PART SEVEN MANAGERIAL FINANCE

Motives for Using Debt

The“tax subsidy”due to deductibility of interest is often cited as a major advantage to the use of debt. However, because of the effects of personal income taxes discussed above, a part of this advantage may be illusory.

The size of the net tax subsidy on debt is very much an unsettled question at present.Until this question is resolved, financial managers might be best advised to stay on the side of conservatism and assume that the tax advantage to shareholders from the use of debt is probably modest.

Betting on the Future

Firms used debt long before interest was made deductible for tax purposes, so there must be other advantages.Earlier in this chapter, we learned that the effect of financial leverage on returns depends on the relationship between the firm's operating return on assets and the interest cost of debt.If operating return is greater than interest cost, then increasing financial leverage by replacing equity with debt will have a favorable effect on earnings. Earnings and return to equity will be higher with debt than without.Conversely, if operating return is less than interest cost, the firm will be worse off with debt .

So, one motive for using debt is simply to gain the advantage of financial leverage that accrues if things turn out well. A management convinced that the future is bright may want to“lever up”and thereby increase the return to owners.If management's predictions are correct, owners indeed will be better off because of the debt .If the predictions are wrong, the piper must be paid.

Do the financial markets place a higher value on firms that bet on the future by using debt? If there existed managers that could predict the future with certainty, the answer would be yes.But even managers with access to the best information cannot do so, and suppliers of capital in the financial markets know they cannot.Debt can make the owners worse off, perhaps very much worse off, if things do not go well.

Earlier in this chapter, we discussed the effect of debt on the magnitude and variability of returns.We found that, in most cases, debt increases both the expected or most likely return and simultaneously increases the variability or riskiness of that return.The increase in risk offsets the increase in expected return in the eyes of suppliers of capital, and the current value of the firm is affected only to the extent of tax benefits. We found this to be so in our discussion of the“EBIT pie”and division of EBIT among its various claimants.

The use of debt makes sense only if management is reasonably convinced that operating return on assets in the future will exceed the interest rate on debt.However, even where this is the anticipated outcome, it does not necessarily follow that debt ought to be used.Management must make a judgment that the prospect of higher returns justifies running the risk that returns may turn out to be lower.If the future looks sufficiently bright, management may decide to“bet on the future”via increased use of debt.However, the financial markets are unlikely to place a higher current value on the firm's securities simply because the gamble is being taken. Any immediate effect on firm value results only from tax benefits, which, for reasons discussed earlier, are likely to be modest.In short, the financial markets are likely to give credit for the use of debt only after the returns are all in.

Financing Costs

Another motive for using debt has to do with financing costs.For many firms, and nearly all small firms, debt raised via financial intermediaries is very much cheaper than debt or equity raised via the public financial markets. The main types of financial intermediaries are commercial banks, insurance companies, savings and loan associations, savings banks, and pension funds.

Intermediaries reduce financing costs by reducing the costs of matching up borrowers and lenders.The intermediary acts as“agent”for both borrower and lenders in the tasks of gathering funds, credit analysis, record-keeping, and so on.Savers with small amount can lend much more cheaply and safely by going through a commercial bank than by lending directly to firms.A firm that wants to borrow a million dollars can do so much more cheaply by making one stop at a bank than by gathering small amount from hundreds or even thousands of individual savers.The net effect is that the entire process of borrow ing and lending is much less expensive than it would be if intermediaries did not exist.In technical jargon, financial intermediaries reduce“friction”due to costs of search, acquisition, and information-processing.

Commercial banks are the primary suppliers of funds to small firms.By law, commercial banks deal only in debt contracts.The net result is that debt represents a very economical source of outside funds for many small firms, much more economical than equity capital raised by the public financial markets.For small or little-known firms, raising equity capital via the public financial market is prohibitively expensive because it requires a substantial amount of information-processing and credit analysis by hundreds or even thousands of different individuals.The commercial bank performs this credit analysis and information-processing function on behalf of all of those individuals.Since the commercial bank offers only debt, debt becomes the cheapest source of funds.

Large firms also often find debt obtained via financial intermediaries an attractive source of funds.Firms with many profitable investment opportunities may find internally generated funds insufficient to satisfy all requirements. Raising the necessary funds by a sale of stock may be considered undesirable because of control considerations or because of the costs and fanfare of a public offering.The alternative of obtaining debt via a loan from a commercial bank or a“private placement”of long-term debt with an insurance company may be quite attractive. By dealing with a financial intermediary, the firm raises the required funds cheaply and conveniently in a single transaction.

We can conclude that there are three main motives for borrowing by firms.One motive is to capture the tax benefits of deductibility of interest. Just how large these benefits are to shareholders after personal taxes is open to some question.Another motive is to exploit the effects of favorable financial leverage.A final motive is to use debt when the sale of stock may dilute existing control of the firm or involve large issuance costs.

Even if there were no tax benefit at all, many firms would borrow for one of the other two reasons.Firms with access to either debt or equity via the public markets might choose to borrow in order to exploit the effects of financial leverage.Firms that cannot raise equity economically choose debt because it is the only economical source of external funds.

John J.Pringle and Robert S.Harris, Essentials of Managerial Finance © 1984, pp.502-504.Reprinted by permission of Scott, Foresman and Company, Grenview, Illinois.

KeyTerms and Concepts

tax subsidy the convention of allowing interest payments for debt as a business expense, reducing tax obligations.This is seen as a“tax subsidy.”

deductibility of interest refers to the exemption of taxation on interest of debt.

financial leverage financial methods to help the growth of a business.

equity Free enterprise system recognizes the private ownership of property. Roughly speaking, equity means“ownership.”An owner's equity represents all of the claims of the owner that are recognized under the law, such as investment in buildings, machinery, and tools.

The piper must be paid Those who seek benefits must assume responsibility and costs.

EBIT earnings before interest and taxes, also known as operating profit which measures the firm's performance without regard to financing or taxes.Therefore, interest of EBIT refers to the interest of debt.

securities Security is a general term for stock exchange investment, while securities refer to bonds, share certificates, and other titles to property.

financial intermediary go-between between a lender and a borrower, institutes of financial intermediary include saving and loan associations, life insurance companies, mutual savings banks, etc.

saving and loan association a financial institute which is very much similar to a bank, mainly focusing on leasing and property investment.

equity capital a phrase to describe capital structure of a firm.Equity capital is from stock issues, while debt capital is from bond issues.

financing cost the cost of seeking, obtaining and borrowing money.

private placement an individual or a small group rather than a company to borrow money from an insurance company.