Is there a limit to borrowing?

Aravind Sampath
December 12, 2022

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 Learning Objectives

• Understand the negative side effects of debt

• Understand trade-off theory and Pecking order theory
• Understand how much a firm can borrow

Most of the content is sourced from Corporate Finance Theory and Practice, Damodaran, 2nd Edition

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 Refresh Capital Structure

• Debt vs Equity - different claims on a firm’s CF (we also know the intricate
differences by now, refer earlier notes).
• In a world without tax, debt for sake of debt does not create value - firm value is
untouched by leverage.
• In a world with tax, debt has a positive side effect - ITS; levered firms are more
valuable because of this.
• If debt creates value via ITS, a firm can perpetually borrow infinite amount of
money. But in reality it does not work like that - why?

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 Refresh Capital Structure

• Debt vs Equity - different claims on a firm’s CF (we also know the intricate
differences by now, refer earlier notes).
• In a world without tax, debt for sake of debt does not create value - firm value is
untouched by leverage.
• In a world with tax, debt has a positive side effect - ITS; levered firms are more
valuable because of this.
• If debt creates value via ITS, a firm can perpetually borrow infinite amount of
money. But in reality it does not work like that - why?

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 Debt and life cycle choices2

2
Source: Corporate Finance, 2nd Edition, Damodaran
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 Introducing the side effects of debt

• Debt has positive and negative side effects.

• Positive side effects - tax benefits, discipline to management.
• Negative side effects - bankruptcy costs, agency costs, loss of financial flexibility.

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 Positive Side Effects
Interest Tax Shield

• The world of business is such that when firms raise capital via debt and pay
interests, they are allowed to deduct interest expense to arrive at taxable income,
thus reducing overall taxes (while equity does not get this benefit).
• This cash flow saving due to taxes is called interest tax shield = ITS =
Debt × Cost of Debt × Tax Rate
• Therefore, the positive side effect ITS is a function of debt borrowed and tax rate.
• All else remaining same, higher the tax rate, more debt in a firm’s capital
structure and vice versa.
• Note, after India cut corporate taxes in Sep 2019, many firms are on a deleveraging
trend

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 Positive Side Effects
Interest Tax Shield

• ITS effect would be lower if tax code allows part of equity CF to be tax
deductible. e.g. wherever dividends are taxed low than retained earnings, ITS
impact will be lower.
• If the firm does not pay taxes, debt is less attractive. e.g. Carnival cruise lines,
domiciled in Liberia makes most business from US tourists, does not pay taxes, so
expect less debt.

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 The Tax Effect

You are comparing the debt ratios of real estate corporations, which pay the corporate
tax rate, and real estate investment trusts, which are not taxed, but are required to
pay 95% of their earnings as dividends to their stockholders. Which of these two
groups would you expect to have the higher debt ratios?

1. The real estate corporations

2. The real estate investment trusts

3. Cannot tell, without more information

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 Positive Side Effects
Interest Tax Shield

• Debt in a firm’s balance sheet is a function of its potential ITS.

• Firms that already have substantial tax shields via other routes - e.g. depreciation,
would use less debt compared to otherwise.
• Debt in a firm’s balance sheet would mimic the movement of tax rate in the
economy.
• Countries where tax rates are high, firms would have more debt compared to
otherwise.

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 Positive Side Effects
Debt Adds Discipline

• Imagine you’re the CEO of an unlevered firm rich with cash flow. Chances are
that with time, you become complacent, which leads to picking negative NPV
projects for which there’s ultimately no cost to the CEO.
• For such CEOs/firms, debt is the perfect antidote. By adding debt, such firms
have to make enough returns to at least repay debt, else firm risks bankruptcy.
• “Managers of firms with substantial cash flows and little debt are much more
protected from the consequences of their mistakes (especially when stockholders
are powerless and boards toothless). Left to themselves, managers (especially lazy
ones) would rather run all-equity financed firms with substantial cash reserves.” -
Bennett Stewart

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 Positive Side Effects
Debt Adds Discipline

• Assume you buy the argument that debt adds discipline to management. Which
of these firms benefit from debt adding discipline?
1. Low debt firm, promoter owned business.
2. Low debt firm, publicly listed, with activist investors on board via institutional
holding.
3. Low debt firm, publicly listed, shares held by millions of retail investors with no
majority on board.

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 Negative Side Effects
Bankruptcy Costs

• A firm is bankrupt when it is unable to meet contractual obligations.

• What kind of a firm can go bankrupt?
• Both levered and unlevered firms can go bankrupt.
• What happens when a firm is bankrupt? Assets liquidated to meet claims.
• How to measure bankruptcy costs?
• Direct costs - legal, administrative and other overhead costs.
• Indirect costs - costs arising (e.g. loss of sales) because stakeholders’ perception of
bankruptcy.
• As a firm borrows more, risk goes up, alongside cost of bankruptcy and probability
of bankruptcy.

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 Negative Side Effects
Bankruptcy Costs

• Indirect costs are always greater than direct costs of bankruptcy (research also
indicates the same).
• e.g. When Apple was perceived to go bankrupt in 1997, they lost sales, and even
software firms paused updating for Apple.
• When telecom firms in India were perceived to go bankrupt, there was a huge
MNP jump (this has been the case from 2016 till now, though things have
stabilized now).
• Probability of bankruptcy is always a function of (un)predictability of earnings.
More variable earnings, more the probability of bankruptcy and vice versa.

