It has been conventional wisdom that, whatever its troubling side effects, the aggressive use of financial leverage pays off in higher company values. Two decades of finance-based research, which the authors summarize here, qualify that wisdom substantially. Corporate and personal tax rates, which of course vary from situation to situation, significantly affect the attractiveness of debt. So, too, do the hidden costs of higher leverage, which include the restrictions it places on a company’s flexibility in adapting financial policies to strategic goals. To assist companies in building an optimal capital structure, the authors outline a series of questions for CFOs to ask themselves before they establish a debt policy.
A decade of high inflation has trapped many chief financial officers between severe financing needs and weakened balance sheets. The overall deterioration in corporate financial health has been stunning (see Exhibit I). Hard-pressed during the 1970s to supply inflation-mandated additions to working capital and to meet the increased cost of new plant and equipment, CFOs leveraged every new dollar of equity with some 3½ dollars of debt. Having piled so much new debt onto their balance sheets, they now face sharply higher interest payments as a percent of pre-tax profits. Worse, since much of that debt is short term, they also face volatile swings in interest rates and heightened refinancing risks.
Exhibit I Selected ratios of well-being for nonfinancial corporations average of year-end values Source: Henry Kaufman, “National Policies and the Deteriorating Balance Sheets of American Corporations” (New York: Salomon Brothers, February 25, 1981). Address before the Conference Board’s 1981 Financial Outlook Conference.
This deterioration has not gone unobserved. Of a sample of 430 companies with a debt rating of A in 1972, 112 had been downgraded by 1981 and only 39 had received higher ratings. Nor is it apparent that these financial pressures will soon ease. Continuation of inflation at a 10% annual rate will drive up external financing needs and interest expenses as existing low-cost debt matures and must be refinanced at today’s high rates.
CFOs, therefore, often find themselves in conflict with operating managers, who are eager to fund product-market strategies aimed at protecting competitive advantage. Especially in companies for which equity financing is unacceptable and in which operating management—concerned primarily with production, sales, and marketing—is the dominant force, there is great pressure to leverage the company with an even greater percentage of debt. What is the CFO to do? Is such leveraging worth fighting over?
By way of answer, this article summarizes two decades of research on the use of debt by companies with equity-financing alternatives. The major finding is that debt financing has in practice a far lower payoff than many CFOs believe. As a result, some of the assumptions of corporate financial policy are due for a careful rethinking.
We also outline a process by which CFOs can arrive at a sensible debt policy, a policy that protects against short-term vagaries in the capital markets, enhances the company’s value (the total economic value of its debt and equity), recognizes its strategic position, and—not least important—can be understood by senior management.
The Appeal of Debt Financing
Discussion of this subject typically begins with an effort (like that in Exhibit II) to demonstrate debt’s favorable impact on a company’s return on equity. But this enhancement of return on equity is not without cost. It raises fixed interest expenses and thus shifts a company’s break-even point upward toward the expected sales level. More important, it boosts the volatility of earnings and, by extension, of share price. Absolute profits at the low end of the sales range are much lower when a company uses debt financing than when it uses all equity, but its increase in profits at the upper end of the sales range is much greater in percentage terms. The reverse is also true: as sales fall toward the low end of the range, the percentage decline in profits is much greater too. Thus, the greater the reliance on debt, the more a high level of sales increases profits—and the more a low level reduces them. As research by Robert Hamada has shown, 21% to 24% of the nondiversifiable risk (price volatility) of common stocks can be explained by the added financial risk a company takes on by using debt and preferred stock.1
Exhibit II Debt financing and the return on equity aftertax cost of debt is 5%
Of course, equity investors ultimately care about such volatility. Traditional financial theory assumes, however, that they will not become concerned about the increased risk until the amount of a company’s debt grows sufficiently large to threaten it with bankruptcy. If the theory is right, moderate use of debt—enough to leverage earnings but not enough to make investors aware of the heightened risk—pays off in a higher value for the company.
Effects of taxation
This traditional theory was challenged by Franco Modigliani and Merton Miller in their landmark article of 1958. In their view, were there no taxes or transaction costs, debt financing would have no impact on a company’s value.2 For every uptick in financial leverage, equity holders would immediately demand a higher return as compensation for the increased risk.
