Question

Debt is generally cheaper then equity so why don’t companies finance themselves almost completely with debt? How much debt is too much debt? Why would issuing additional debt bring a benefit to shareholders in terms of increased return on equity? Be sure to address all three points mentioned in this question.

Answer 1

To understand the solution better a background of the concept is given

Background

Both debt and equity are used by a company as capital to run their business. But to obtain this capital, there is a cost associated with it. In case of debt, the cost of capital is the interest expense a company pays on its debt. In case of Equity, the cost of capital refers to the claim on earnings which must be given to shareholders for their ownership stake in the business. To understand the concept better, let’s take the help of the following example:

For example, if you run a small manufacturing business and need $80,000 of financing, you can either take $80,000 bank loan at a 10% interest rate or a 25% stake sale of the manufacturing business to person A for $80,000 can be done to raise money.

Debt Financing: Now, suppose the manufacturing business earns $50,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $8,000 (10%*80,000) leaving you with $42,000 ($50,000 - $8,000) in profit.

Equity Financing: In case of equity financing, the debt is zero and hence no interest expense, but can only keep 75% of the profit, which is $37,500 (75%*50,000). The rest of the profit which is $12,500 (25%*50,000) needs to be paid to the owner for his 25% stake in the company.

Debt financing gives higher return for the business. Also, there would be tax benefit in case of debt financing, which we have avoided in the example to make the case simpler.

Main Solution

Point 1: Even though Debt is cheaper than equity, but companies never finance completely with debt, because debt financing means the business has to pay a fixed amount of interest expense to the banks, irrespective of the profitability of the business. The fixed cost nature of debt can be a burden for companies whose future earnings are uncertain. So to avoid high risky situation, companies use an optimal ratio of both debt and equity to finance the business. Companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries.

Point 2: Now, how much level of debt can be considered too much can be explained with the help of the concept of Financial leverage, Financial leverage refers to the use of debt to acquire additional assets, to increase production and sales and hence earnings. The most obvious risk of financial leverage is that it multiplies losses. Also it could affect solvency of a company, a company that borrows too much money might face bankruptcy during a business downturn, while a less-levered company may avoid bankruptcy due to higher liquidity. So the amount of debt should be at the level where a company can pay its interest, taxes and other operational expenses on time and should have enough liquidity to save the business in bad times.

Point 3: Using debt is advantageous to existing shareholders because of the effect of financial leverage, additional debt is used by the companies to purchase additional assets and invest that in expansion of the companies, which would lead to increase earnings because If percentage change of Earning before Interest and Tax (EBIT) is more than percentage change in sales, the higher operating leverage will effect ROE positively because at this level, per unit fixed cost will decrease as the sales increases due to economies of scale. A small increase in sale will boost EBIT and if EBIT increases, ROE will automatically increase. ROE = Net Income/Average Shareholders Equity.