January 2016 Data Update 6: Debt, the double edged sword
The Trade off on debt
Pluses of Debt | Minuses of Debt |
---|---|
1. Tax Benefit: Interest expenses on debt are tax deductible but cash flows to equity are generally not. The implication is that the higher the marginal tax rate, the greater the benefits of debt. | 1. Expected Bankruptcy Cost: The expected cost of going bankrupt is a product of the probability of going bankrupt and the cost of going bankrupt. The latter includes both direct and indirect costs. The probability of going bankrupt will be higher in businesses with more volatile earnings and the cost of bankruptcy will also vary across businesses. |
2. Added Discipline: Borrowing money may force managers to think about the consequences of the investment decisions a little more carefully and reduce bad investments. The greater the separation between managers and stockholders, the greater the benefits of using debt. | 2. Agency Costs: Actions that benefit equity investors may hurt lenders. The greater the potential for this conflict of interest, the greater the cost borne by the borrower (as higher interest rates or more covenants). Businesses where lenders can monitor/control how their money is being used can borrow more than businesses where this is difficult to do. |
In the Miller-Modigliani world, which is one without taxes, bankruptcies or agency problems (managers do what's best for stockholders and equity investors are honest with lenders), debt has no costs and benefits, and is thus irrelevant. In the world that I live in, and I think you do too, where taxes not only exist but often drive big decisions, default is a clear and ever-present danger and conflicts of interests (between managers and stockholders, stockholders and lenders) abound, some companies borrow too much and some borrow too little.
The Cross Sectional Differences
Damodaran Online |
Damodaran Online, January 2016 |
Damodaran Online, January 2016 |
The Regional Divides
Damodaran Online, Data Update of 41,889 companies in January 2016 |
The Bottom Line
Datasets
- January 2016 Data Update 1: The US Equity Market
- January 2016 Data Update 2: Interest Rates and Exchange Rates - Currencies
- January 2016 Data Update 3: Country Risk and Pricing
- January 2016 Data Update 4: Costs of Equity and Capital
- January 2016 Data Update 5: Investment Returns and Profitability
- January 2016 Data Update 6: Capital Structure
- January 2016 Data Update 7: Dividend Policy
- January 2016 Data Update 8: Pricing, with an end of month update
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