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Why Debt over Equit?
 

BudFox24's picture
IB
 
Points)
 on 8/14/12 at 1:00am
debt equity.jpg

Reasons why a company would use debt financing as opposed to equity financing? The only reasons that i can think of is to not dilute equity ownership and also lower firmwide (WACC) am i missing anything else here?

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riskorangutan's picture

debt is cheaper. Required

ST
(Monkey, 62
 
Points)
 on 4/18/10 at 4:30pm

debt is cheaper. Required return on equity is higher.

PerennialAmbition's picture

Debt financing can possibly

IB
(Monkey, 39
 
Points)
 on 4/18/10 at 5:07pm

Debt financing can possibly be tax deductible while equity financing is not.

YostDisciple09's picture

Leverage. Debt is cheaper

IB
(Monkey, 34
 
Points)
 on 4/18/10 at 6:13pm

Leverage. Debt is cheaper than equity.

TNA's picture

Debt is cheaper because of

O
(Human, 13,508
 
Points)
 on 4/18/10 at 6:25pm

Debt is cheaper because of interest tax shield. Problem is there is a limit because the more debt you issue the more risky you become which increase what you need to pay in order for investors to be interested in your debt.

Google answers all questions

http://wiki.answers.com/Q/Why_is_debt_a_cheaper_fo...

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jhoratio's picture

I've explained this a million

IB
 
Points)
 on 4/18/10 at 7:30pm

I've explained this a million times but debt doesn't lower your WACC. The required return on the debt is lower than equity yes, but the increased leverage makes the equity riskier and therefore raises the required return on equity to exactly offset. WACC stays exactly the same. Is this why our financial system is overlevered? Because armies of morons who should probably know better actually think more and more debt makes a business less risky (lowers WACC)? Geeez.

Reasons for debt are the tax shield, levering returns to equity and not wanting to give up ownership interest. WACC has absolutely nothing to do with it.

monkeyman2010's picture

i think the contradiction

IB
 
Points)
 on 4/18/10 at 9:07pm

i think the contradiction here is people are assuming the cost of debt is always lower than the cost of equity. in fact, it is not. the cost of debt graph is parabolic-- meaning after a certain point, you are considered over-leveraged [at extremely high-risk of bankruptcy] and your cost of debt is very high.

the idea of capital structure management is that there is an IDEAL level of debt a company should hold in order to minimize their wacc. when they have less debt than the ideal, then more lowers the wacc (this is what everyone seems to be saying). what jhoratio points out is that when you have MORE debt than the ideal, less debt needs to be held in order to lower wacc.

the ideal amount of debt is determined by the volatility of your cash flows. that's why pharmas and techs tend to be no to low debt companies-- their earnings depend on striking gold from the next big thing which is too volatile of a cashflow to pay off debtors in the long run.

jhoratio's picture

You are not correct,

IB
 
Points)
 on 4/18/10 at 10:20pm

You are not correct, monkeyman. WACC is an opportunity cost. An opportunity cost is the return on the next best thing you could do with your assets. The return on the next best thing is not influenced in the slightest by how much debt some other company has. The opportunity cost for employing assets in a certain enterprise has NOTHING AT ALL TO DO with the capital structure.

Barbarian's picture

Because of 3 simple reasons.

O
 
Points)
 on 4/18/10 at 10:26pm

Because of 3 simple reasons. Money, Cash, Hoes.

__________________________
if you ain't first, you last

beatallica's picture

very simple analysis usually

O
(Orangutan, 260
 
Points)
 on 4/19/10 at 2:45am

very simple analysis usually done by bankers:

Cost of equity = 1/(P/E ration) - called the Earnings Yield
Cost of debt = Can be easily found out through the cost of debt with similar risk trading in the markets

Choose whichever is lower.

For a texhbook answer, see http://en.wikipedia.org/wiki/Pecking_Order_Theory

tandaradei's picture

OP, you are absolutely

IB
 
Points)
 on 4/19/10 at 4:00am

OP, you are absolutely correct, these are the answers I would give in an interview. Possibly would add that an equity raising has higher fixed transaction costs than debt raisings.

I wouldn't mention this, but there is also the pecking order theory: managers would rather go for debt than more equity, because they have more discretion about it. An equity raising requires a shareholder vote, with debt they only need board approval.

Also - the signaling theory. Managers load up on debt to indicate they run a lean shop with little discretionary cash flow to squander.

