Why should Debt matter?
Theories about capital structure
When I was a graduate student at the London school of economics, we were taught why would a firm want to raise debt from the market. More specifically, different firms have a different proportion of debt and equity in their balance sheets; what can be the causes of these differences in debt ratios across firms?
When we look at the liability side of a balance sheet- we break them down into two parts: Capital and Debt. Capital is the money which the firm owns to its shareholders and the profits it has accumulated as reserves over the years. Debt is what the firm owes to its creditors.
Going through the capital structure of any 10 companies, you would see that each firm has a different level of debt in their balance sheet. This question has been one of the well-researched questions in corporate finance, the study of which has kept many academic researchers busy. To understand then why different firms have different debt levels, entails output from years of research and quite fascinating theories arising out of it.
As an introductory article, this would just highlight the various theories before delving deeper into the academic research associated with these theories in greater details in the upcoming posts. The next article can be found here: Capital Structure puzzle
The trade-off theory
One common advantage of issuing debt is that you receive tax benefits from the issuance of debt, however, the cost is that too much debt is associated with a higher probability of defaulting on your interest or principal payments. Thus, a firm tries to offset these costs and benefits in order to determine the optimum capital structure.
The above picture shows how you can maximize the value of the firm by taking on additional debt (up to a point). By using the tax shield associated with debt you can increase the value of the firm, however with the increase in debt levels in the balance sheet, after a point the value of the firm would reduce as these advantages are offset by the increasing costs of financial distress.
Pecking order theory
This theory suggests that firms follow a pecking order when deciding how to finance projects. If you have three sources of funds: internal funds, debt, and equity, you would prefer your retained earnings to debt and debt to equity.
If you can finance a project with internal funds, that means you do not have to raise debt or equity, which may or may not give you the right valuations. Thus, you would prefer internal funds to debt or equity.
However, why is debt preferred over equity? Equity is associated with a higher risk premium than debt. Equity gives the shareholder a share in the assets of the company. Thus, if the assets are good you would get paid off, but if the assets are not worth a lot, then you would lose out.
So, as a manager has greater information than the outsiders, the managers have an incentive to issue equity when they think that equity is overvalued by the market. However, the market would see through this and would penalize this information disadvantage by giving lower valuations to firms who would issue equity. This thus sends a ‘negative signal’ to the market.
Given the above, a firm with good assets would not want to raise equity but would want to go to the debt route. Thus, firms would raise debt rather than go to the market for lower valuations.
Market timing
Firms go to the equity markets when there is ‘run-up’ in the prices of the stocks. Thus, when equity markets look good, firms go to the stock market to raise money, and when the debt market seems favorable, they raise money from the debt market. So, a firm times the market in order to raise funds.
The above description lays down a very preliminary explanation of the capital structure theories. Academic research is full of rich details and a lot of empirical explanations which we would see in the next posts. Different theories give a different explanation for this question. And, over the next few posts, we could see how can we explain different capital structure decisions by using each of these theories.
The next article can be found here: Capital Structure puzzle
