Benefits of Debt
The advantages of debt may be enumerated as:
1. Interest payments are tax-deductible. Because the maximum corporate tax rate is in the mid-30 percent range, the effective aftertax cost of interest is approximately two-thirds of the dollar amount expended.
2. The financial obligation is clearly specified and of a fixed nature (with the exception of floating rate bonds). Contrast this with selling an ownership interest in which stockholders have open-ended participation in profits; however, the amount of profits is unknown.
3. In an inflationary economy, debt may be paid back with “cheaper dollars.” A $1,000 bond obligation may be repaid in 10 or 20 years with dollars that have shrunk in value by 50 or 60 percent. In terms of “real dollars,” or purchasing power equivalents, one might argue that the corporation should be asked to repay something in excess of $2,000. Presumably, high interest rates in inflationary periods compensate the lender for loss in purchasing power, but this is not always the case.
4. The use of debt, up to a prudent point, may lower the cost of capital to the firm. To the extent that debt does not strain the risk position of the firm, its low aftertax cost may aid in reducing the weighted overall cost of financing to the firm.
Drawbacks of Debt
Finally, we must consider the disadvantages of debt:
1. Interest and principal payment obligations are set by contract and must be met, regardless of the economic position of the firm.
2. Indenture agreements may place burdensome restrictions on the firm, such as maintenance of working capital at a given level, limits on future debt offerings, and guidelines for dividend policy. Although bondholders generally do not have the right to vote, they may take virtual control of the firm if important indenture provisions are not met.
3. Utilized beyond a given point, debt may depress outstanding common stock values.
A market with an increasing presence in world capital markets is that in Eurobonds. A Eurobond may be defined as a bond payable in the borrower’s currency but sold outside the borrower’s country. The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds sold by companies in Switzerland, Japan, the Netherlands, Germany, the United States, and Britain, to name the most popular countries. An example might be a bond of a U.S. company, payable in dollars and sold in London, Paris, Tokyo, or Frankfurt. Disclosure requirements in the Eurobond market are less demanding than those of the Securities and Exchange Commission or other domestic regulatory agencies. Examples of several Eurobonds are presented in Table 16-5.
Leasing as a Form of Debt
When a corporation contracts to lease an oil tanker or a computer and signs a noncancelable, long-term agreement, the transaction has all the characteristics of a debt obligation. Long-term leasing was not recognized as a debt obligation in the early post–World War II period, but since the mid-60s there has been a strong movement by the accounting profession to force companies to fully divulge all information about leasing obligations and to indicate the equivalent debt characteristics.
Table 16-5 Examples of Eurobonds
Source: Bloomberg, March 2015.
This position was made official for financial reporting purposes as a result of Statement of Financial Accounting Standards (SFAS) No. 13, issued by the Financial Accounting Standards Board (FASB). This statement said certain types of leases must be shown as long-term obligations on the financial statements of the firm. Before SFAS No. 13, lease obligations could merely be divulged in footnotes to financial statements, and large lease obligations did not have to be included in the debt structure (except for the upcoming payment). Consider the case of Firm ABC, whose balance sheet is shown in Table 16-6.
Table 16-6 Balance sheet ($ millions)
Before the issuance of SFAS No. 13, a footnote to the financial statements might have indicated a lease obligation of $12 million a year for the next 15 years, with a present value of $100 million. With the issuance of SFAS No. 13, this information was moved directly to the balance sheet, as indicated in Table 16-7.
We see that both a new asset and a new liability have been created, as indicated by the asterisks. The essence of this treatment is that a long-term, noncancelable lease is tantamount to purchasing the asset with borrowed funds, and this should be reflected on the balance sheet. Note that between the original balance sheet (Table 16-6) and the revised balance sheet (Table 16-7), the total-debt-to-total-assets ratio has gone from 50 percent to 66.7 percent.
Table 16-7 Revised balance sheet ($ millions)
Though this represents a substantial increase in the ratio, the impact on the firm’s credit rating or stock price may be minimal. To the extent that the financial markets are efficient, the information was already known by analysts who took the data from footnotes or other sources and made their own adjustments. Nevertheless, corporate financial officers fought long, hard, and unsuccessfully to keep the lease obligation off the balance sheet. They tend to be much less convinced about the efficiency of the marketplace.