How much debt is too much debt?

The capital structure of a company refers to the mixture of equity and debt finance used by the company to finance its assets. The decision on what mixture to use is called the financing decision. (ACCA, 2009).

On February 25 2014, Bloomberg announced that Det Norske Oljeselskap ASA, the oil producer, was reviewing its funding options and looking to cut costs as a plunge in crude oil prices caps the cash flow it needs for new projects. A financial decision has been made that the company will increase their debt finance and may also be able to issue new shares. In essence, the company is trying to create the optimal capital structure, at the lowest possible cost to their shareholders (Bloomberg, 2015).

At this stage in my studies, I understand that financing a business through borrowing is cheaper and less risky than using equity; therefore it is unsurprising that companies, such as Det Norske, are increasing their debt levels. The benefits that companies can obtain through debt finance are as follows (Arnold, 2013):

•  lenders require a lower rate of return than ordinary shareholders
•  debt financing securities present a lower risk than shares because they have prior claims on annual income and in liquidation.
• a profitable business effectively pays less for debt capital than equity, as debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid.
• issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.

The traditional view implies that the market value is very much dependent on a company’s capital structure. It suggests that by increasing their debt finance, Det Norske would be financed to a greater extent by cheaper borrowed funds; therefore the weighted average cost of capital (WACC) would decrease (Arnold, 2013). A lower WACC, would result in a higher market value of the company, thus increasing shareholders wealth.

But is there such a thing as too much debt?

 

Put simply, yes. As debt begins to increase, Det Norkse will increase their chances of financial distress which could ultimately result in liquidation (Arnold, 2013). Although a successful company, if Det Norske is faced with a prolonged period of declining profits, the interest on the debt will still need to be paid, which may affect the company’s ability to pay dividends (ACCA, 2009). This increase in dividend volatility is a financial risk to shareholders. As a result, shareholders will require greater returns to compensate them for this risk, thus the cost of equity will increase, which will lead to an increase in the WACC. Furthermore, if profits are low, the company’s shareholders will find their returns declining to an exaggerated amount (Arnold, 2013). This research demonstrates that debt really is a ‘ball and chain’ for a company – there is no way to avoid payments, especially during a bad year.

What this argument identifies is that an increase in debt reduces the WACC, but it also increases WACC due to equity holders wanting higher returns. This demonstrates the complex relationship between debt and a company’s capital structure. 

However, in 1958 Modigliani and Miller (M&M) proposed an alternative theory by making some assumptions. Given these assumptions they concluded that the value of a firm remains constant regardless of the debt level. The WACC is constant as the cost of equity increases this is offset by the cost of the cheaper debt, and therefore shareholder wealth is neither enhanced nor destroyed by changing the gearing level, thus capital structure is irrelevant (O’brien, Klein and Hilliard, 2007).

 

In 1963, M&M revised their theory to include corporate tax and their conclusion altered dramatically. As debt becomes cheaper (due to tax relief on interest payments), the cost of debt decreases significantly (Watson and Head, 2013). This would mean a decrease in WACC (due to the cheaper debt) is now greater than the increase in WACC (due to the increase in financial risk); thus WACC falls as gearing increases (ACCA, 2009). If this theory is correct, this implies that Det Norske should gear up as much as possible, if they wish to reduce their WACC.

 

In contrast to both theories, which attempt to find an optimal capital structure, in this approach there is no search for an optimal capital structure. Companies simply follow an established pecking order which enables them to raise finance in the simplest and most efficient manner (ACCA, 2009) The order is as follows:

(1) use all retained earnings available
(2) issue debt
(3) issue equity, as a last resort.

 

I believe that companies should build up cash reserves in case of any future unforeseen expenses, which would reduce the amount of time spent on raising external finance to peruse new projects. 

 

So what is the best course of action for Det Norske to take?

 

Although increasing debt levels has its benefits, a company with excessive levels of debt could face huge implications, as outlined above.  I would discourage Det Norske from following M&M’s theory as I believe it would result in instability, as they failed to take into account bankruptcy costs, agency costs and tax exhaustion. In addition, M&M also assumed perfect capital markets in their theory, and as I discussed in my previous blog, this not true as prosecutions for insider information have taken place. I believe an optimal capital structure does exist, but is hard to define as each structure is unique to each individual company. Det Norske should consider what a “reasonable” level of debt is; based on the industry it operates in.

Additionally, although I do not support the pecking order theory, as I believe Det Norske should retain cash reserves, the company should not ignore the fact that the theory places debt higher than equity. This somewhat supports the traditional theory, that Det Norske should gear up, but once again, to a “reasonable” level to finance new projects.

References

ACCA (2009) Optimal Capital Structure. Retrieved from http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_junjul09_lynch.pdf

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.O’Brien

Bloomberg (2015).  Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Retrieved from  http://www.bloomberg.com/news/articles/2015-02-25/billionaire-roekke-s-det-norske-reviews-funding-amid-oil-drop

O'Brien, T. J., Schmid Klein, L., & Hilliard, J. I. (2007). Capital structure swaps and shareholder wealth. European Financial Management, 13(5), 979-997
 

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.