Firms' Debt Financing - Research Paper Example

Debt Financing Table of Contents Table of Contents 1 Introduction 2 Conceptual Relevance 3 Debt Financing 3 Cost of Agency 5 Agency Conflicts 6 Benefits of Debt Financing over Agency Conflicts 8 Recommendations 12 Conclusion 13 References 14 Bibliography 17 Introduction The capital structuring for the firms has gained significant importance in deciding the appropriate structure that will provide maximum advantage with minimum cost to the firms. There has always been a debate over the equity and debt financing for capital structure and it still continues (Becker & Stromberg, 2010). The increasing importance of debt financing in modern era of business has encouraged for the study of debt financing, which will be discussed in this paper. The debt finance concept and its relevance will be explained in detail to understand its importance and develop the knowledge. Along with this, the cost of agency will be focused with the conflicts that rise during the structuring of debt finance. Subsequently, the benefits of debt financing over the agency conflicts will be discussed to know its relevance in financing in recent times. There are several arguments related to the firms’ debt financing that reflects whether the capital market is imperfect or not. There are other factors within the firms such as managers try to avoid high debt ratios to safeguard their interests in the firm (Myers, 1976). Every firm needs to borrow money for the business in short or long run and there are options such as equity, debt and others. It is important for the firms to decide the structure of finance that provides benefit. Conceptual Relevance Debt Financing Debt financing is one of the strategies which the firms employ for borrowing from the investors or lenders with a contract that the repayment will be made within a stipulated time period with certain interest (Reference for Business, 2011). The firms borrow money for raising funds for working capital or for the motive of capital expenditure through the financial instrument such as selling bonds, notes bills and others to institutional and individual investors and lenders. The institutional and individual investors and lenders become the creditors of the firms and promise that the amount and interest on the debt will be paid by the firms within the specified future date (Investopedia, 2011). The payment of debts and dividend are different. The interest and the principal amount/payments upon the debts are firm’s obligations, whereas the dividend payments are not obligations for the firms. The shareholders of the firms are not entitled legally for the dividends but the bondholders, bill holders and other financial debt instrument holders are entitled legally for the principal and interest amount from the firms (Lecture 3). According to the trade-off model the firms should issue debts as long as the marginal benefit is greater than the marginal cost. In the general financing structuring of the firms the high-tax rate firms should apply more debt than low-tax rate firms (Graham, 2008). Relationship among bankruptcy costs, agency costs and taxes is illustrated below: Source: (Pearson Education, 2004). Through the debt financing, the principal and interest that are paid are treated as expenses and thus get deducted from the business income taxes in certain cases. This allows reducing the cost through the debt financing option. Cost of Agency The agency cost is an increase of cost of debt. This happens when there are conflicts between the management and shareholders. Due to the increase in the agency-cost problems, the bondholders and other financial debt instrument holders impose certain restrictions on the firms through bond indentures. The investors and lenders of the debt financing are aware of the fact that management is controlling their money and there are high probabilities of ‘principal-agent’ problems in the firms. Due to these two reasons the debt holders put certain restrictions or financial constrains upon the use of their money (Investopedia, 2011). The situation of agency cost mounts up when the management of the firms employs or their behaviours are benefiting the shareholder more than the bondholders or other debt financial instrument holders. If the firms take riskier projects that would benefit shareholders more than the bondholders then in this case, if the risk is high there is possibility that debt bondholders will be in a default position. Due to the cost of agency, the debt holders have crucial claim on the fraction of the firm’s income that are in the structure of principal and interest payments on the debts. Along with this claim they also have claim upon the firm’s assets, but that is only in the case of bankruptcy. The debt holders provide the money to the firms at a rate that are totally based upon the riskiness of the assets of the firms which are in the present situation and on the capital structure of equity and debt financing of the firms. They also depend upon the riskiness expectations that are related to the changes of risk of these two factors. Agency Conflicts Agency cost has already been discussed in the conceptual relevance part. In this part of report, agency conflict will be discussed and the reasons behind it will be determined. The fundamental problem that has arisen through the agency theory is the self interest behaviour. The managers of a corporation may have certain personal goals, which may compete with the goals of shareholder. Shareholders invest in an organisation with an intention of maximising their wealth. Since the managers are authorised by the shareholders to administer the assets of the firm, a conflict of interest may exist between these two stakeholders of an organisation. According to the agency theory, in the imperfect