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The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Of course, a company's owners want it to be successful and provide the equity investors with a good return on their investment, but without required payments or interest charges, as is the case with debt financing. Equity financing places no additional financial burden on the company. Since there are no required monthly payments associated with equity financing, the company has more capital available to invest in growing the business.
But that doesn't mean there's no downside to equity financing. In fact, the downside is quite large. You will have to share your profits and consult with your new partners any time you make decisions affecting the company. The only way to remove investors is to buy them out, but that will likely be more expensive than the money they originally gave you.
Debt financing involves the borrowing of money and paying it back with interest. The most common form of debt financing is a loan. Debt financing sometimes comes with restrictions on the company's activities that may prevent it from taking advantage of opportunities outside the realm of its core business.
Creditors look favorably upon a relatively low debt-to-equity ratio, which benefits the company if it needs to access additional debt financing in the future. The advantages of debt financing are numerous. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax deductible. Finally, it is easy to forecast expenses because loan payments do not fluctuate. The downside to debt financing is very real to anybody who has debt. What if your company hits hard times or the economy, once again, experiences a meltdown?
What if your business does not grow as fast or as well as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company's ability to grow. If you think debt financing is right for you, the U. Company ABC is looking to expand its business by building new factories and purchasing new equipment.
To obtain this capital, Company ABC decides it will do so through a combination of equity financing and debt financing. The loan must be paid back in three years. There could be many different combinations with the above example that would result in different outcomes. For example, if Company ABC decided to raise capital with just equity financing, the owners would have to give up more ownership, reducing their share of future profits and decision-making power.
Conversely, if they decided to use only debt financing, their monthly expenses would be higher, leaving less cash on hand to use for other purposes, as well as a larger debt burden that it would have to pay back with interest. Businesses must determine which option or combination is the best for them. Financial Statements. Fixed Income Essentials.
CFOs, therefore, often find themselves in conflict with operating managers, who are eager to fund product-market strategies aimed at protecting competitive advantage. Especially in companies for which equity financing is unacceptable and in which operating management—concerned primarily with production, sales, and marketing—is the dominant force, there is great pressure to leverage the company with an even greater percentage of debt. What is the CFO to do? Is such leveraging worth fighting over?
By way of answer, this article summarizes two decades of research on the use of debt by companies with equity-financing alternatives. The major finding is that debt financing has in practice a far lower payoff than many CFOs believe.
As a result, some of the assumptions of corporate financial policy are due for a careful rethinking. But this enhancement of return on equity is not without cost. More important, it boosts the volatility of earnings and, by extension, of share price. Absolute profits at the low end of the sales range are much lower when a company uses debt financing than when it uses all equity, but its increase in profits at the upper end of the sales range is much greater in percentage terms.
The reverse is also true: as sales fall toward the low end of the range, the percentage decline in profits is much greater too. Thus, the greater the reliance on debt, the more a high level of sales increases profits—and the more a low level reduces them. Of course, equity investors ultimately care about such volatility. If the theory is right, moderate use of debt—enough to leverage earnings but not enough to make investors aware of the heightened risk—pays off in a higher value for the company.
This traditional theory was challenged by Franco Modigliani and Merton Miller in their landmark article of These arbitrage activities will soon correct any mispricing of the securities and drive them back to equivalence. This fiscal Garden of Eden is a wonderful illusion, of course; it does not really exist.
The source of this largesse is obvious: the Internal Revenue Service. The complication arises from uncertainty about what tax rates to assume. If, for example, all investment income were taxed at the same personal rate, debt financing would remain just as attractive as before. In the real world, of course, interest and dividends are not taxed alike. For companies that pay no dividends and whose shareholders never sell their stock, the effective personal tax rate on equity income is zero.
In practice, these differences in personal tax rates carry a great deal of weight in capital-structure decisions. The appendix shows this influence at work. Assume a company with expected constant earnings before interest and taxes out to infinity and with a policy of distributing all of its earnings as dividends.
