Why Don't Firms Use More Debt and Less Equity?
When it comes to financing, both individuals and corporations must balance their capital structure to optimize costs and maintain control. The choice between raising funds through debt and equity depends on a variety of factors such as the cost of capital, access to capital, and risk aversion. While the after-tax cost of debt is often cheaper than equity, firms still strive for a balance between the two. This article explores why companies might opt for equity over debt and the factors that influence their capital structure decisions.
Why Use Equity Instead of Debt?
A corporation may choose to raise funds through equity rather than debt for several reasons. First and foremost, equity is often perceived as 'free money,' as companies do not need to make regular payments. Unlike debt, dividends do not need to be paid unless the company chooses to distribute them. Additionally, corporate structures can be designed to allow for additional capital raising without losing control. For instance, Google's share classes exemplify how firms can maintain control while raising capital through equity.
Another key reason firms opt for equity is the need to raise substantial amounts of money that individual banks cannot provide. In these cases, issuing corporate bonds may not be the best option. Moreover, companies might raise equity for strategic reasons without a specific or disclosed project in mind. Selling shares in the market means selling a piece of the future of the company, which can attract a diverse investor base. Lastly, firms that cannot secure debt financing, such as start-ups, have no other option but to issue equity.
When Debt is Cheaper, Why Not Go All In?
Given that the after-tax cost of debt is typically cheaper than equity, one might wonder why firms do not use more debt and less equity. Despite this general rule, companies aim for a balanced debt-equity ratio rather than pure debt. This balance is crucial for several reasons.
First, debt can lead to bankruptcy. If firms are not able to service their debt payments, it can result in bankruptcy, which can severely impact a company's reputation and financial health. Therefore, beyond a certain level of debt, companies preferred to raise money through equity. This threshold varies depending on the company’s industry, creditworthiness, and the prevailing economic conditions.
Second, the cost of debt has inherent limitations. As companies continue to take on more debt, the cost of financing increases. This is because lenders charge higher interest rates to companies with higher debt-to-equity ratios. Consequently, the difference between the cost of debt and the cost of equity diminishes. This means that at some point, the cost of raising additional debt does not justify the benefits of reduced equity costs.
Striking a Balance: The Optimal Debt-Equity Ratio
Again, achieving the right balance is crucial for firms. While debt can be cheaper in the short term, the long-term risks and the increasing cost of debt can outweigh the benefits. Companies must carefully evaluate their financial situation, market conditions, and strategic needs to determine the optimal debt-equity ratio.
For instance, in the current market, some of the best corporate bonds sell at negative interest rates, making them extremely attractive from a cost perspective. However, this may not always be the best option for every company. Start-ups and firms with a high risk profile might find it challenging to secure debt financing and must rely on equity to raise capital.
Conclusion
Firm's capital structure decisions are complex and multifaceted. While raising funds through debt can be cheaper, it comes with significant risks such as bankruptcy and higher interest costs. On the other hand, equity is a safer option but may be more expensive in the short term. The key is to find the right balance that aligns with the firm's strategic goals, financial situation, and market conditions. Understanding these dynamics can help firms make informed decisions and optimize their capital structure for long-term success.