Friday, September 22, 2023
HomeOpinionThe Other Side of Debt Financing

The Other Side of Debt Financing

“How much debt is right for a company?” This is a question my friend asked me the other day when we had coffee together. Even though at that spot I answered him “it depends on the situation (industry, profitability, competitive position and sales volatility) the firm is in”, later that day this very brief conversation brings me back to the corporate finance class which I took some years before. What does an optimal capital structure look like? Is debt better than equity? What is the relationship between capital structure and firm value? How to make a wise investment decision? These were some of the questions which filled my mind right after that conversation. In a way to answer these and other questions I did some research about capital structure which becomes the foundation of this article.
The relative proportion of equity (E), debt (D) and other securities that a firm has outstanding constitutes its capital structure (an equity represents ownership interest of shareholders of a company whereas debt represent money borrowed by the company that must be repaid). When a corporation want to raise funds from outside investors, the most common choices are financing through equity alone or financing through a combination of equity and debt. However, some earlier research reveal that the total value of a firm, its share price and its cost of capital is independent of its choice of capital structure. This means, in a perfect capital markets (no taxes and transaction costs), capital structure merely allocates cash flows between debt and equity without affecting the total cash flows to the firm. But capital markets are not perfect in real world, so what is the significance of the (research) result? This is a very common question raised by many people. A brief response may be that all scientific theory begun with a set of idealized assumptions. It is only after we know this that we can measure how much closely the assumptions hold and consider consequence of any major deviations.
In a real world, the assertion that capital structure will not affect firm value is at odds when we observe that a lot of companies invest significant amount of time both in terms of managerial time and effort and investment banking fees to manage their capital structure. In fact, the choice of leverage is of critical importance to firms’ value and future success in many cases. For instance, in 2018 Awash, Abyssinia, Wegagen, United, Dashen, Oromia COPB and Addis Int bank (all Ethiopian’s banks) have different D to E ratio, though the variation is not as pronounced as firms in different industry (see the Figure 1 below). (Here readers should note that I am not implying any performance comparison by stating the D to E ratio).
If capital structure is unimportant regarding firm value, why we see consistent difference in capital structure across industries and firms? Many previous researches make it clear that capital structure is unimportant in a perfect capital market. Therefore, if capital structure matter, it must stem from market imperfections. One of the most important market imperfections that we will discuss in this text is taxes. Corporations must pay taxes on the income they earn. Because they pay taxes on their profit after interest payments are deducted, interest expense reduces the amount of corporate taxes a firm pay. This means the interest shields the tax the corporation must pay which is usually referred as the interest tax shield. This feature of the tax code creates an incentive to use more debt.
When a firm uses debt, the interest tax shield provides corporate tax benefits. This means a corporation will pay less taxes when it has debt and pays interest for that than it has no or low debt. This conclusion can easily be illustrated with the Pizza example. No matter how you slice the pizza, it is the same amount you have (a setting in a perfect capital markets). However, assume the tax man get a slice of the pizza as a tax payment for every slice equity holder get, but when debt holders get a slice, there is no tax payment. By allocating more pizza to debt holders, more pizza will be available to investors. Even though the total amount of the pizza does not change, there is more pizza left for investors because less pizza is consumed by the tax man as taxes (in other words the tax man gets a fraction of the smaller pizza allocated to equity holders).
All the above discussion leads us to one critical question. “Do firms prefer debt as a source of funding for capital expenditure?” Though I could not find compiled data for Ethiopian companies, evidence of US corporation may give us some insight about firms’ behavior. Data from 1975-2011 shows when US firms want to raise new capital, they do so primarily by issuing new debt. But this does not mean that all firms sell debt to raise funds. There are many firms who sell equity to raise funds, but other firms are buying or repurchasing an equal or greater amount of equity. In other words, firms are net purchaser (rather than issuer) of equity whereas they are net issuer of debt. Hence for US firm’s debt is preferred as a source of external financing. However, companies only revert to external sources (E and D) of financing when the internal sources (retained earnings) are not enough. This means retained earnings is firm’s first choice when it comes to capital expenditure. In other words, a pecking order theory holds which says a manger prefer retained earnings and only issue new equity as a last resort.
