Why Is the Debt Vs. Equity Issue So Important?

An investor’s desire for high returns is tempered by the amount of risk the investor is willing to assume. Debt versus equity addresses this tension directly. Debt can be used to lever up earnings, but when overdone can lead to bankruptcy. The trick for companies and their investors is to recognize the right mix of debt and equity to optimize growth without committing to excessive levels of interest payments that drain away cash at an unsustainable rate.

Capital Structure

The capital structure of a company consists of its long-term debt and equity. Long-term debt refers to bonds and notes that mature in over one year. Equity has two components: the stock issued by the company and the unspent profits, known as retained earnings. Capital is used by the company to finance operations, purchase assets and acquire other companies. The weighted average cost of capital is an expression of how much the company has to pay to acquire capital. Debt and equity usually have different acquisition costs.

Equity

Equity is the ownership stake in a company, divided up among its common and preferred stockholders. The “cost” of issuing stock is the return on investment required by stock investors. Return on common stock is the growth in stock price -- fueled by increases in earnings per share -- plus dividend payments, whereas preferred share returns are simply the dividends paid. Dividends, while an inducement to stock purchasers, are not guaranteed and may change over time. Equity is “safer” than debt because failure to pay dividends will not result in default. When new common stock is issued, the existing shareholders experience a dilution in ownership, and the earnings-per-share will immediately decrease. Dilution and/or dividend reductions will cause investors to sell their shares, driving down stock prices. Since many top executives are compensated in part by stock price targets, the “cost” of equity financing can be very personal

Debt

Debt financing can leverage earnings-per-share, because if used wisely, debt increases earnings without diluting shares. The more debt, the more leverage. The cost of a debt instrument is its interest rate. If a company loads up on debt, it will find an increasingly burdensome obligation to spend cash on interest. If business conditions, such as a downturn in sales, result in a cash shortage, then the company may risk defaulting on its interest payments. The company’s credit rating will fall and investors will shun lending money or even buying shares. Over-leveraged firms can find themselves bankrupt very quickly if they don’t have sufficient cash reserves. One other consideration: interest is tax-deductible, dividends are not.

Weighted Average Cost of Capital

The debt versus equity issue is important because it determines the weighted average cost of capital, or WACC. As its name implies, each source of capital in the WACC is weighted by the amount used and its after-tax cost. An efficient company minimizes its WACC, because otherwise it is paying too much to finance itself. When taking on a new capital project, a company will explore different financing options to find the combination that raises WACC the least. If a project’s percentage return is lower than the company’s WACC, management will most likely not approve it because it’s a money-loser. The debt-to-equity ratio of a company is a snapshot of its capital structure and a way to directly compare the opportunities and risks of similar companies within the same industry.