“In the most basic sense, if a firm’s capital structure has both debt and equity components, it is because of the general proposition that investors with different risk preferences seek investments with appropriate risk/return characteristics.”
Stephen G. Moyer, CFA
We start our discussion with a quote that I find fascinating about capital structure. During my academic studies, I have never come across with such an interesting explanation. The capital structure would remind people of the theories such as Modigliani-Miller Theorem (MM). However, this article will focusing on the qualitative aspect of debts within the capital structure without any mathematical formulas involved. The article will be structured as follows:
- Why do debts offer lesser return?
- Why would people prefer debts that offer lesser return?
- The recovery rate in debt investment.
- Differences between Bonds Bank borrowings.
- Why use debt in the capital structure when equity is free?
In corporate finance, capital structure is a core part of the financial management because the poorly designed capital structure will have a detrimental effect on the business, potentially lead to the distressed situation. You have probably heard of high-risk, high return, and nothing illustrates better using capital structure.
Why do debts offer lesser return?
Why do people invest in equity rather than debt? To a large extent, the risk preference dictates which instruments to invest to achieve the best possible return for a given level of risk. The capital structure ranking is usually as follows:
Senior Secured Debt > Senior Unsecured Debt > Subordinate Debt > Preferred Stock > Common Stock
Debt has lesser risk due to the seniority of the ranking and it gets paid first in the event of default. Any proceeds recovered will be used to amortize the debts first before moving down to the capital structure. Hence, debt investments usually offer the lower returns relative to equity. The return is typically fixed at a certain percentage + floating element (could be LIBOR or bank base rate). Equity investors, on the other hand, are the ultimate owners of the company. They have the residual claim and shares of the company’s profits and equity. Equity investors expose to higher risks than the debt investors hence they usually have higher rewards. Imagine you could either invest in bonds or equity in Tesco, but both are offering 5% expected return. Most likely you will be choosing debt since it ranks higher than equity in the event of default (the recovery rate would be higher). Therefore, to encourage the people to assume greater risks in a free market, you need to offer a higher expected return.
Who would prefer debts with lesser return?
The main reasons are the ability to tolerate investment risks and investment. Generally speaking, there are two types of incomes. One is interest or dividend income while the other is capital appreciation. Bonds or debts are usually more stable (in price relative to stocks) with limited capital appreciation (except for the distressed debts where the face value could deviate far from the par value). Because of the nature of return, pensioners, for example, might favour stable income (or at least the pension funds that manage the portfolios on the behalf them would) due to their circumstances while the young investors who do not need interest income now might favour capital appreciation (which exhibits greater volatility).
The Recovery Rate in Debt Investments
When we say debts exhibit lesser risk, we do not mean it is not prone to default. It still exposes to default risks (be it bankruptcy, distressed exchange or payment default). The important consideration after the bankruptcy is recovery rate (how much the debt investors or banks can recover from the company). With regards to bankruptcy, many people must have heard of Chapter 11 and 7 in relation to bankruptcy and reorganization. We will be covering it in the future. The graphs below are taken from Moody’s Research on the corporate defaults and recovery rates.
The default rate is usually low in terms of default volume but surged up during the financial crisis. The default volume during 2008 financial crisis was close to $300billion. To put that in a different perspective, $300 billion is almost the GDP of Malaysia and Singapore (2013 figures). However, these statistics are based on Moody’s database hence the actual numbers can be a lot higher as there are many private companies do not credit rate by Moody’s.
As discussed earlier, the seniority indicates the riskiness. It is impossible that Junior has higher recovery rate than Senior for instance. As you move down the capital structure, the recovery rate should reduce. If the recovery rate is higher or the same, the market has no strong reason to invest in senior when the riskiness is the same (expressed by the recovery rate).
Graph taken from Federal Reserve Bank of Kansas City by Nada Mora.
It shows that the recovery rate and the real GDP growth and said to have a positive correlation of 0.45. It is a good explanatory variable but does not fully explain the recovery rate. Nevertheless, GDP growth is also market sentiment indicator which means as the economy is growing, market sentiment might not discount the asset value that deeply thus resulted in higher recovery compared to during the recession where people are much more cautious with overpaying.
