After a brief gap (due to various preoccupations), let me resume my blogs. Let me brief on the past posts in the above series. The first one dealt with basics of real assets and financial assets. The second one explained the characteristics of financial assets; the third one was about the financial system and the fourth and fifth dealt with raising funds (capital) from through borrowing and from the shareholders through the primary markets respectively. The last post ended with a question: when raising funds directly from public involves lot of costs (in various forms), why do firms raise funds from the public? Let me try to answer.
Let us first understand why firms do not like too much of debt. Debt capital, though less costly as the interest rates are fixed and they do not participate in the profits of the firs, has its own disadvantages. Firstly, the interest payments on debt are committed costs and the firm has to pay the same, irrespective of whether the firm makes profit or not and whether it has enough cash balance or not. Default in payment payment leads to lot of complications like hampering the image of the firm, reduced credit rating, and even legal proceedings by the lenders in extreme cases. Secondly, the lenders start insisting on certain operational restrictions. They would require the firm to take them into confidence before implementing major decisions like expansion of business, payment of dividend, raising further funds etc. Thirdly, as the going gets tough for a firm (may be due to unfavourable external environment), firms with more debt find it difficult to sail through, as they have to deal simultaneously with the hostile business conditions and the highly demanding lenders. This is exactly what the aviation sector is facing now.
Now let me explain, why equity (owner's funds) may be attractive inspite of relatively higher costs. The equity capital is almost a permanent source of capital. The firm is under no obligation to repay this capital under any circumstances, except in case of winding up of business or buyback of shares. Here again, the decision to buyback the shares is not demanded by the shareholders. The firm is also not under any obligation as far as payment of dividend (the share of profit) is concerned. A firm with more equity capital attracts a better image in the business circles and financial markets. Such a firm also enjoys better bargaining power with the lenders, when it comes to raising additional funds through borrowing.
Let us first understand why firms do not like too much of debt. Debt capital, though less costly as the interest rates are fixed and they do not participate in the profits of the firs, has its own disadvantages. Firstly, the interest payments on debt are committed costs and the firm has to pay the same, irrespective of whether the firm makes profit or not and whether it has enough cash balance or not. Default in payment payment leads to lot of complications like hampering the image of the firm, reduced credit rating, and even legal proceedings by the lenders in extreme cases. Secondly, the lenders start insisting on certain operational restrictions. They would require the firm to take them into confidence before implementing major decisions like expansion of business, payment of dividend, raising further funds etc. Thirdly, as the going gets tough for a firm (may be due to unfavourable external environment), firms with more debt find it difficult to sail through, as they have to deal simultaneously with the hostile business conditions and the highly demanding lenders. This is exactly what the aviation sector is facing now.
Now let me explain, why equity (owner's funds) may be attractive inspite of relatively higher costs. The equity capital is almost a permanent source of capital. The firm is under no obligation to repay this capital under any circumstances, except in case of winding up of business or buyback of shares. Here again, the decision to buyback the shares is not demanded by the shareholders. The firm is also not under any obligation as far as payment of dividend (the share of profit) is concerned. A firm with more equity capital attracts a better image in the business circles and financial markets. Such a firm also enjoys better bargaining power with the lenders, when it comes to raising additional funds through borrowing.
I completely agree with your approach on capital structure sir, If I plan to start a company I would definitely feel safe having equity than debt. But, I always hear people saying debt to be cheaper than equity when it comes to big companies. I also see that Modigliani miller theory doesn't really hold good in the real world situation due to his assumptions.
ReplyDeleteThanks Sushma for your comments. See, 'Debt' is a double-edged sword. When the going is easy, it helps you multiply the profits; and when the going gets tough, it forces you to bleed. So, the relevant question is not 'whether debt is good or bad'; rather "how much debt to use, when to use and how to use?" There are many Indian firms that have exhibited wonderful performance even without (or with only minimum of) debt!! Take ITC for example. By 2012, their networth was Rs.18791 crore whereas the total debt was only Rs.79 crore (just 0.42%!!).
ReplyDeleteLet me also add that 'debt' is definitely cheaper compared to equity for two reasons: (a) the interest payments are tax exempt & it reduces the overall (effective) cost; and (b) even at a pre-tax level, debt is cheaper as the lenders do not share the business risk. (This argument fails at extremely high proportions of debt as the lenders start indirectly getting affected by the business risk). As far as Modigliani-Miller propositions are concerned, they have been modified through further research to bring them closer to reality. You can see a detailed discussion of the same in 'Principles of Corporate Finance' by Richard Brealy & Stewert Myers.
ReplyDeleteSir, adding on to your post, debt would also promote in minimising the tax liability and the after tax cost of debt is conisedered in WACC because interest payments are eligible
ReplyDeletefor tax deductions (and to make comparable with cost of equity as we consider earning after tax for equity).