Modigliani and Miller’s reasoning becomes clear if we compare, for example, the total funds available for distribution to a company’s suppliers of capital under two very different capital structures: one that is all equity; the second, half equity and half debt paying 10%. Total distributable funds (or EBIT, earnings before interest and taxes) are $1,000 in each case on a capital base of $4,000. As Exhibit IIIA shows, in a world without taxes the decision to use debt does not affect a company’s value.
Exhibit III Impact of debt on total distributable funds
Furthermore, if the securities of the company with 50% debt exceed in value those of the other business, investors would profit from selling their high-priced shares and using the proceeds, plus an equivalent amount of personal borrowing, to buy shares in the company with no debt. These arbitrage activities will soon correct any mispricing of the securities and drive them back to equivalence.
This fiscal Garden of Eden is a wonderful illusion, of course; it does not really exist. Corporate taxes are here to stay, and they have a great impact on a company’s capital structure. Exhibit IIIB shows that, in a world of corporate taxes, the decision to use debt increases the funds our sample company can distribute to its suppliers of capital by $96 ($616 versus $520) over what it could return to them with an all-equity capital structure. The source of this largesse is obvious: the Internal Revenue Service. By making the interest cost of debt tax deductible, the IRS provides a subsidy equal to the company’s marginal tax rate (assumed to be 48%) times its interest expense ($200), or $96.3 But this is not all, for there are personal income taxes to consider, which greatly complicate the choice between debt and equity. The complication arises from uncertainty about what tax rates to assume. If, for example, all investment income were taxed at the same personal rate, debt financing would remain just as attractive as before. Exhibit IIIC extends our company example to show that, if both interest and dividend income were taxed at a 50% personal rate, a capital structure of 50% debt would still enhance the company’s total distributable funds—here by $48 ($308 – $260).
In the real world, of course, interest and dividends are not taxed alike. Furthermore, much of the return on equity comes in the form of capital gains, which are taxed only when the underlying shares are sold, and then at but 40% of the rate on interest income. For companies that pay no dividends and whose shareholders never sell their stock, the effective personal tax rate on equity income is zero.
In practice, these differences in personal tax rates carry a great deal of weight in capital-structure decisions. Think of a situation in which the effective tax rate on returns from debt is 35% and on returns from equity, 0%. As Exhibit IIID suggests, debt financing becomes much less attractive than in our previous examples, for the use of debt enhances total distributable funds by only $26 ($546 – $520)—as opposed to $48 (when all personal income is taxed at the same rate) and $96 (when no personal taxes exist).
Debt policy & corporate value
The impact of debt financing on total distributable funds influences, in turn, a company’s value. The appendix shows this influence at work. If, for example, a company in the 48% bracket were to substitute $1,000 of debt for $1,000 of equity and if the personal tax rate were 35% on debt income and 10% on equity, the value of the company should increase by .28 times the amount of the debt ($1,000), or $280.
Assume a company with expected constant earnings before interest and taxes out to infinity and with a policy of distributing all of its earnings as dividends. If the company has no debt, then the operating earnings available to investors as dividends are equal to EBIT(1 – Tc), and investors will have, for purposes of consumption (after payment of personal taxes), an amount equal to EBIT (1 – Tc) (1 – Tpe), where Tc is the company’s tax rate on a marginal dollar of income and Tpe is the shareholder’s tax rate on a marginal dollar of income in the form of dividends.
Equation 1:
Funds available for consumption after payment of all taxes 4 EBIT (1 – Tc) (1 – Tpe).
Assume a company similar in all respects to the one just described except that it leverages itself with debt, D, borrowed at an interest rate, i, from investors who are taxed on interest income at a rate Tpi. The company is able to distribute to its suppliers of capital an amount equal to (EBIT – iD) (1 – Tc) + iD, and the investors will have, for purposes of consumption (after payment of personal taxes), an amount equal to (EBIT – iD) (1 – Tc) (1 – Tpe) + iD (1 – Tpi). This is equal to EBIT (1 – Tc) (1 – Tpe) – iD (1 – Tc) (1 – Tpe) + iD(1 – Tpi). The first term is identical to the funds available for consumption from an unleveraged company.
Thus, the value of a leveraged company, V1, equal to the value of an unleveraged company, Vu, plus the present value of an annual flow equal to iD [(1 – Tpi) – (1 – Tc) (1 – Tpe)]. The appropriate discount rate is the rate for flows of equal risk, adjusted for personal taxes, or i (1 – Tpi). The present value of an annual flow of iD [(1 – Tpi) – (1 – Tc) (1 – Tpe)] to infinity, at a rate equal to i (1 – Tpi), is
Equation 2:
Thus,
Equation 3:
where
V1 = value of a leveraged company.