capital and labour market, managers try to enhance their own utility at the corporate shareholder’s expenses. Due to the uncertainty and asymmetric interest agents, they have become capable to operate in their own self interest instead of the best interest of the firm. This kind of self-interest behaviour of the managers encompasses the consumption of certain corporate resources and avoidance of the optimal risks. The first one they acquire informs of the perquisites and it has been noticed that the risk-averse managers often circumvent profitable opportunities that might be beneficial for the shareholders. When the outside investors become aware with the game, they restrict their investments in that particular organisation or discount the amount they willing to for the shares of the organisations. Conflict may arise not only between the shareholders and the managers but also between the stockholders and the creditors. Creditors have fundamental claim on the earnings of the firm in form of the principal payments along with the interest. In case of the bankruptcy, they claim on the assts of the firm. On the other hand, the stockholders operate a firm through the managers which affect the risk attributes and the cash flows of the organisation. The rate of interest of the debt is fixed with respect to the risk associated with a particular project. After fixing up the rate of interest if the management take decision to enter into a riskier project, then conflicts may arise. If the project turns out to be successful then the entire profit will be enjoyed by the shareholders and the creditors will only get the predetermined low interest rate. In oppose to that if the project turns out to be a failure, then the creditors will be forced to share the losses. These are the basic reasons for the cause of conflicts between the principles and agents. In case of the managers and shareholders conflict, it can be reduced to certain extent through implementing performance compensations of the executives with involvement of adequate monitoring (Reference for Business, 2011). Benefits of Debt Financing over Agency Conflicts Before analysing the impact of the debt financing on the agency cost, few elements should be evaluated that can influence both the aspects. Ownership structure plays an important role in causing agency conflicts and can influence the agency cost. Ownership structure engages characteristics such as proportion of the company stock acquired by the top management and the existence and absence of the large block holders. These features possess immense impact upon the effectiveness of the monitoring process of the management by the shareholders. In addition, these characteristics can also have an effect on the managerial incentives. Jensen & Meckling (1976) had proposed an ‘agency cost model of financial structure’, where they had mentioned that there is differences between the control and corporate ownership when an entrepreneur owns entire 100% stock of a company. The reason behind it is that entrepreneurs bear all the cost of each and every activity and accumulate all the benefits of their actions. It can be interpreted as generally fixed claims that may expose management towards the greater individual risk. However, on the other hand, it may minimise the agency costs through ‘forcing the payout of free cash’. By relying less on the debt financing, the managers with disseminated ownership may select to diminish the personal risk. However, with significant ownership stakes, managers can use more debt financing. Thus, the shareholders will be able to gather more agency-cost reducing advantages. Jensen and Meckling (1976) had elaborately described the way to overcome the agency cost through adopting debt financing. They had indicated two ways. Adoption of debt financing leads to sale of comparatively less external equity in order to enhance a provided amount of external financing. Another way is that through employing debt in place of equity financing, an organisation may be able to minimise the value and amount of perquisites that managers would have consumed. Moreover, the burden of having a regular ‘debt-payment service’ can be served as an effective means to discipline the corporate managers. Excessive perk consumption by the managers may cost to control their organisations following default with the debt financing. The reason behind it is that, the willingness of the managers to risk losing control of their firm might be expressed if they opt for debt financing. Furthermore, if the managers are not able to perform effectively then the shareholders will be willing to disburse a higher price for the shares of the firm. Now the question is that why organisations do not opt for ‘maximum debt’ financing instead of being such an effective disciplining device. The reason is that debt financing also possess certain agency costs. In the capital structure of the firm with the increment in the proportion of debt, the bondholders will start taking on more of the operating risk and business of the organisation. However, the managers and shareholders will still manage the operating and investment decision of the firm. This provides the managers a wide range of incentives to efficiently steal bondholder wealth for other shareholders and themselves. The easiest way to obtain it is to float a bond issue and pay out the money as a dividend to the shareholders. Thus, the organisation fails to pay to the bondholders and no other options are left with them as they are prevented by the limited liability concept to charge their money from the shareholders. Thus, agency conflicts are raised (Megginson & Smart, 2008). Both the cost of debt and cost of external equity vary with the debt to equity ratio of the firm in a way dependent on agency costs. The variation