6 things to know about corporate debt borrowing
TRANSCRIPT
Things you should know about corporate debt borrowing6
It is general knowledge that companies need to borrow money to function. Rarely does it happen that companies generate enough funds to not only meet costs and pay employees but also plan new projects and expand in size. This is where debt and equity come in. This is called the company’s capital structure. This is becoming more relevant today considering the debt problems that Indian companies and banks are facing. Here are six things to know about capital structure:
Cost of debt: Everything comes at a price, even money. Whenever companies borrow money
either through bank loans or other assets like Bonds and Debentures, they promise to pay an
interest amount on this borrowing. This is the cost of debt. Higher the interest rates, greater is the
cost. However, debt gets a tax benefit – the interest paid can be deducted from total income while
calculating tax. This essentially reduces the cost of debt.
#1
Cost of equity: It takes a lot of money to list shares in the stock market. Moreover, companies
need to find the right price for the shares in the initial public offer. Otherwise, there may not even
enough investors. All this forms the cost of equity. Additionally, companies have to pay tax on the
dividends distributed to investors. This could also be considered an additional cost for companies.
#2
Debt v/s Equity: Usually, debt is considered a better option than equity. It is considered the
cheaper option. Plus, companies have more flexibility when it comes to paying back the debt.
Equity, on the other hand, is not as flexible. Also, the cost of equity is often directly proportional to
the amount of debt a company has – it increases as a company piles on more debt. This is why
analysts look at a newly listed company’s debt while analyzing if the shares are worth investing in.
#3
Financial distress: The downside to debt is that it increases a company’s risk. Usually, a company
is obligated to pay off its debt first and then pay its equity shareholders. So, whatever money a
company earns goes off in paying off costs and interests due. All the money left becomes the
company’s profit. This is often reinvested in the company for future growth and expansion. As a
company piles on debt, its interest obligation increases. So, if ever the company is in financial
distress from lack of sales and revenues, a high debt is detrimental – it only increases its expenses.
This is called the cost of financial distress.
#4
Optimal capital structure: This is why debt is good for a company only up to a certain limit. This is
called the ‘optimal capital structure’. So how do you measure this limit? The optimal capital structure
is when the tax benefits of debt are maximized. The moment the cost of financial distress turns
higher than the benefits, the capital structure becomes debt-heavy and risky. This, however, is
easier said than done. The cost of financial distress is not easy to measure.
#5
Measuring risk: This is where credit ratings come in. Agencies like CRISIL, CARE Ratings and
Moody’s measure a company’s ability to repay. This is called as credit risk. Based on this analysis,
the agencies assign the company’s debt a credit rating. Any change in the rating influences the cost
of borrowing for the company. This also affects the company’s share price. So if a rating is
downgraded, share prices can fall. This increases the overall cost for the company and minimises
any tax benefits.
#6
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