Vu = value of an unleveraged company.
Tc = corporate tax rate on a marginal dollar of earnings.
Tpe = personal tax rate on equity returns.
Tpi = personal tax rate on interest income from corporate debt.
D = dollar amount of debt.
2. Increase in the Company Value from Use of Debt (Derived from Equation 3 Above)
These calculations suggest a few general observations. Note, first, that a company’s exact payoff from debt financing depends on the particular tax rates of both company and investors and is, consequently, difficult to define. Note also that when the personal tax rate on equity is much lower than that on interest income (a condition that is currently built into the U.S. tax codes), the payoff is likely to be less than traditional financial theory would predict. Finally, note that for a company with no taxable income to shelter, using debt financing actually reduces its value!
Empirical studies have, in general, shown that—because of the tax deductibility of interest—debt financing leads on average to an addition to company value equal to some 10 to 17% of the addition to debt.4 A company that switched from an all-equity capital structure to one that included $10 million of debt would, therefore, see its value rise by $1 million to $1.7 million.
The Problems with Debt
Now, these aggregate findings seem to argue for a company’s raising its level of debt as much as possible. According to Modigliani and Miller, however, the “existence of a tax advantage for debt financing…does not necessarily mean that corporations should at all times seek to use the maximum possible amount of debt in their capital structures. (T)here are, as we pointed out, limitations imposed by lenders, as well as many other dimensions in real-world problems of financial strategy which are not fully comprehended within the framework of static equilibrium models… These additional considerations, which are typically grouped under the rubric of ‘the need for preserving flexibility,’ will normally imply the maintenance by the corporation of a substantial reserve of untapped borrowing power.”5
This flexibility is important as a defense against financial distress and its attendant costs, which include, but are not limited to, the costs of potential bankruptcy. (Indeed, in most cases, bankruptcy costs are rather small. For example, out-of-pocket bankruptcy costs for railroads amounted to only 3% to 5% of their past market value.6) Far more significant is the likelihood that aggressive use of debt will make it difficult to raise necessary funds quickly on acceptable terms. And, obviously, liquidity constraints can lead to altered operating and product-market strategies that, in turn, may reduce a company’s market value.
Managers fearful of incurring liquidity constraints or of violating debt covenants will usually trim strategic expenditures, be unaggressive in exploiting market and investment opportunities, and base operating policies on the low end of a range of sales forecasts. At the same time, competitors are more likely to mount an attack, for an aggressive financial strategy often renders a company less capable of responding vigorously to market conditions.
Problems may also arise with the hidden “agency” costs of monitoring the loan covenants, indenture agreements, property mortgages, and performance guarantees that accompany debt financing. Especially for highly leveraged growth companies, agency costs may become prohibitive as debt approaches 20% to 30% of capital at market value. The specter of financial distress reminds lenders that a substantial portion of that value reflects future investment opportunities, which are meaningful only if the company continues to prosper. Providers of debt capital are usually willing to lend against tangible assets or future cash flows from existing activities but not against intangible assets or uncertain growth prospects. For most companies, the implicit costs of financial distress brought on by too much debt—lost opportunities, vulnerability to attack, suboptimal operating policies, and inaccessibility to debt capital—loom larger than the threat of bankruptcy. Furthermore, as the level of debt rises as a percentage of total capital, so does the probability that a company, especially if it has high depreciation charges, will have insufficient income to enjoy fully the tax deductibility of its interest expense.
Establishing a Sound Debt Policy
CFOs do, naturally, pay attention to these various considerations, but their main responsibility must be to balance a company’s financial needs with its ability to obtain financing. It is their job to preserve continuity in the flow of funds so that no strategically important program or policy ever fails for lack of corporate purchasing power. And they must protect this continuity of funds even during turbulent capital markets or bad times for the company.
Accordingly, CFOs must rely on traditional suppliers of capital. The delays involved in developing new institutional sources, especially when conditions are difficult, make the timely pursuit of strategy impossible. CFOs should, of course, constantly attempt to broaden their range of financing alternatives, but they must realize that critically important programs require well-established sources of capital that are reliable even in adversity.
