This week, we reveal the science behind our thinking on debt.
The decision to use debt as a source of financing is widely studied under the body of knowledge known as capital structure. A firm’s assets can only be financed with two sources of funds: equity or debt. The term capital structure refers to how a firm finances its business using a proportional mix of equity and debt.
One of the core interests in capital structure studies is to investigate whether using more or less debt affects the value of the firm.
Does having more debt affect the value of the firm?
To answer this question, we need to understand the central theory behind the literature on capital structure: The Modigliani and Miller’s Irrelevance Principle (MM). This theorem was first proposed by Franco Modigliani and Merton Miller in 1958 and contributed to their awarding of the Nobel Prize in Economics.
The value of a firm is determined by two things: its earnings potential and the cash flow risks of its business. If this firm is domesticated in a county with no taxes, no transaction costs, no risks of bankruptcy, and equal borrowing costs for everyone, then using more or less debt does not affect the value of the firm. The reason is that investors can either buy a firm with debt or borrow money to invest in a firm without debt, at equal borrowing costs.
If the MM principle holds true, then there is no reason to care about capital structures since it does not affect the value of the firm. Unfortunately, most assumptions of the theorem do not hold in real life, which implies that capital structures do affect firm value. One of the violations at the core is the existence of taxes all over the world.
Debt comes with interests, and this financing cost is expensed off the company’s accounts before taxes are computed. If a firm uses debt to scale its business, then the tax-deductible interest payments act as a shield that ‘subsidizes’ the firm’s source of funding. Thus, the greater proportion of debt, the greater the savings on net distributable income, and the more valuable the firm.
Bankruptcy risks limit capacity to borrow
In previous articles (e.g. Gut instincts with science), we mentioned that equity is more expensive than debt. The availability of the tax shield allows us to replace equity with cheaper debt, which reduces the overall costs of financing and increases the value of the firm.
However, there is a limit to the use of debt: Bankruptcy risks. As the amount of debt increases, the financing commitments of the firm becomes heavier and heavier. Unlike dividends, firms cannot miss interest payments without dire consequences (e.g. Repossession). Also, debt-holders will write increasingly stringent covenants to protect their loans. In response to these risks, equity-holders will demand higher levels of equity returns because the probability of assets left after liquidation is getting lower and lower.
Thus, like most good things in life, moderate consumption of debt is advisable.
In the next issue, we will explore some puzzling observations on capital structure strategies that researchers have noticed over the years.
Dr. Jack Hong is the co-founder of Research Room Pte. Ltd., a management consulting and advanced analytics company that delivers complex prediction and decision-making capabilities for commercial, government, and not-for-profit organizations. Dr. Hong has extensive research and commercial experience in applying advanced empirical science to drive business, financial and policy value chains. He is concurrently an adjunct faculty with the Singapore Management University (SMU).