Question

If a large company has no debt that means that they are not using leverage of an appropriate amount of debt to enhance the earnings of their stockholders. Another concern is that they become a prime target for a hostile takeover. Why would that be?

Answer 1

Company's capital structure is made up of borrowed capital as well as owned capital. Borrowed capital means Debt, a kind of loan on which interest is to be paid and owned capital means Equity and preference shares i.e. amount invested by shareholder who will earn dividend on it. A proper capital structure must have a proper mix of both kind of capital i.e. debt as well as equity. If the company has more of debt in its capital structure then its interest obligation increases. If a company finances all of its capital through equity then all of its income is available to be distributed to shareholder as dividend that make it look attractive to the opposite party who think it to be profitable to takeover that company. But just because of the availability of debt, the net income available for distributing to the shareholder decreases because from the available Earning Before Income and Tax(Operating Income), the company will have to pay the interest and also provide the benefit of tax shield.

(In $)

	1000000 (100%Equity) Company A	1000000(80% equity ,20% debt @ 5%) Company B
EBIT	100000	100000
-Interest	(0)	(10000)
EBT (Earning before Tax)	100000	90000
-Taxes(30%)	(30000)	(27000)
EAT (Earning after Tax)	70000	63000

In the above example, Company A is only using equity and is taxed $30000, left with the residual income of $70000 to be available for the shareholder but Company B has $200000 of debt making its ta liability to be $27000 and residual income of $63000. On the face it appears that Company A is more profitable so businesses will try to takeover Company A.