Questions to ask
The critical measure of a company’s overall financial health is, as Exhibit IV suggests, the degree of fit between its strategic goals and operating policies and its ability to raise funds. More particularly, its debt policy must ensure access to funds on a timely basis from traditional suppliers of capital. How can CFOs formulate a sensible and successful debt policy for their companies—one that they can sell with confidence to the rest of top management? We suggest that they begin by asking themselves the following questions:
Exhibit IV Corporate financial system
1. What are the company’s real financing requirements? How much additional money will it have to raise during the next three to five years to carry out its portfolio of product-market strategies? What is the likely duration of that need? Can it be deferred without incurring large organizational or opportunity costs?
2. What are the special characteristics of that financing in terms of currencies, maturities, fixed versus floating rates, special takedown or prepayment provisions, ease of renegotiation, and the like?
3. What segments of the capital markets will the company tap for each type of finance needed?7
4. What are the lending criteria used by each of the target sources of capital? An analysis of these criteria, which differ considerably from lender to lender, will suggest a target capital structure for the company.8 The appropriate level of debt in that structure will vary, in turn, from company to company with differences in industry, quality of management, sales volatility, competitive position, profitability, and so on. For example, companies with high operating and competitive risk might try to offset it with low financial risk; in contrast, companies with low operating and competitive risk are much freer to use high levels of debt.
In practice, many companies express their target debt level as that which will result in a bond rating of A or higher. Their concern for an A rating reflects three major considerations: first, companies rated below A have been unable at times to raise funds in the public bond market on acceptable terms; second, life insurance companies, which have traditionally been a source of debt finance for BBB rated companies, are vulnerable to a sudden reduction in loanable funds should policyholders decide to borrow against the cash value of their policies; and third, companies need financial reserves to protect against adversity. For example, since the Ford Motor Company hit difficulties in 1979, its debt has been downgraded three times in less than three years.9
5. Could the company comply with all loan covenants, as reflected in its pro forma financial statements, in good times and bad?
6. Will the company’s debt policy allow a flow of funds to all strategically important programs even during adversity? Specifically, against what scenarios of adversity is management most eager to protect itself? If bad times hit, what are the company and its competitors most likely to do? Further, in each of these scenarios, how much additional finance would the company need? How much warning would it have? How would its target sources react?10
7. Will the company be competitively vulnerable if it achieves its target capital structure? This danger can take any of several forms: attack by a competitor who sees the company as financially weak; management’s adoption of conservative operating and investment policies—to the detriment of the company’s long-term competitive position—because of worries about a shortfall of finance; or inability to find funds for strategically important programs during adversity and thus loss of position to competitors who are able to get financing. A loss of even one percentage point in profitability, if it continues for ten years, will more than offset the estimated gain of 4% in the per-share value of a company’s equity that, as Exhibit V shows, results from an increase in debt from 20% of book value to 40%.
Exhibit V Theoretical wealth-creation opportunities through the capital-structure decision
8. What are the implications of the new debt policy for existing bondholders and shareholders, the latter in terms of earnings per share, dividends per share, and market price?11
9. Can the new debt policy be implemented? Can the funds needed during the next five years be raised in a manner consistent with the target capital structure? Will management be willing to raise funds in that manner? If not, is management prepared to change its product-market strategies or dividend policy?
The CFO’s Responsibility
Answers to this set of questions can help CFOs arrive at sound decisions regarding capital structure and effectively communicate them to other top managers. Although much research supports the belief that some substitution of debt for equity will boost a company’s value, no simple formulas exist for calculating the optimal level. But limits to the payoff from using debt do indeed exist. In theory, as we have seen, a growth in debt from 20% to 40% of book capital will increase the per-share value of a company’s stock by only 4% or so—not counting the expected costs of financial distress (see Exhibit V). The problem for CFOs is, therefore, to identify the point at which the incremental risks of financial distress more than offset the incremental benefits of the interest tax shield.
Financial statements of many American companies, however, reveal a heavier reliance on debt than is justified by the payoff from the tax deductibility of interest. Why so? Because under certain conditions a CFO may be inclined to push a company’s capital structure beyond its optimal balance point. Among these conditions:
- The company is privately held and is precluded either from raising new equity or from raising it at an acceptable price. Here the alternative to debt financing is to forgo projects that are strategically important.
- The CFO overestimates the payoff from debt financing by confusing the high returns from borrowing at a low fixed rate before an unexpected surge in interest rates with the payoff from the tax deductibility of interest.
