Sunday, 1 November 2015

Debt or Equity?

The idea of having an optimal capital structure is one that is sought after by many organisations; however is this possible, or simply an unachievable theoretical vision?  To achieve an optimal capital structure a company must finance itself using the perfect ratio of debt and equity in order to maximise a company’s market value and the company’s overall Weighted Average Cost of Capital (WACC).

In the overall scheme of things debt is a cheaper and less risky option of finance for a company and financing through equity is high in risk, which in turn, demands higher returns. One reason behind debt being cheaper than equity is due to the fact that lenders generally require a lower rate of return than shareholders do for securities or collateral. Also debt interest can be offset against pre-tax profits before the calculation of the corporate tax will, which reduces the overall tax paid. Transaction costs are also much lower when financing with debt, as the costs of issuing and trading shares are much higher than the costs of servicing and raising debt. So with all of this considered, debt appears to be a much more appealing source of increasing capital than equity does, however is this actually the case?

In theory the more a company borrows and has high levels of debt and high gearing, the lower the overall cost of finance would be. So does it make sense for a company to just raise capital using as much debt as possible? Probably not! Not only does a high gearing level decrease the overall financial costs, but it also increases the chances of a company becoming financially distressed! This could lead to: lawyers’ fees, accountants’ fees, court fees and a waste in management’s time.

 A different and rather controversial view on capital structure is Modigliani and Miller’s (M&M) in their 1958 paper. Their argument was that it does not matter how a company structures it capital, as it does not impact on the WACC. They make the point that a business’ market value depends purely on risk and what a company’s investment policy is. However with this view Modigliani and Miller have made some massive and undeniable assumptions! The main two being that there is no taxation involved and that all markets are strong form efficient. Obviously this is never going to be the case! With these assumptions in mind I do not see how this theory can be relevant, as there is never going to be a situation in business where there is no taxation or there is perfect market efficiency. I almost find this theory of Modigliani and Millers’ irrelevant and somewhat amusing that it is held in such high regard when it holds no genuine substance.

In conclusion to whether or not it is better to finance using debt or equity, I have decided that the optimal structure for a company depends on what industry they are in and how they are able to handle their debts. Obviously financing using debt has it perks, but eventually it does need paying and too much debt can lead to financial distress. So it is essential for companies to find the ideal debt to equity ratio, however this is obviously not an easy thing to achieve!

Feel free to leave any comments…


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