Assume a company similar in all respects to the one just described except that it leverages itself with debt, D, borrowed at an interest rate, i, from investors who are taxed on interest income at a rate T pi. The first term is identical to the funds available for consumption from an unleveraged company.
Thus, the value of a leveraged company, V 1 , equal to the value of an unleveraged company, V u , plus the present value of an annual flow equal to iD [ 1 — T pi — 1 — T c 1 — T pe ]. The appropriate discount rate is the rate for flows of equal risk, adjusted for personal taxes, or i 1 — T pi.
These calculations suggest a few general observations. Note also that when the personal tax rate on equity is much lower than that on interest income a condition that is currently built into the U. Finally, note that for a company with no taxable income to shelter, using debt financing actually reduces its value! This flexibility is important as a defense against financial distress and its attendant costs, which include, but are not limited to, the costs of potential bankruptcy.
Indeed, in most cases, bankruptcy costs are rather small. Managers fearful of incurring liquidity constraints or of violating debt covenants will usually trim strategic expenditures, be unaggressive in exploiting market and investment opportunities, and base operating policies on the low end of a range of sales forecasts. At the same time, competitors are more likely to mount an attack, for an aggressive financial strategy often renders a company less capable of responding vigorously to market conditions.
The specter of financial distress reminds lenders that a substantial portion of that value reflects future investment opportunities, which are meaningful only if the company continues to prosper. Providers of debt capital are usually willing to lend against tangible assets or future cash flows from existing activities but not against intangible assets or uncertain growth prospects. For most companies, the implicit costs of financial distress brought on by too much debt—lost opportunities, vulnerability to attack, suboptimal operating policies, and inaccessibility to debt capital—loom larger than the threat of bankruptcy.
Furthermore, as the level of debt rises as a percentage of total capital, so does the probability that a company, especially if it has high depreciation charges, will have insufficient income to enjoy fully the tax deductibility of its interest expense.
It is their job to preserve continuity in the flow of funds so that no strategically important program or policy ever fails for lack of corporate purchasing power. And they must protect this continuity of funds even during turbulent capital markets or bad times for the company. Accordingly, CFOs must rely on traditional suppliers of capital. The delays involved in developing new institutional sources, especially when conditions are difficult, make the timely pursuit of strategy impossible.
CFOs should, of course, constantly attempt to broaden their range of financing alternatives, but they must realize that critically important programs require well-established sources of capital that are reliable even in adversity. More particularly, its debt policy must ensure access to funds on a timely basis from traditional suppliers of capital. How can CFOs formulate a sensible and successful debt policy for their companies—one that they can sell with confidence to the rest of top management?
We suggest that they begin by asking themselves the following questions:. How much additional money will it have to raise during the next three to five years to carry out its portfolio of product-market strategies? What is the likely duration of that need? Can it be deferred without incurring large organizational or opportunity costs? What are the special characteristics of that financing in terms of currencies, maturities, fixed versus floating rates, special takedown or prepayment provisions, ease of renegotiation, and the like?
What segments of the capital markets will the company tap for each type of finance needed? What are the lending criteria used by each of the target sources of capital? An analysis of these criteria, which differ considerably from lender to lender, will suggest a target capital structure for the company. For example, companies with high operating and competitive risk might try to offset it with low financial risk; in contrast, companies with low operating and competitive risk are much freer to use high levels of debt.
In practice, many companies express their target debt level as that which will result in a bond rating of A or higher. Their concern for an A rating reflects three major considerations: first, companies rated below A have been unable at times to raise funds in the public bond market on acceptable terms; second, life insurance companies, which have traditionally been a source of debt finance for BBB rated companies, are vulnerable to a sudden reduction in loanable funds should policyholders decide to borrow against the cash value of their policies; and third, companies need financial reserves to protect against adversity.
For example, since the Ford Motor Company hit difficulties in , its debt has been downgraded three times in less than three years. Could the company comply with all loan covenants, as reflected in its pro forma financial statements, in good times and bad? Specifically, against what scenarios of adversity is management most eager to protect itself?
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