- The CFO fails to understand the theoretical basis for wealth creation through debt financing at the company level or to take account of both corporate and personal taxes.
Other, more general, considerations may also be involved:
- Less effort and time are required to bring out a debt issue than an equity issue. DuPont, for instance, once raised several billion dollars of financing by telephone in one afternoon.
- Earnings-per-share growth is often an important measure of managers’ performance and an important influence on their compensation. Thus, to heighten EPS growth by increasing financial leverage may seem to them an attractive policy.
- Many managements strive to avoid interference or control by outside suppliers of capital.12 Low debt levels may help them avoid onerous restrictive covenants; but in a world of inflation-induced financing needs, dependence on the equity markets may appeal even less than the covenants do. Further, distrustful of the equity market’s rationality in setting prices and concerned for the volatility of their company’s stock, managers remember that leveraging with debt raises the rate of sales growth that can be financed without the sale of new equity.
An unleveraged company earning a 15% return on capital after taxes and reinvesting 60% of its earnings can finance nominal sales growth of 9% per year without the sale of new equity (see Exhibit VI). With inflation at 9%, real growth is zero. In contrast, were the same company leveraged with debt equal to 40% of book capital, it could fund nominal sales growth of 13% per year and real sales growth of 4%. It would also need to seek new equity less often and so could tap the market on more favorable terms.
Exhibit VI Financial leverage and sustainable sales growth
Especially given the many-sided appeal of debt financing, good two-way communication between CFOs and the rest of top management is essential. Major mistakes in capital-structure decisions often follow from (1) undue emphasis on but one of the many determinants of an appropriate debt policy, (2) failure to give sufficient consideration to the volatility of lenders’ attitudes, (3) failure to test the debt policy in advance for its viability in times of adversity, or (4) the tendency of operating managers to push CFOs during buoyant times toward higher debt levels than are prudent.
As too many businesses have learned the hard way, the time to build financial reserves is when things are going well. Correcting an unduly aggressive use of debt is always painful, but especially so if that adjustment must be made under duress. To avoid such agonizing retrenchments—that is, to plan for a steady flow of capital (and to secure management’s commitment to that plan)—is the central professional challenge and responsibility of today’s CFO.
1. Robert S. Hamada, “The Effect of the Firm’s Capital Structure on the Systematic Risk of Common Stocks,” Journal of Finance, May 1972, p. 435.
2. Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review, June 1958, p. 261.
3. See Modigliani and Miller, “Corporate Income Taxes and the Cost of Capital: A Correction,” American Economic Review, June 1963, p. 433.
4. Ronald W. Masulis, “A Model of Stock Price Adjustments to Capital Structure Changes,” Working Paper, UCLA, September 20, 1980; Modigliani and Miller, “Some Estimates of the Cost to the Electric Utility Industry, 1954–57,” American Economic Review, June 1966, p. 333.
5. Modigliani and Miller, “Corporate Income Taxes and the Cost of Capital,” p. 442.
6. Jerold B. Warner, “Bankruptcy Costs: Some Evidence,” Journal of Finance, May 1977, p. 337.
7. See Jay O. Light and William L. White, The Financial System (Homewood, Ill.: Richard D. Irwin, 1979) for a full discussion of the forces influencing the rules that govern decisions in the major institutions and the impact of such rules on pricing of securities in financial markets.
8. See Morton Backer and Martin L. Gosman, “The Use of Financial Ratios in Credit Downgrade Decisions,” Financial Management, Spring 1980, p. 53. Their three-year study explores the marked differences in the financial ratios various lenders use to assess creditworthiness.
9. See also Standard & Poor’s Ratings Guide, edited by Karl Sokoloff and Joan Matthews (New York: McGraw-Hill, 1979), for a discussion of the rate-setting process.
10. For an excellent discussion of the need to develop a comprehensive financial and operating plan to meet sudden adversity, see Gordon Donaldson, “Strategy for Financial Emergencies,” HBR November–December 1969, p. 67.
11. For a discussion of the determinants of share prices, see Thomas R. Piper and William E. Fruhan, Jr., “Is Your Stock Worth Its Market Price?” HBR May–June 1981, p. 124.
12. See Gordon Donaldson, “Self-Sustaining Growth: A Study of the Financial Goals of the Mature Industrial Corporation,” Working Manuscript, October 1981.
A version of this article appeared in the July 1982 issue of Harvard Business Review.