Question

Is that reasonable to assume the same interest rate before tax for all the debt in all recapitalization situations in a company? In the cases of 30%, 50% and 70% debt ratio.

Answer 1

No. It is not correct to assume same interest rate before tax for all debt in all recapitalization level or debt ratios. This is a practical example, where as your level of debt rises, interest rates also rise.

But to reach to this conclusion, let us look at why is this the case.

Now, the interest rate that is paid is basically the return expected by the lender for his 'investment' (funds borrowed) in the firm. For many firms, they can sufficiently cover their interest expenses at low levels of debt in their capital.

But, as the debt ratio increase, so would be the interest payments that would be needed to service the debt. Increased interest payments would have to be compulsarily met (unlike dividends which can be skipped). Increase interest payments may weaken the financial stand of company and may lead to a credit rating downgrade. A lower credit rating would basically change their risk profile, and the new lender would demand more return for the higher risk that he is taking.

So, as the debt increases in capital structure, risk (of default) also increases. this risk increases slowly at the initial levels of debt but may aggravate to unsustainable level after the optimal debt ratio.

And in line with our basic investment policy, higher risk demands higher return, the interest rates would keep on increasing as the debt ratios increase.

So, interest rates would be lower when debt ratio is closer to 30%, but as this ratio climbs, so would the risk and interest rates climb on the new debt issuances.