Brief Overview of Debt and Equity. The Only Two Choices for Financing. Debt (Leverage) The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. Equity
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Debt is always the least costly form of financing.
Debt will always be perceived by investors to be less risky than equity. Therefore, its required return will always be lower.
Advantages of Debt
Disadvantages of Debt
Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.
In financial leverage, the fulcrum is the fixed cost of the debt financing.
The small force is variability of operating income.
The large force is the variability of cashflows to shareholders (EPS)
The larger the fixed interest payments…
The more a small change in operating profit…
Will be amplified into a larger change in EPS
A survey of Chief Financial Officers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions
1. Maintain financial flexibility4.55
2. Ensure long-term survival4.55
3. Maintain Predictable Source of Funds4.05
4. Maximize Stock Price3.99
5. Maintain financial independence3.88
6. Maintain high debt rating3.56
7. Maintain comparability with peer group2.47
So, if capital structure changes do not affect the cost of capital, then capital structure is irrelevant since it will not affect firm value.
The tax advantage of debt would be progressively offset by the rising potential for bankruptcy and the resulting financial distress costs, and also by the rising agency costs.
The result would be that the WACC would fall as debt went from zero to some larger amount, but would eventually reach a minimum and then start to climb.
Thus, there would be an optimal capital structure where the WACC is minimized. This would be less that 100% debt.