Differences between Bonds vs. Bank Borrowings
One of the differences lies in the type of investors holding the debt. Bank borrowings, as the name indicates, hold by the banks (where they grant credits to companies). Bonds, on the other hand, are usually arranged by the investment banks where they would go and find debt investors (pension funds, fixed income asset management, and insurance companies) to subscribe.
“A Bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain.”
Simply put, banks are more restrictive, and readers should not be surprised. I heard many people complaining, but as an insider, banks make money from other people’s money. They have a duty to protect depositors’ money. I would not go into the details of how the banking system works. Essentially, the banks are highly regulated industry and subject to capital requirements. If bank’s capital base is £1,000 with £10,000 total assets, a 10% drop in asset value (through problem loans, especially those unsecured with low recovery rate) will wipe out the bank’s capital, making its assets not being able to meet depositors’ demand. Therefore, the bank is very cautious about the potential problem loans and will take actions accordingly before the loans get worse. This is also a reason why people see the bank as the last resort because bond markets are seen as more user-friendly.
One advantage is that the bond investors do not subject to capital requirement rules. Hence they can invest quite freely. Usually, the bonds are ‘unmonitored’ and bondholders cannot influence the business activity. On average, the bond yield is lower than the bank interest rate for low-risk borrowers1. The monitoring mechanism that I can think of is credit rating where high profile companies will pay credit rating agencies to perform credit analysis to indicate the riskiness of the borrowings and monitoring the credit ratings over time (upgrade and downgrade to reflect the current credit risk). However, for banks, they do not pay credit rating agencies for risk assessment. Instead, they have their own in-house credit analysis department to monitor. The market for corporate bonds is much bigger than the bank loans.
Why use debt in the capital structure when the equity is ‘free’?
By raising debt, the company needs to pay the interest payment while the company does not need to pay shareholders except if the company wants to declare dividend payments. Many companies, especially small ones, do not distribute dividends.
Imagine you are an investor and choose to invest in a start-up company with no cash flow generation, little tangible assets, uncertain product feasibility and expected to offer 5% return (just assuming). Most likely you would not invest since in Malaysia especially, the FD rate is also offering a similar return if not better. Equity investors should aim to earn a risk-adjusted return. If investing in Blue Chip Company is earning 7% return, why would the investors invest in the start-up company? There is always an opportunity cost. The start-up company needs to deliver superior returns in the future to maximise shareholders value and compensate for the risks the investors are taking. Hence, the short answer is no. Equity is not free and due to the greater risk, the cost of equity should be higher (higher net profit).
Debt is heavily used due to the following factors
- Cheaper financing cost
- Enhance the return
- Tax deductibility
- Do not dilute ownership
1) As pointed out previously, the cost of financing for debt is cheaper due to the seniority in the capital structure.
2) Readers might think that if financing cost is cheaper, of course, the return would be higher. However, this point is actually referring to the DuPont Return on Equity. DuPont analysis demonstrates to us that higher leverage would lead to higher return on Equity (assuming it is profit making). To understand more, the readers can visit the following site: http://www.investopedia.com/terms/d/dupontanalysis.asp
3) As the tax is based on the profit before interest and tax (of course, in reality, the tax computation is much more complicated than just the percentage of profit before interest and tax). As some portion of the profit goes toward financing cost, there is less of it being taxable.
4) Raising debt would not give up the ownership hence the shareholders retain full control of the company. If the company decided to raise additional funds from shareholders, essentially the company is giving up some equity stakes to the people that inject the capital into the company.
Capital structure is an advanced topic in corporate finance, and we do not aim to cover the whole topic in one single article hence hopefully the readers could have a basic overview and appreciate the importance of debt financing. A key part of my responsibility is to analyse the creditworthiness of the corporates and ensure the capital allocation is to the good businesses and safeguard bank’s lending position (to avoid excessive risk taking and minimize problem loans).
1 Russ, Katheryn N. and Valderrama, Maria T. “A Theory of Bank versus Bond Finance and Intra-Industry Reallocation.” Journal of Macroeconomics, September 2012, 34(3), pp. 652-73.
Contributor: Jackson Yuen