M&M II might make it sound as if it is always a good thing when a company increases its proportion of debt relative to equity, but that's not the case. Additional debt is good only up to a certain point because of bankruptcy costs.
Bankruptcy costs can significantly affect a company's cost of capital. When a company invests in debt, the company is required to service that debt by making required interest payments. Interest payments alter a company's earnings as well as cash flow.
For each company there is an optimal capital structure, including a percentage of debt and equity, and a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender.
The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly. (Read more about bankruptcy in Not Too Big To Fail: Corporate Financial Struggles and An Overview Of Corporate Bankruptcy.)
Optimal Capital Structure
Is there an optimal debt-equity relationship? In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expenses and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments. (For more stories on company debt loads, see Will Corporate Debt Drag Your Stock Down? and Burn Rate Key Factor In Company's Sustainability.)
A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.
Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels. (Read about personal debt in What's Your Debt Really Costing You? and Debt Settlement Arrangements And Your Credit Score.)
What Is the Optimal Capital Structure?
As we have seen, some debt is often better than no debt, but too much debt increases bankruptcy risk. In technical terms, additional debt lowers the weighted average cost of capital. Of course, at some point, additional debt becomes too risky. The optimal capital structure, the ideal ratio of long-term debt to total capital, is hard to estimate. It depends on at least two factors, but keep in mind that the following are general principles:
First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property and equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally use more long-term debt.
Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments in favor of future price returns. These companies are considered growth stocks. High-growth companies do not need to give these shareholders cash today; however lenders would expect semi-annual or quarterly interest payments.
In summary, the optimal capital structure is the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this optimal capital structure.
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