By Brandon Mitchell
Annette Poulson has written a survey of literature on how corporations choose to finance. The following are some comments on that essay.
We are all familiar with the variety of motivations for taking on personal debt whether it be to facilitate consumption (credit cards) or to leverage cash flow for investment (home loans) but for what reasons do companies choose to take on debt, especially as they have the ability to raise capital through further equity issues?
From the investor’s perspective debt level has long been a metric to pay attention to. Luminaries such as Benjamin Graham, Peter Lynch and Warren Buffet have all suggested that, in some ways, the level of debt a company operates under can be an indicator of company health. So why debt finance and what, if any, effect does debt structure have on company value?
From the ‘cash-flow’ perspective of company valuation, debt financing may be said to have no effect on the value of a company. Some call this the ‘irrelevance proposition,’ that debt to equity levels do not have an effect on the overall value of the company. The reasoning goes something like this. The same cash flows bought at the same price should be equally valued. Say you own a 10% stake in a firm. The firm holds zero debt. You are entitled to 10% of the profits of the firm, revenues less expenses. Now imagine an identical firm with identical cash flows. You have a 10% equity stake in that firm as well, but this firm decides to raise capital through a bond issue. In creating this liability, the value of your stake is lessened as the profits of the company are lessened as the interest payments on this debt are entered into the expenses side of the ledger. Instead of registering profits, that cash flow will go to debt holders. But, if you were to own 10% of this debt issue as well, then ex hypothesi, you would own the same cash flow as you do with the company with no debt and, by our stated valuation method, the debt plus equity in the latter case would be valued the same as the equity in the former case. The point here is that if the same cash flow can be bought with the same capital, then the debt vs. equity structure shouldn’t be important. We would expect the equity stake in the first company to be of equal value to the combination of the equity and debt stake in the second. Investors that have the same stakes (10% equity in one case and 10% equity and 10% debt in the other) see the same profits and enjoy the same payouts and so value the two companies the same.
But things are never so simple. When taxes are considered, we see that in the real world the cash flows of the companies won’t be identical and clear incentives are introduced for certain behaviours. The first consideration is that corporate income taxes apply to profits. Interest payments on debt are considered expenses. Corporations then can afford to reward investors in their debt at a higher rate than equity investors as payments to equity holders are taxed at the corporate level and payments to bondholders are not. In effect, there exists a subsidy in the amount of the corporate tax rate for financing via debt.
However, we cannot look only at the incentives created by one portion of the tax code while ignoring what incentives might be created by the rest of the code. The irrelevance proposition discussed above, that debt to equity ratios per se aren’t relevant to a company’s overall value because either way investors own the same cash flow, was dependent on investors actually receiving the same cash flow. Corporate taxes make it cheaper for a company to use their cash flow to service debt rather than pay shareholders.
In addition, we need to pay attention to the tax consequences on what investors get. Investors will prefer to be compensated in a way that gets counted as a capital gain rather than ordinary income. Interest payments on debt are counted as ordinary income. Gains on equity that are unrealized for a year or more are counted as capital gains and are taxed at a significantly lower rate. Investors will have a preference to be compensated in equity gains to the tune of the difference between their marginal rate and the capital gains rate.
So, overall, it is in the best interest of companies to finance investment through the reinvestment of profits. The money is then not taxed on the corporate side and investors, instead of seeing the income, see a long term capital gain. But, if there is not sufficient excess revenue inside the company to make the desired investments, outside capital must be sought. In those instances, it makes sense to debt finance, given the subsidy created by tax treatment.
However, just as the cost of debt for individuals is determined by their ability to repay their debt, so too are companies constrained by current and expected cash flows when borrowing. The need for the company to remain solvent becomes a limiting factor for the amount of debt financing that is possible. The increasing cost of additional debt as overall levels rise will be a consideration when a firm chooses how to finance investment. Those increasing costs are driven by particular concerns on the part of bondholders. One such concern is that shareholders of a company with a large debt burden and faced with insolvency will be much more likely to head to the roulette table with the remainder of the company’s assets; taking on far more risk when the bondholders might prefer an orderly liquidation. As a result, borrowing past a certain level is likely to be cost prohibitive for companies in many situations.
For companies with long records and stable cash-flows, the level of leverage that they can reach is likely to be much higher than for newer companies who may have heaps of earnings growth potential but don’t currently operate a business large enough to get the amount from money markets they want. In such situations or when a company has reached a high level of leverage and still wants to raise capital, new issues of equity are likely going to be competitively priced relative to another bond issue.
And so our account of the incentives faced when deciding how to raise capital, we might make the following predictions. Companies wishing to make investments will first do so out of spare revenue. Then they will look to money markets to access as much as possible at a reasonable rate. Finally, especially if there is high expected earnings growth, thereby making their equity particularly attractive while their balance sheet may not be, they will look to the equities markets.