Question

Discuss the tradeoff between taking on a large load of debt due to its lower cost versus the increased probability of financial distress when too much debt is used on the other hand. How does this relate to an optimal capital structure? Initial response 250-300 words

Answer 1

Of the two primary sources of capital, namely, debt and equity, debt has lower cost for the firm. It is for two reasons; the first one being that debt suppliers demand lower return [being preferred over equity for interest payment and principal payment] and the second one being the tax deductibility of interest expense for the firm.

Debt being cheaper, it would be in the interest of the firm and the shareholders to increase the debt proportion, as more and more debt would result in lower WACC and higher net present values for investments made. But, the addition of debt beyond a certain proportion would be counter productive as increased debt increases the probability of bankruptcy.

When the probability of bankruptcy of the firm increases, the cost of both debt and equity is bound to go up. The cost of equity would increase much more than the increase in the cost of debt, as the burden of financial distress, in the case of bankruptcy, will fall on the equity holders. This will take the WACC curve upwards from the point of minimum value.

The situation can be explained by the traditional theory of capital structure, which, lays down that:

*Up to a certain proportion of debt that, is considered normal, the cost of debt and cost of equity would be held constant. Up to that point of leverage, the WACC will keep on decreasing as more and more of debt is added.

*Beyond the proportion of debt, mentioned in the para above, the cost of debt and cost of equity would increase marginally as more of debt is added. But those increases would be marginal and the increase in cost of equity would be almost set off by the advantage due to higher debt, making the WACC constant.

* Beyond a proportion of debt, above the level referred to in the para just above, the risk of the firm would be perceived as being too high and both the cost of debt and cost of equity would rise sharply, pushing the WACC up and up.

Hence, there is a point beyond which debt cannot be increased to the benefit of the shareholders.