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 Negative Side Effects
Bankruptcy Costs

• Indirect costs should be high for firms that sell following products/services:
1. Durable products with long life requiring service and replacement - e.g. automobile,
aeroplane.
2. Goods/services where quality is important, but difficult to determine in advance.
3. Value of product depends on services and complementary products supplied by third
parties - e.g. mobile phone.
4. Any type of product requiring continous support from manufacturer.
• Indirect bankruptcy costs high for these type of firms.
• Greater indirect bankruptcy costs or probability of bankruptcy, less debt
the firm must use.
• If firms can structure their debt so that debt is a function of operating cash flows,
then firms can add more debt (this is why most firms fix Debt to Value ratio).
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 Negative Side Effects
Bankruptcy Costs

• Rank the following firms on bankruptcy costs.

1. A small grocery store
2. Boeing/Airbus
3. High Tech. Firm

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 Negative Side Effects
Agency Costs

• Agency cost arises when owner hires an agent to run business on their behalf. The
cost arises due to conflict of interest between the principal (owner) and the agent
(manager).
• Classic agency cost - equity holder vs debt holder.
• e.g. Fedex and the gamble!!
• Greater agency costs associated with a firm, less it can borrow.

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 Negative Side Effects
Agency Costs

• How do agency costs show up?

• Increased cost of debt - if debtors perceive agency costs, they may simply demand
higher cost of debt.
• Also, bondholders/debt holders may write restrictive covenants i.e. conditions on
how the firm may spend the capital (much like Greece bailout in the early to mid
2010s). However, this comes with two costs
• Monitoring costs
• Lost investments

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 Negative Side Effects
Agency Costs

• Agency costs due to risk shifting is high when investments cannot be

observed/monitored by debt providers. Such firms should borrow less.
• Agency costs because of monitoring/second guessing investments is high when
projects are not only long term, but follow unpredictable cash flow paths and take
years to breakeven. Such firms must also borrow less.
• Why do you think Amazon (Facebook, Google, Microsoft, Infosys and a host of tech
firms) have almost zero debt?
• These firms invest in products/services that cannot be observed/monitored or even
take long to break even - therefore, the debt would always be near zero.

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 Negative Side Effects
Agency Costs

• You’re the authority to stamp loans. Which of the two firms would have greater
Agency costs?
1. A large pharmaceutical firm
2. A large regulated telecommunications firm

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 Negative Side Effects
Loss of Financing Flexibility

• In the earlier module, we assumed cost of debt remains a constant.

• Please note, in the real world, the marginal cost of debt is not zero (i.e. cost of
debt does not remain constant).
• After a particular point, every additional | 1 of borrowing will elicit a greater cost
of debt.
• When firms reach their capacity to borrow, they lose the flexibility of raising
capital via debt for any potential future projects.
• All else remaining same, more uncertain a firm is on future financing
requirements, less debt to be used for current projects

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 Theories on limit to usage of debt

• There are two major theories about capital structure.

1. Trade-off theory
2. Pecking order theory

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 Theories on limit to usage of debt
The Trade-off Theory

• Trade-off theory suggests that theoretically, a firm must borrow to the point
where the positive side effects of debt equals the negative side effects of debt.
• This means, ideal amount of debt is when benefits of debt match the costs
(non-financing costs).
• The ideal debt is when PV (debt benefits) = PV (debt costs).
• When costs of debt (bankruptcy, agency, flexibility) are greater than benefits (tax
effect, discipline), it destroys firm value and first principles are breached.
• However, there is no precise formula for this, neither is it practical to arrive at the
number.
• In reality, we can only estimate firm’s current/projected CF and arrive at
appropriate costs for scenarios - that may provide insight to an approx. debt to be
maintained.
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 Theories on limit to usage of debt
The Pecking Order Theory

• Unlike trade-off theory, the pecking order theory provides a guideline on how firms
must raise capital.
1. Use internal finacing first
2. Issue debt next
3. Equity is the last resort
• Unlike trade-off theory, pecking order theory does not provide a target D/E ratio.

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 Debt as a signal

• Firms’ decisions to raise/retire debt may be a signal to the market in terms of

anticipated profits.
• Though we see instances of managers attempting to fool investors by
over-utilizing debt, they fail in the long-run.

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 Factoring individual taxes

• Equity holders face double taxation: (1 − taxratefirm ) × (1 − taxrateindividual )

• Debt holders face single tax at individual level as firm does not pay taxes on
interests paid to debtors: (1 − taxrateindividual )

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 What is an optimal capital structure

• Recall first class - whatever decision we study, we come back to first principles -
value creation.
• Ultimately when it comes to financing, firms maximize value when the capital
structure choice minimizes the overall firm’s cost of capital i.e. RWACC
• Common sense must dictate that financial risk also follows operational (business)
risk - industries whose operational risk is high with volatile CF would have less
debt and vice versa.
• The starting point to investigate whether firms create value by financing is to
understand operational risks - then need to add all real world firm specific factors
including bankruptcy cost, agency cost etc.
• Best capital structure is that which minimizes firm’s overall Cost of Capital.

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 What do you think of this advertisement?

You are reading the Wall Street Journal and notice a tombstone ad for a company,
offering to sell convertible preferred stock. What would you hypothesize about the
health of the company issuing these securities?

1. Nothing

2. Healthier than an avg. firm

3. In deep financial trouble!!

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