ZIRH's picture

it is only cheaper if it is a

IB
 
Points)
 on 4/19/10 at 12:17pm

it is only cheaper if it is a profitable business, since u're not sharing the profits w someone else who bought a huge stake in your company...

as always, banking interview questions should be answered with "it depends, but..."

midnight_oil's picture

Jhoratio - what if a company

IB
 
Points)
 on 4/19/10 at 3:02pm

Jhoratio - what if a company has 99% of debt and 1% of equity? How would their WACC compare with a 30% / 70% company? And assume that they're putting on this debt step-by-step; i.e. doing convert and subordinated offerings back-to-back.

How will that offsetting mechanism you've explained adjust to get us to the same WACC? Wouldn't a higher debt load increase the Rd over time?

Thanks.

kuf135's picture

WACC is based on the Required

IB
(Monkey, 40
 
Points)
 on 4/19/10 at 7:04pm

WACC is based on the Required Return on Assets and is not affected my capital structure according to Modigliano & Miller Proposition. This is because as you increase your debt equity ratio you're increasing your leverage, equity becomes riskier therefore investors demand a higher return on equity. The firm has a higher cost of equity offsetting the weighted average benefits of the lower Required Return on the debt.

singularity's picture

Did you just copy that out of

IB
(Baboon, 148
 
Points)
 on 4/19/10 at 6:11pm

Did you just copy that out of your corpfin textbook?

Aside from the EMH assumption of M-M, it also stipulates the absence of taxes. You can try really hard but you will never quite convince me that taxes don't exist.

MezzKet's picture

don't forget bankruptcy risk

PE
(Gorilla, 640
 
Points)
 on 4/19/10 at 8:18pm

don't forget bankruptcy risk and debt's relative position in a waterfall... this is the most imprtant reason why equity requires a higher return vs. debt at different parts of the capital structure...

Scratchy's picture

Raising equity ==> many

IB
(Baboon, 120
 
Points)
 on 4/20/10 at 3:39am
beatallica's picture

this is all you need to know:

O
(Orangutan, 260
 
Points)
 on 5/3/10 at 4:09pm
qweretyq's picture

I was once asked what is a

ST
 
Points)
 on 5/4/10 at 2:41pm
beatallica's picture

qweretyq wrote: I was once

O
(Orangutan, 260
 
Points)
 on 5/6/10 at 10:20am
Djalminha's picture

qweretyq wrote: I was once

IB
 
Points)
 on 5/6/10 at 11:35am
BanditPandit's picture

Because if you e-quit you can

O
 
Points)
 on 8/14/12 at 3:00am
Cola Coca's picture

jhoratio: I've explained this

O
(Orangutan, 321
 
Points)
 on 8/14/12 at 3:28am
GS's picture

BanditPandit: Because if you

ST
 
Points)
 on 8/14/12 at 4:32am
Oreos's picture

BanditPandit: Because if you

HF
(Neanderthal, 2,450
 
Points)
 on 8/14/12 at 5:23am
KevinFromPorkland's picture

Nope..people are this stupid.

O
(Chimp, 8
 
Points)
 on 8/14/12 at 8:55am

If you wait to be fed, you won't learn how to hunt.

KevinFromPorkland's picture

Nope..people are this stupid.

O
(Chimp, 8
 
Points)
 on 8/14/12 at 8:55am

If you wait to be fed, you won't learn how to hunt.

shark-monkey's picture

Everyone pretty much went

HF
 
Points)
 on 8/14/12 at 9:22am

Fear is the greatest motivator. Motivation is what it takes to find profit.

BCbanker's picture

I wouldn't get too caught up

IB
(Gorilla, 633
 
Points)
 on 8/14/12 at 9:24am
ladubs111's picture

Best answer was already

IA
 
Points)
 on 8/14/12 at 9:26am
Tolland15's picture

Equity issuances have higher

O
(Baboon, 150
 
Points)
 on 8/14/12 at 10:36am

I was taught that the human brain was the crowning glory of evolution so far, but I think it's a very poor scheme for survival.

Oreos's picture

Tolland15: Equity issuances

HF
(Neanderthal, 2,450
 
Points)
 on 8/14/12 at 10:50am
NewGuy's picture

Because you think the ROI on

HF
 
Points)
 on 8/14/12 at 11:15am
Nabooru's picture

Djalminha: qweretyq: I was

(Gorilla, 689
 
Points)
 on 8/14/12 at 11:39am

Who are you going to believe, me or your lying eyes?

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