This is the second and final part of my article. This focuses on debt financing. In the first part, in which I wrote on equity financing, I began by stating that my wife hates debt while I, on other hand, do not mind debt and lose no sleep if I do not zero out my credit card balance at the end of the month. Unfortunately, the word “not” was left out of that sentence. But the point is that individuals have different tolerances for debt and so do businesses.
Debt financing involves borrowing money with a pledge to repay it over time with interest. The borrowing is typically in the form of a loan from a bank or other financial institution (often short term) or by offering bonds to investors (long-term). In the language of finance, the borrower is said to “take out” a loan and the lender to “make out” a loan. Also, the interest paid is a cost of funds to the borrower (firm) and a return on investment to the lender (investor). A firm is said to be levered or geared when it has debt in its capital structure.
The decision to take on debt and how much of it, should be made after carefully considering all the possible consequences of debt including those that I will discuss below.
Tax Deductibility
In many jurisdictions, interest payment is a tax deductible expense. This means that interest is subtracted from income before tax is calculated. As a result, the effective interest cost to the firm is less than the stated interest if the company is profitable. As an example, assume a firm’s tax rate is 20% and its annual taxable income is ¢500, then taxes payable is ¢100. Now suppose the firm had borrowed ¢1000 at 10% interest to fund its operations, its annual interest payment is ¢100. However, because the ¢100 will be deducted from the ¢500 taxable income before taxes are calculated, it will end up paying a tax of ¢80 on a taxable income of ¢400 thereby saving ¢20. This savings of ¢20 is referred to as a debt tax shield and it effectively reduces the firm’s cost of debt from 10% to 8% for that year. The concept of debt tax shield is critical in project investment analysis as it significantly enhances a project’s viability.
Independent Operations.
One of the main advantages of debt financing is that the bank or lending institution does not have a say in how the company is run. Because the bank has no ownership in the business the entrepreneur is allowed to make all the decisions s/he deems to be in the company’s best interests. Also, because the principal amount of the loan plus the interest and the terms are all known beforehand, the business is able to plan ahead and build the financing obligations into the company’s long-term strategy without any surprises.
Debt is Cheaper
Generally, debt is a cheaper form of financing than equity. This starts with the fact that equity is riskier than debt. Unlike its obligations to pay interest to debt holders, a company typically has no legal obligation to pay dividends to common shareholders. Additionally, shareholders are the first to lose their investments when a firm goes bankrupt. And finally, the tax deductibility of debt interest and not dividend makes debt cheaper than equity. Consequently, shareholders justifiably demand a higher return than debt holders.
Discipline Effect of Debt
Debt is often viewed as having a disciplining effect on management, especially if its maturity is relatively short. It does so by forcing the firm to disgorge cash flows and prevents managers from “consuming” it. In order words, it reduces their ability to turn “free-cash flow” into lavish perks or undertake futile investments. The debt burden also incentivises corporate executives to think and plan long-term, at least to meet their obligation to repay creditors on time. Planning to avoid becoming cash-strapped and the possibility of bankruptcy has a positive disciplining effect on management.
Leveraging Effect
Debt is used to increase a project’s return; leverage effect. As long as the firm can earn a return on investment on the borrowed funds that is greater than the interest cost, the project’s rate of return will be magnified. Leverage cuts both ways, however. If the project does not earn at least the cost of debt, the leverage will serve as a drag on profitability.
Bankruptcy Cost
Debt financing often comes with strict conditions or covenants in addition to interest and principal repayments at specified dates. Failure to meet these requirements can have severe consequences. Generally, non-repayment of debt puts the creditor in the driver’s seat and can force the firm into bankruptcy. Under the real market conditions of corporate taxes and bankruptcy costs, the cost-benefit effect of debt is modelled this way. The risk of bankruptcy which is extremely low with moderate amounts of debt rises as debt increases. At a certain debt level, the increase in bankruptcy cost just offsets the increase in benefits from debt tax shield. Beyond that point, the incremental bankruptcy costs outweigh the incremental benefits from debt tax shield. WACC then increases and firm value decreases.
Conclusion
From a risk perspective, is it more prudent to fund projects with only equity because equity is less risky to the firm, notwithstanding the cost? From a cost perspective, is it more prudent to fund all projects with only debt because debt is cheaper, notwithstanding the risk? Truth is, both extremes are generally not prudent or efficient.
Indeed it would not be rational for a company to be funded only by equity. It’s too inefficient. On the other hand 100% debt would be too risky. A business needs to balance the use of debt and equity to keep the average cost of capital at its minimum. We call that the weighted average cost of capital or WACC. The continued debate in academia is how to determine the right amount of debt at which the firms weighted average cost is minimized and its value maximized.
My final comment and caution. Recent global developments due to the financial crises of 2008 have serious lessons for us in Ghana. The unsustainable debt levels piled up by the developed markets due to cheap credit, complex financial instruments that facilitate transactions some without transfer of economic risk, and unethical lenders who encouraged people to incur debt, knowing full well that they did not have cash flow to sustain it, ultimately took its toll. And we still live with its effects today. Yet countries like Canada sailed through the crises unscathed because their financial institutions, particularly, their banks were well capitalized and regulated with strict standards. I do not feel our financial institutions are so regulated, seeing the rate at which many micro-finance institutions rise and fall. Additionally, in our case, the persistently high cost of doing business, particularly debt cost in the range of 30-40%, has the potential to drive firms out of business. The ripple effect would be disastrous for our economy.
In conclusion, I hope you realize that besides the objective measure of a quoted cost of capital, there are a number of subjective yet equally important issues to consider in deciding whether to use debt or equity to finance your business.
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