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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debt is cheaper. Required return on equity is higher.
Debt financing can possibly be tax deductible while equity financing is not.
n/a
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_form_of_finance_than_eq…
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.
Where do you get this reasoning from - the Modigliani-Miller theorem? Do you realize that you violate the theorem's assumptions when claiming one reason for debt is tax shields?
Not to mention, I'm pretty sure empirical evidence disagrees. Build a table for how an actual company's WACC would vary using various D/E ratios if you wish to see for yourself.
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.
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.
Because of 3 simple reasons. Money, Cash, Hoes.
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
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.
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..."
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.
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.
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.
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...
Raising equity ==> many months + pbs with shareholders (shareholder structure, shareholders meeting) + pb with SEC (lots of filings to produce) + communication + fees to be paid to IBs etc Raising debt => 'overnight' + not as strategic + easier to structure etc
this is all you need to know: http://img98.imageshack.us/img98/8594/wacc.jpg
you always tend to be "optimal"
I was once asked what is a typical percentage of debt a company has? I was like wtf?? how do you answer that i said 30/70
sector country debt markets economy etc etc
42
I see what you did there
Because if you e-quit you can fight online another day. If you quit on debt you'll get your ass taken to jail.
Why debt over equity? (Originally Posted: 01/04/2015)
Seeking some intuition as to why corporations would prefer debt over equity. I get that the cost of debt is less than the cost of equity from a CAPM perspective, but I think I'm failing to see how issuing equity, with no repayments required, is more "costly" than issuing debt which requires interest and principal repayments.
Here are some points I've considered:
Debt creates a tax shield (fair, but payments of (1-t)*D plus after-tax interest still have to be made [rough calculation not discounting for time value])
Interest payments over the duration of a bond add up to less than combined dividends (sure, but what of companies that pay a historically low dividend/don't repurchase often?)
Issuing equity dilutes ownership interest (sure, but unless there's a large institutional buyer, I assume it wouldn't be too hard to maintain a large degree of control)
I feel like these are "side" issues though. What am I missing conceptually that makes equity so expensive? I assume it's not just issuance/transaction costs. Thanks for all the help.
I don't think Bankruptcy courts have the power to sentence people to jail
This isn't a funny joke. I'm assuming it's a joke as no one is this retarded. Please tell me no one is this stupid!
Gotta pull your head out of the theory my man! Ask yourself this question - why does one make an equity investment in a corporation(hint- not out of the kindness of his heart)? Second, ask yourself why the equity investor, who holds a residual claim on the business that is subordinated to the debt holder, would require a higher rate of return on his investment (i.e. the business' cost of capital)
Nope..people are this stupid.
I get this from the investor's perspective, but the payments aren't mandatory. Cost of debt (assume it to be = interest rate) has to be paid, but if a stock goes sideways (or even if it gains w/ no dividends), what's the bottom line payout that's so expensive compared to debt/interest expense?
Nope..people are this stupid.
Equity owns the company. Owners gotta get paid. Owners have more risk. Sums it up.
Bear in mind as well that "the corporation" is equity ie the board and management represent the interests of equity. So the question is really why does equity want to use debt, rather than more of their own equity.
Think about where the word "leverage" comes from. It's about equity owners wanting to use debt, because debt "levers" their returns higher. That is, the corporation/equity can use debt funding to fund growth/deals that could make stellar returns, but debt's share of those returns is capped at the interest rate, while equity gets all the upside.
That also means that, if a project is more risky than usual, equity doesn't have to put more of their capital at risk. They use debt and debt takes the risk, but with debt's returns on that risk capped at the interest rate.
Equity may just not have the funds to fund growth and existing equity holders don't want to have their ownership diluted by issuing more equity.
This is really close to what I was looking for. Pushing a little to make sure I get it, let's think of accepting a positive NPV project as raising the asset beta (asset return). Because debt beta (cost) stays constant, we expect a greater return for equity. That makes sense. Does issuing more equity, beyond control issues from dilution, materially change this greater return, even though the underlying assets haven't changed?
This thread should be renamed "Corporate Capital Structure 101"
This thread should be renamed "Corporate Capital Structure 101"
Take it to the extreme to understand the basics of the concept: my company has a market cap of $1 billion. I have a project that I think will net me $100 billion, but the project will cost me $500 million to earn the $100 billion. So, I can sell $500 million worth of shares and my share of the $100 billion will be a lot less because I sold the upside to other investors or I can borrow $500 million and keep almost all of the upside for myself.
Everyone pretty much went into detail about why or why not debt is usually cheaper (assuming no financial distress). But I would add that Debt can be quicker and more discrete in raising capital. i.e. a company could issue 144A Debt securities on the private market.
I wouldn't get too caught up in the theory. I have worked on a ton of deals where the idea is its always better to play with the house's money. You can get asymetric payouts. You put in $1 equity and get $9 debt. Your downside is $1. Your upside is way bigger. You sell the $10 company for 5x what you paid years later and collect $50 - 9 = $41. You make 41x your money instead of 5x. (5x is all equity financing. You put in $1, get $9 other equity, and own 10% of company. When you sell for $50 you get 10%, or $5.
Best answer was already stated about time, cost, hassle for 2ndary ipo vs just issuing debt at these cheap ass rates. Not to mentioned if you notice a lot of these companies are issuing debt to buyback stocks because they can take abit more leverage pay off older debt with 5-6% interest rates and return "value" to shareholders. Keep interest coverage ratio the same but bump up ur stock price RSU and stock option for vest date.
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