Question

(a) (i) Read the two Economist articles entitled ‘Debt is Good for You’ (dated 01/25/2001) and ‘Debtors’ Prison’ (dated 02/09/2009), which discuss the reasons for corporations’ increased use of debt financing, and subsequent concerns about excess borrowing. (ii) Summarize and synthesize, in not more than two (2) pages, the contents of the articles, and conclude with an opinion on how the information you have read would affect your capital structure decisions as a financial manager (i.e. would you use less or more or less debt than suggested by the MM and Trade-off (static) models of capital structure), and why.

Answer 1

The article “Debt is Good for you” provides an insight into the positive impacts of debt and how it can create more value for the stock holders because of its impact on tax savings and since dividend is distributed net of taxes and is again taxed in the hand of dividend receivers. Thus it provided an opinion that increasing debt is actually good as it creates a tax shield and also due to higher leverage, the return on equity is higher.

In the other article, wherein the negative effects of debt are emphasized especially post the financial crisis, it is presented that high level of debt lead to significant erosion of value. With over leveraging of the capital structure, the business model becomes highly susceptible to slight variations in the demand and overall economic scenarios.

As a prudent financial manager, it makes sense to maintain an optimal capital structure which would depend also on the robustness of the business model and the interest cost scenario. To account for a possible deterioration in the overall business scenario, it is always preferable to err on the side of caution and have the balance sheet less leveraged as it provides a better capability to withstand economic recessions and prevent a company from going bankrupt.

So while financial theory may call for an optimal capital structure wherein debt plays a significant role to maximize return on equity, prudence calls for a much more conservative capital structure to ensure sustainability of business and its continuity.