Does this mean that firms should use more and more leverage because of the existence of tax advantages for debt financing? Not at all! Studies confirmed that companies should not use the maximum possible amount of debt in their capital structure. Companies should reserve flexibility, a substantial reserve of untapped borrowing power. This is achieved by limiting the amount of debt in capital structure to a certain level even if there is a possibility to borrow more. Excessive leverage may lead a company to financial distress: a situation where it is unable to pay its debt obligations. However, far more significant than financial distress and its attendant cost of bankruptcy is the fact that aggressive use of debt will likely limit the possibility to raise funds quickly on acceptable terms. This leads to liquidity constraints which will reduce the market value of the company. Managers fearful of incurring liquidity constraints will trim strategic expenditure and will not be aggressive in exploiting marketing and investment opportunity. Problems also arise with agency cost of monitoring loan covenants, property mortgages and performance management as the firm need guarantee proper payment of debt obligations. In fact, according to some research agency costs may become highly prohibitive especially as debt approaches 20% to 30% of the capital market value (debt as a fraction of total firm value).
Even financial distress and bankruptcy cost which we consider to be not significant, can sometimes be so significant that each may completely offset the benefit of interest tax shield. For instance, bankruptcy is a long and complicated process which imposes both direct and indirect costs on the firm and its investors. Though the bankruptcy code is designed to provide an orderly process for settling a firm’s debt, the process is still complex, time-consuming and costly. When a firm becomes financially distress, it usually hires outside professional including legal and accounting experts, consultants, appraisers and investment bankers which are usually costly. In addition to direct legal and administrative cost, there are also several indirect costs associated with financial distress whether a firm has filed for bankruptcy. Even though these costs are mostly difficult to measure they are much larger than the direct cost of bankruptcy. An example of these costs includes loss of customers, loss of suppliers, loss of employees and loss of receivables.
In summary, a company’s chief financial officer (CFO) need to ask a series of questions to determine the right amount of debt in the capital structure. These questions include but not limited to: how much additional money the company needs to raise in the next 3 to 5 years to carry out its strategies? Can it can be deferred without incurring large organizational and opportunity cost? What are the lending criteria of each target sources? Will the company debt policy allow a flow of funds to all strategically important programs even in the event of adversity? Will the company be competitively vulnerable if it achieves its target capital structure? This means a CFO need to weigh the tax benefit of debt against loss of flexibility and costs associated with bankruptcy and financial distress to determine the right amount of debt in the company. Nevertheless, in order to apply this core concept, it is needless to say that the existence of financial markets (capital markets) is indispensable. Unfortunately, as a nation we are new to financial markets and because of its nonexistence we lost many promising investment opportunities. On the contrary, we invest on many bad investments (sometimes) purely because of the lack of detail financial information. Hence, it is important to build awareness about financial engineering among all business stakeholders so that our industries may benefit from the resource effectiveness stemmed from the use of such value creation model.

Abiy Getachew is a consultant at HST consulting p.l.c.
You may reach him at

Previous article
Next article

Most Popular

Recent Comments

Be original – Al Nejash Media on Be original
[09.15.2018.00:15] Russian, Turkish presidents to discuss Idlib on September 17 – 含的兒子是古實、麥西、弗、迦南。 7 古實的兒子是西巴、哈腓拉、撒弗他、拉瑪、撒弗提迦。拉瑪的兒子是示巴、底但。 8 on MetEC outsources electromechanical work of GERD to Chinese firm
BREAKING NEWS: Azeb Asnake removed from EEP – Al Nejash Media on BREAKING NEWS: Azeb Asnake removed from EEP
Big fish Getaneh Kebede signed with Saint George – Al Nejash Media on Big fish Getaneh Kebede signed with Saint George