It is general knowledge that companies need to borrow money to function. Rarely does it happen that companies generate enough funds to not only meet costs and pay employees but also plan new projects and expand in size. This is where debt and equity come in. This is called the company’s capital structure. This is becoming more relevant today considering the debt problems that Indian companies and banks are facing.
Everything comes at a price, even money. Whenever companies borrow money either through bank loans or other assets like Bonds and Debentures, they promise to pay an interest amount on this borrowing. This is the cost of debt. Higher the interest rates, greater is the cost. However, debt gets a tax benefit – the interest paid can be deducted from total income while calculating tax. This essentially reduces the cost of debt.
In finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital in the company’s shares. In return, equity investors expect to get rewarded in terms of capital appreciation and dividends. Equity shares are issued to investors through Initial Public Offers at an optimal price (which should neither be too cheap nor too expensive) which is determined based on several factors like market sentiment, economic conditions, relative valuations and so on so forth.
Usually, debt is considered a better option than equity. It is considered the cheaper option. Plus, companies have more flexibility when it comes to paying back the debt. Equity, on the other hand, is not as flexible. It does not mean that the company should go on piling up debt. Ideally, the mix of own funds (equity) and debt should be optimal. Companies saddled with huge debt are perceived as risky by investors, which is why analysts look at a newly listed company’s debt while analyzing if the shares are worth investing in.
The downside to debt is that it increases a company’s risk. Usually, a company is obligated to pay off its debt first and then pay its equity shareholders. So, whatever money a company earns goes off in paying off costs and interests due. All the money left becomes the company’s profit. This is often reinvested in the company for future growth and expansion. As a company piles on debt, its interest obligation increases. So, if ever the company hits a rough patch due to factors like economic downturn, a high debt can become detrimental, potentially leading towards bankruptcy. This is called the cost of financial distress.
This is why debt is good for a company only up to a certain limit. This is called the ‘optimal capital structure’. So how do you measure this limit? The optimal capital structure is when the tax benefits of debt are maximized. The moment the cost of financial distress turns higher than the benefits, the capital structure becomes debt-heavy and risky. This, however, is easier said than done. The cost of financial distress is not easy to measure.
This is where credit ratings come in. Agencies like CRISIL, CARE Ratings and Moody’s measure a company’s ability to repay. This is called as credit risk. Based on this analysis, the agencies assign the company’s debt a credit rating. Any change in the rating influences the cost of borrowing for the company. This also affects the company’s share price. So if a rating is downgraded, share prices can fall. This increases the overall cost for the company and minimizes any tax benefits.
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