors is higher. This is essentially because some of the money that is paid to investors is tax free.
There are two factors that affect the difference between the leveraged payout and the unleveraged payout. These are tax rate and capital structure. In general, the less income that is taxed, and the income that is taxed at the lowest rate will increase the amount that is paid to investors. Attached will be a spreadsheet in which you can experiment with capital structure, and the interest tax shield. Instructions will be included in the spreadsheet.
Bank loans are a very common form of debt. Big companies are often able to gain very cheap loans from banks, so it is a good option for them. However, banks are often hesitant to make big loans for risky investments that the company plans to make. In this case, financing a risky venture is much more suited to equity, where investors with a higher risk appetite will be willing to give capital.
The obvious difference here is the role of venture capitalists, however big corporations will have less interaction with venture capitalists than small start-ups.
Is debt good or bad?
The answer, as with everything in finance, is it depends. Debt is usually riskier. There is always an agreement with debt that a certain amount will be repaid, and that always includes interest. Therefore, if the company is unable to make a return on the capital raised through debt, they will be in a very bad place. Equity, on the other hand, has no required payout to shareholders. Of course, the company will still in (hopefully) the shareholders best interests, but there is no guaranteed payout if the investment should fail.
In excessive levels, debt can be extremely bad for company. Issuing debt for all financing needs is not the answer. However, if a company has very low levels of debt, it may be beneficial for them to issue debt in certain circumstances. However, this will always come down to specific circumstances, the interest rate environment, the general business environment and a host of other factors.
Below is the Excel Spreadsheet to analyse the effects of Tax Rate and Capital Structure