Question

Why is the default risk higher (and debt/Investors are therefore requiring higher returns as a result) when I increase the debt/equity Ratio? Thanks a lot in advance.

Answer 1

Debt repayment has to be repaid first before any payment can be made to shareholders. If debt increases then financial risk (the risk that the company will default on payments) is high. As debt is increased in the capital structure, initially it helps in lowering the cost of capital for the company as it replaces a costlier source of funds (equity) with a cheaper source. It also provides tax savings. However, if debt is increased proportionately then the tax saving benefits are outweighed by the debt repayment requirements so that the cost of capital starts increasing again. This means that the company has lesser funds available for investing in capital projects and the funds will be sourced at a higher rate. Thus, the reinvestment rate and the return on investments both go down. If this situation persists for long, then cash flows will dry up as the company will not generate enough for its growth. Thus, the company will default on its debt payments.

1). Debt payments here refer to the periodic interest payments which a company has to make to its debt holders and the final bond value at maturity of the debt. Default risk covers the risk of not being able to make the interest payments and/or the final value at maturity, both.

2). The company gets a tax saving from the interest payment which it makes. The interest expense is deducted from the operating profit and then tax is applied to it so essentially, the company pays lower tax than it would pay if there was no interest expense to be made (since operating profit would be taxed directly). As the debt starts growing, the interest payments far outweigh this tax benefit.

3). Lesser funds here mean that the overall net income will go down so the fund available for capital investments will be lower. However, since debt ratio now is quite high in the capital structure, the WACC for the company will be high as well. That is why there is an optimal capital structure for a company which is at a certain debt equity ratio. At this point, the WACC for the company is lowest. After that point, if debt increases, then WACC starts increasing.