Most of the business in modern times runs on credit. From suppliers to customers, business is based on credit transactions mostly and hence a chance of debt formation is inevitable and unavoidable as well. What you can do is manage such debt effectively and wisely to prevent its accumulation and reaching unmanageable limits hen situations go out of your hands.
Given the situation, the question now arise is how much debt is reasonable and feasible for your company. Such quantification needs a lot of expertise and knowledge about debt and its formation, effects and management. Moreover, it is universally believed that, irrespective of the consequences, it is the aggressive use of financial leverage that usually pays in company values.
Qualification of the Belief
The attractiveness of debt is dependable on the personal as well as corporate tax rates which vary according to the prevailing situation. The hidden cost of such high leverage also affects the business finance and its policies to achieve strategic goals as it restricts the flexibility of the company. Therefore, there is a need ofan immaculately planned and strategic debt policy which will enable the company to build an optimal capital structure.
The chief financial officers or CFOs of several companies faced a lot of dilemma in choosing between severe financing and a weakened balance sheet for over a decade due to the high inflation rate. The corporate financial health was jeopardized and it deteriorated dramatically to keep up with the inflation mandated supplies and additions to the working capital. Moreover, the rising cost of me plant and equipment also forced the CFOs to incur a debt of three-and-a-half dollar for a single dollar of equity.
The Consequences of it
With so much debt accumulated and reflected in the balance sheet the CFOs of current times have a hard time managing their debt with high rate of interests which affects a significant portion of their pre-tax profits. More significantly, they now face unpredictable swings in the rate of interest with the increased risk of refinancing or even opt for credit card debt consolidation loan. Furthermore, given the current rate of inflation will call for more need of finance from the outside. The interest on such debts will be much higher at its maturity than at its current rates and need may arise to refinance at a higher rate as well.
The CFO War
This gives rise to conflicts with the CFOs and the operating managers who are only concerned with the funding of the marketing strategies of the product to gain the competitive advantage. When a company is based on productions, marketing and sales with the only dominant part for company management such disputes and anomalies are more prevalent. In such companies there is a greater intent to leverage the company with higher percentage of debt.
Most CFOs will opt for debt financing in such situations but in fact and practice debt financing has a lower payoff which is true and on the contrary of the popular and usual belief of the CFOs. This is where careful considerations of all contributing factors is required to quantify the amount of debt that is reasonably feasible for a company.
Need for a Sensible Debt Policy
A sensible debt policy can solve a major portion of such difficult situations which will protect your company from such short term caprices in capital market. Such policy will not only help in that but will also increase the company’s values which includes the total economic value if its debt and equity. Apart from that it will be easily understandable by the senior members of the company management who will recognize the strategic position and also its requirement.
It will also make reasonable people understand hoe debt raises the fixed interest rates which shifts the break-even point of the company upward towards the expected and estimated sales level.It also extends the share price which boosts the unpredictability of earnings. Therefore, using up all the equity and opting for debt financing will only result in the lower of profits for the business.The reverse is also true when sales fall, the percentage decline in profits will be much greater which means greater debt reliance will result in high level of sales and therefore increased profits.
The Effects of Taxation
Few believe that if there were no taxes or cost of any transaction then debt financing will have zero impact on the value of the company. The equity holders will demand higher returns as compensation for an increased risk when such financial leverage is given to the company. Moreover, debt also has an effect on the total distributable funds available to the company. If the securities of such debt affected company exceed in value then investors will selltheir highpriced shares. With is and along with some more money borrowed, they will now buy shares of a company that has no debt. Such activities of the investors will result in immediate correction of the mispricing of securities to drive back to equivalence.
Policy and Value
Debt financing therefore affects the total distributable funds and also the company’s value in turn. The exact payoff of the company from debt financing will depend on the specific tax rates of it as well as that of the investors. The payoff will be less when personal tax rate on equity will be less than the income from interest. Finally, the value of the company that will have no taxable income to fall back on will be low due to aggressive debt financing. In a nutshell and according to the empirical studies it can be said that due to the tax deductibility factor of the interest, debt financing leads to the addition of value to the company value which can be as high as 10 to 17 percent of debt addition.
Therefore, you should spend some time with the calculators, charts and figures to find out the statistics and specifics before to take on debt financing and it all depends on the skill of the CFO.