in the agency costs of different sources of finance indicates that various financial assets are consisted in the optimal capital structure. From the above analysis, it can be suggested that capital structure need to be balanced. However, if the debt to equity ratio increases beyond certain level, then the ‘managerial agency cost of debt’ will begin to dominate the ‘managerial agency cost of external equity’. The outcome of this can be better executed through simultaneous use of both the external equity and debt. For a given size of an organisation, as the level of the outside funding increase, the agency cost of the finance will also increase. Hence, it has been observed that agency cost is the highest for the organisations operated by the professional managers and especially when they possess organisation specific knowledge and skills. In addition, with the expansion of the firm the requirement of the capital is also increased and decision regarding the selection of the capital structure has also become complicated. Hence, the agency costs are also increased (Moschandreas, 2000). It is widely argued that through using debt financing, the agency conflicts can be conquered. The primary reason behind it is that debt payment is mandatory; otherwise the company will be declared as bankrupt. This fact prevents the managers from the excess consumption and makes them more disciplined. There is another benefit of adopting debt financing as it is the subject to direct monitoring of the managers of a firm by the capital market. Moreover, it is necessary to mention here that by taking the decision of choosing debt financing, managers somehow increase the level of risk for their job. Most of the benefits of the debt financing over the agency conflicts and costs has been discussed. Debt financing has several benefits and reduction of agency cost is one among them. Eventually, the expected cost of the debt financing can be demonstrated through forming an equation and the equation can be exhibited through a diagram. VL = VU + TC D − BC – AC The equation expresses the value of levered firm with respect to the value of an unlevered firm. The value is adjusted with the present value of the tax shield, bankruptcy cost and agency cost. The value of the agency cost is equivalent to the present value of the differences between the agency cost of outside equity and outside debt. (Source: Lecture 3) Recommendations The arrangement of debt finance in the worst state might tend to be difficult as the investor and lender might consider that the firm is unable to pay off the debts on the specified time. With the appropriate management of debt and equity ratio it is possible to determine the exact amount of debt required for the firm. This way the management of appropriate funds that are required for financing will be taken and interest can be paid upon that amount. Therefore, no ideal money in form of debt will be with the firm. The entire debt finance should be utilised in the projects for the purpose that has been raised. This way the investment of the entire amount will increase the leverage of the firm operations and the pay back option will be easy. The secured and unsecured debt financing options should be evaluated properly to determine the advantage of the firm and the debt holders. This way the management of debt funds with the option of secured and non-secured debt will increase the mobility of funds with more benefits. The debt negotiator should be a skilful person in evaluating the cost-benefit of the debt financing so that the maximum benefit is taken from the debt finance in short and long run period. Conclusion The debate of debt financing is still going on and there are clashes between the management and the shareholders and the debt holders. The debt financing depends upon the firm’s ability to pay, the tax ratio that they pay and the strategic decision they make for the future market. The value of secured assets, firms size, non-debt tax shield, ability to generate the internal resources, percentage of state-owned shares and other industrial variables affect the debt financing policy and the management needs to evaluate different parameters before deciding for the debt financing. There are big firms that have the debt financing and are represented in their balance sheet. This is because there are various options which may be for tax breaks, big acquisitions, low interests funding and other reasons. The debt financing is a good option for the firms. If they are efficiently and effectively implemented and managed, it will enhance the growth of the firms. References Becker, B & Stromberg, P., 2010. Equity‐Debt Holder Conflicts and Capital Structure. Harvard Business School. [Online] Available at: http://www.hbs.edu/research/pdf/10-070.pdf [Accessed March 10, 2011]. Graham, J. R., 2008. Taxes and Corporate Finance. Tuck School of Business. [Online] Available at: http://mba.tuck.dartmouth.edu/pages/faculty/Espen.Eckbo/PDFs/Handbookpdf/CH11-Taxes.pdf [Accessed March 10, 2011]. Investopedia, 2011. What Does The "Agency Cost Of Debt" Mean? Finance. [Online] Available at: http://www.investopedia.com/ask/answers/09/agency-cost-of-debt.asp [Accessed March 10, 2011]. Investopedia, 2011. Debt Financing. Finance. [Online] Available at: http://www.investopedia.com/terms/d/debtfinancing.asp [Accessed March 10, 2011]. Jensen, M.C. & Meckling, W. H., 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics. Moschandreas, M., 2000. Business Economics. Cengage Learning EMEA. Megginson, W. L. & Smart, S. B., 2008. Introduction to Corporate Finance. Cengage Learning. Myers, S. C., 1976. Department of Corporate Borrowing. Sloan School of Management. Pearson Education, 2004. Capital Structure Determination. Finance. 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