The financing that a business organization needs to conduct its business operations comes from two sources. One is equity and the other is debt. Equity financing comes from the owners of the business. On the other hand, debt financing comes from parties which have no ownership interests in the operations of that business organization. Because the debt financiers are not the owners of the business, a conflict of interest arises. The parties which are financing the business organization by means of debt are interested in the operations of that business only to the extent that they are going to get their money back in full with interest at the end of the repayment period.
However the shareholders, who are the owners of that business, and the managers, who run the day-to- day operations of that business, are interested in maximizing the wealth of the business organization in the long term.
This long- term objective on the part of the shareholders and the managers of the business motivate them to invest in risky projects which have potentially higher returns and thus give the firm greater profit potential in the long term. However the enhanced riskiness of the projects also reduces the company’s profit potential in the long term and in the process hurt the company’s ability to pay off debt. In this form, the agency costs arise as a result of debt financing. Agency costs are not the only disadvantages of debt financing. There is also the aspect of regular payments which can have a severely negative impact on small firms. These firms most of the time are suffering from shortage of liquidity. The need to pay regular payments in order to pay off debt only exacerbates the situation. Often the small firms will find themselves unable to make timely payments.
In situations such as these, the lender will often impose late fees on the debtor or could even call in the collateral. All this is apart from the fact that the inability to pay off loans in this case will have far reaching repercussions in the form of a damaged credit rating for the firm and this damaged rating will hurt the firm’s ability to raise further debt financing in the future. And of course raising debt is not all plain sailing. Often lenders will demand a very high credit rating and evidence of rock solid future business performance before they sign off on any loans.
Debt financing has its share of advantages primary among which is the opportunity that a firm gets to pay lower taxes as a result of debt financing. One of the problems of debt financing is that the debtor has to make regular interest payments. However when it comes to tax calculations, interest payments are deducted. In the case of equity financing, the management has to make regular payments in the form of dividends to the stockholders. However these dividends are not exempt from tax calculations. The interest payments are. So debt financing acts as a tax shield which is the major advantage of this form of financing.
There are many other advantages associated with debt financing. For example lenders are not able to interfere in the running of the business that the stockholders are entitled to. As a result the managers and the stockholders get to keep their freedom when it comes to making strategic decisions for the firms. This is the other side of the coin from agency costs where the owners of the business have interests which are different from those of the lenders of the business. Also the accounting regulations concerning the reporting of debt are somewhat lax compared to those in equity reporting.
So in that respect, debt financing has lower transaction costs. Effect of debt on cost of equity The riskiness of the capital structure of a company depends on the extent to which it is financed by debt. As a result, the higher the level of debt, the greater is the risk inherent in company operations. The risk arises from the potentialities of bankruptcy that go up when the company resorts to debt financing. In the event that the company is not in a position to make the regular interest payments involved in debt, lenders can force the company into bankruptcy. When that situation arises, lenders are the first to be paid off from the company’s remaining assets. In this scenario, lenders receive the first priority. It is only when there are assets remaining after the lenders have been paid off that stockholders start to receive their dues. This means that the riskiness of the company that the stockholders are investing in is greater. As a result there is a greater risk premium which in turn means that the equity investors are now demanding a higher rate of return, the effect of debt financing. The optimal capital structure of the firm As mentioned before, the capital structure of the firm has the two components of debt and equity.
The management of the company can play around with different percentages of debt and equity until through trial and error it reaches the mix at which the tax benefits of higher debt matches the agency costs and the bankruptcy costs of debt financing and also the costs associated with the writing and the enforcing of debt contracts. Analysis of three companies McDonalds in the food business, Sheraton in the hospitality business and Calvin Klein in the clothing manufacturing business have all reached the mature stage of their lifecycle. They all have successful operations worldwide and are generating healthy profits.
This also means that they will have to pay high taxes. In order to avoid these large tax requirements, they will resort to the tax benefits to be gained from a highly leveraged capital structure. So all these companies should have high debt. Another factor in favor of high debt ratios in the capital structure of these companies is that the high debt ratios will add discipline to the managers of these companies so that there will be reduced agency costs. Against all these must be considered the fact that managers and shareholders prefer retained earnings above all else in financing their needs because this maintains decision-making flexibility in their favor and also maintains control in their favor. Because the three companies all have successful operations, they will have huge reserves of retained earnings to draw upon. Therefore the managers and shareholders of these companies will strike a balance between retained earnings and straight debt in arriving at the optimal capital structure.
So, given the scope of their operations in the stage of the life cycle they are in, the three companies should have medium debt ratios These three companies should also have medium asset betas. As mentioned before, the cost of equity moves in the same direction as the debt ratio because as the level of debt goes up, so does the riskiness of the companies’ operations. As a result, the beta component of the companies’ costs of equity will go up. However, since the three selected companies have medium debt ratios, they will also have medium asset betas. BIBLIOGRAPHY Brigham, Eugene F. , and Michael C. Ehrhardt. Financial Management: Theory & Practice. South western college pub. 2007. Higgins, Robert C. Analysis of Financial Management. McGraw-Hill/Irwin. 2007 Shapiro, Alan C. Multinational Financial Management. McGraw-Hill/Irwin. 2007
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