Question

Bankruptcy Cost -

(A) Suppose interest on debt was not paid prior to corporate taxes, so debt was not tax-advantaged, but interest still had to be paid or else the borrower was in default. Many fewer companies would risk issuing compare debt in this case. How would this negatively impact investors?

(B) In their early years, many dot.com companies have earnings (EBIT) that fluctuate dramatically, sometimes positive and sometimes negative. Those companies almost never use debt financing during those early years. Why not?

Answer 1

Part (A): If the companies stop issuing debt, then it will impact investors in ways as below:

• Fixed income investors who prefer a fixed return will have lesser investment options since the corporate debt market will shrink.
• Since the pay out (interest cost) is fixed, using debt helps equity investors improve their ROE as long as their investment return is higher than the cost of debt
• Since the cost of debt (even without the tax advantage) is lower than equity, if the debt issuances reduce then the cost of capital for firms will go up which will indirectly impact the investors

Part (B): Debt financing requires a relatively steady EBIT since the debt pay outs are committed pay outs and unlike equity have to be paid on time otherwise the company would be in default. Given the restrictive nature of the debt covenants companies with erratic cash flows will always find it difficult to service their debt and more importantly even raising debt financing at reasonable rates will be challenging. Hence the reason that the dot com companies relied on equity source instead of debt for their funding requirements.