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The pros and cons of using debt in a company’s capital structure

Aug 27, 2020

It is generally believed, despite potential pitfalls, the use of debt in a company’s capital structure pays off in higher returns to shareholders and company values. This “conventional wisdom” is illustrated in the following example:

 

Scenario A

 

Scenario B

Debt capital

$0

 

$1,000,000

Equity capital

$2,000,000

 

$1,000,000

Total capital

$2,000,000

 

$2,000,000

Net income

$200,000

 

$200,000

Return on equity

10%

 

20%

 

 

 

 


Businesses generally exist to return value to  shareholders and therefore need to continue to invest capital in initiatives that not only preserve but also grow shareholder value. The question of how to capitalize a business is a decision faced by all business owners. Besides utilizing internally generated cash flows to fund preservation and growth initiatives, a business has two general options to raise additional capital: debt financing and equity financing.

However, more debt isn’t all good news and the question of how much debt is prudent is a nuanced exercise. Tax rates, which vary from situation to situation, materially affect the attractiveness of debt. Less observable costs of higher leverage which include the limitations it places on a company’s flexibility in adapting to changing economic environments affect the calculus as well.  Debt requires repayment with interest and if not repaid according to agreement, can force the company into bankruptcy. 

Companies without debt inherently have less financial risk as there are no required payments and no threat of bankruptcy. However, the use of no leverage in a company’s capital structure can concentrate shareholders wealth in a closely held private company that may not be providing a sufficient risk-adjusted return to its equity shareholders.

Optimal cap structure theory

Financial theory teaches the optimal capital structure is the mix of debt and equity that minimizes a company’s weighted average cost of capital (WACC). The valuation or market value of a company is inversely correlated to its WACC so accordingly the lower a company’s WACC, the higher its market value.

Two common methods of determining an optimal capital structure are using guideline comparable companies and fundamental credit analysis. 

The guideline comparable company method observes the capital structures of guideline (most often publicly traded) companies that operate in the same or similar industry under the assumption that the capital markets implicitly force these companies to maximize shareholder value, which includes operating with an optimal capital structure. 

The fundamental credit analysis method challenges a company to think like a bank or a bond ratings agency. A company would analyze its cash flows and balance sheet to ascertain how much credit a bank would lend. Alternatively, credit rating agencies publish cash flow related metrics such as debt/equity ratios and cash flow interest coverage ratios associated with different bond ratings. A company can then use these published metrics to determine what levels of debt would allow them to be considered “investment grade.” The resulting conclusions of a firm’s optimal capital structure analysis is most often thought of in terms of a reasonable range rather than a point estimate.

Debt is less expensive than equity because it is less risky since interest payments have priority over dividends and debt holders are paid back prior to equity holders in the event of bankruptcy. Debt is also cheaper than equity because interest expense acts as a tax shelter while dividends are paid out of after-tax income.

Optimal capital structure theory does suggest a limit to the amount of debt a company should employ in its capital structure. 

Excessive leverage results in large interest payments, increased earnings volatility and the risk of bankruptcy. This increase in the financial risk to equity holders means they will require a greater return to compensate them, which in turn increases the WACC and decreases the value of a business. The optimal capital structure uses enough equity to mitigate the risk of being unable to pay back the debt. 

Companies with consistent cash flows can tolerate more debt in their capital structure while a company with volatile cash flows will have less debt and more equity in its capital structure.

Debt as a tool

While debt or leverage can conjure up negative images in a business owner’s mind or create sleepless nights during periods of economic volatility, there are benefits to using prudent levels of debt in a company’s capital structure.

Through the use of senior debt offered by commercial banks and some credit unions, borrowers can more easily budget and forecast knowing exactly how much they will payback over a specific timeframe. Comparatively, equity financing is more expensive than debt as equity investors expect a return on investment commensurate with the risk (of total loss) inherent in their investment. In almost all cases, equity will cost more than debt as equity investors in privately owned business will require a rate of return approaching 20%.

Additionally, even if a business is able to currently cash flow its operations and growth initiatives, there is value to establishing a business relationship with a debt provider before you need to take on debt. 

Similar to building personal credit, a business benefits from a trustworthy record of debt repayment. According to the Federal Reserve’s 2019 Small Business Credit Survey, 33% percent of business loans that were denied cited “too new/insufficient credit history” as the reason.

From a personal wealth perspective, utilizing prudent amounts of debt means equity investors have less of their net-worth concentrated in a privately owned and generally illiquid asset. For some business owners this concentration of wealth risk is either acceptable or the only option, but for others, the option exists to replace a portion of their equity investment with a prudent amount of debt — often termed a “debt” or “dividend” recapitalization — and investing the recapitalization proceeds in a more diversified basket of assets.

The trouble with debt

It was historically believed that higher costs of debt for privately owned companies was primarily the result of financial reporting reasons, which is to say, creditors charge privately owned companies a higher rate of interest because they are not required to report as much information as publicly owned companies. 

More recently, this reasoning has expanded to include risks related to access alternative sources of liquidity and higher default rates experienced by privately owned companies. Lenders understand that as debt approaches imprudent levels for a company so do the associated costs of monitoring, work-out processes and foreclosure.

Financial flexibility is an important guard against financial distress which can drive a company into bankruptcy. The excessive use of debt as a business practice can result in challenges, or worse the inability, to access capital quickly and on palatable terms in times of economic distress (e.g. COVID-19).  It is during these times of economic distress that capital constraints can lead to scaled down operating plans which often result in reduced company value.

In times of economic distress, business owners and management may reduce or eliminate strategic initiatives, operate the business in a conservative manner, or decide not to capitalize on current opportunities in an effort to preserve liquidity or not violate debt covenants. To make matters worse, more strongly positioned competitors often attack weaker positioned peers who are less capable of reacting in a dynamic manner.

Being disciplined

The utilization of debt in a company’s capital structure can be a wise way to return additional value to shareholders but for many business owners the use of debt can be an emotional issue. Not wanting to be beholden to creditors and the potential for volatile cash flows during challenging economic periods can cause some business owners to take an overly cautious approach to minimizing a firm’s cost of capital and thus reducing the return to shareholders. 

Conversely, business owners who do not fully appreciate the risk that financial leverage introduces into a firm can result in unrealistic expectations around how much a bank will lend to a company and at what rates. 

Developing a disciplined process that considers company performance, industry dynamics, the current economic environment and the needs and expectations of shareholders will provide management the framework to make an informed and prudent decision as to an optimal capital structure. 

Author(s)

Paul Ouweneel
Paul D. Ouweneel, CFA, CPA, CFP
Partner, Valuation, Forensic and Litigation Services
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