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Perhaps one of the main reasons why companies choose to finance their business using debt capital is because while suppliers of equity capital are part owners of the business and have a say in how it is operated, suppliers of debt capital do not have any ownership of the company, but are merely creditors. When the debt is repaid, it is said to be redeemed, and the lender no longer has a stake in the company. Share capital, in contrast, is considered to be a permanent investment, where dividends are paid to the shareholders (Lumby and Jones, 2003).

Suppliers of debt capital are contractually entitled to receive an annual percentage return, or coupon rate, on their loan, which must be paid before any dividends are paid out to the shareholders. Because the payment of interest takes priority over dividends, a supplier of debt capital is taking less of a financial risk than a supplier of equity capital, who will only receive dividends if the company is profitable and at the discretion of the directors. Debt capital, therefore, although potentially yielding less return than equity capital, is a more assured investment (Lumby and Jones, 2003).

In the United Kingdom, the United States, and many other countries, companies are allowed to offset the debt interest against their corporation tax liability, so debt interest is essentially tax free and therefore subsidized by the government. Under United States law, for example, debt capital interest payments are deducted before taxes, with the person receiving the interest payments paying tax upon receipt of it. Equity capital, in contrast, is taxed twice: the company must pay corporation tax on its profits before dividends are paid to the shareholders and the recipients of those dividends must also pay capital gains tax. Although capital gains tax is less than tax on interest payments, up to a certain point, the tax on debt capital will still be less than the tax on equity capital.

Gearing, or leverage, is defined as the ratio of the total market value of a company’s debt capital to the total market value of its equity capital. The formula for gearing is often expressed as the debt to equity ratio, and is written as:-

RWE Group, headquartered in Essen, Germany, is one of Europe’s leading suppliers of electricity and gas. Its major power generation, sales and trading markets are in the United Kingdom, Germany, and Central Eastern Europe. In addition to providing much of Europe’s power, RWE also owns American Water in the United States and Thames Water in the United Kingdom, which it intends to sell in 2007 (RWE Group, 2006). In RWE’s 2005 Annual Report, total liabilities are listed as E95,005 million, while equity was E13,117 million, giving a debt to equity ratio of 7.24, which indicates RWE is a very capitally intensive firm.

The higher the level of gearing, or the more debt that a company incurs, the higher the financial risk that is borne by the ordinary shareholders, thereby causing the cost of equity capital to rise. Simply put, an increase in gearing leads to an increase in financial risk, which will lead to an increase in the cost of equity capital. The reason for this is because in addition to the increased interest payments required of higher gearing, shareholders will expect greater returns from their equity capital because they are taking a greater risk in investing in a company that has a high level of gearing.

The Modigliani-Miller theorem, which first appeared in the June 1958 edition of the American Economic Review in an article entitled, “The Cost of Capital, Corporation Finance, and the Theory of Investment”, is perhaps the theory that turned the study of finance into a separate discipline (Poulsen, 2006). The Modigliani-Miller theory states that in the absence of taxes, bankruptcy costs, and agency fees, it does not matter if a firm’s capital is raised by issuing stock (equity capital) or selling debt (debt capital). In its simplest form, the formula is written as:-

While in theory, it would be permissible for companies to finance their companies solely with debt capital; in practice this is rarely the case. There are many reasons why companies do not solely obtain their finance using debt capital to include tax implications, bankruptcy costs, and agency fees. Most companies’ financial structures are such that no more than 50% of their capital is debt capital, with the average company financing itself with 25% debt capital. According to RWE Group’s 2005 Annual Report, for example, it had a net financial debt of E11,438 million and equity of E13,117 million; with both types of capital totaling E24,555 million. Therefore, the debt capital was 47% and the equity capital was 53%, which falls in line with standard business practice.

The higher the level of gearing used, the greater the risk is the company might default on the loan. It is for this reason that institutions who lend money often impose legally binding covenants before granting a loan. They may insist the company keep their gearing down to a certain level, and if the company breaches those conditions, the bank will be entitled to immediate repayment of the loan (ICAEW, 2005). In addition, the debt holder may also restrict the amount of dividends that are paid to the shareholders, or they may restrict management from disposing of major assets without the debt holder’s agreement (Lumby and Jones, 2003).

In conclusion, debt is a very important element in a company’s capital structure because it enables a company to obtain finance without having to issue securities, and thereby giving away ownership of the business. To a certain degree, debt capital presents less risk to the debt holder because, by law, interest payments have to be made before dividends are paid to the shareholders. In addition, utilizing debt capital gives the company a tax break because in most economies companies do not have to pay tax on their interest payments, but they must pay tax on the dividends they pay out to their shareholders. Although from a debt holder’s perspective, debt capital is not as risky as owning shares in a company, the higher the debt the company incurs, often termed gearing, the greater the risk is to the company because it may not be able to repay the loan. Because the shareholders are taking a greater risk by agreeing to debt, they will expect a higher return on their equity capital as a company’s debt increases. Lenders too will place legally binding restrictions, in the form of covenants, on the company it lends money to, thereby limiting its activities. Therefore, while it is theoretically possible to have a company wholly financed with debt capital, in practice, most companies have gearing of no greater than 50% of their capital.

References

Institute of Chartered Accounts in England and Wales (ICEAW) (2005). Directors Briefing: Overdrafts and Bank Loans, Business Hot Line Publications: London

Investopedia (2006). Debt to Equity Ratio
URL: http://www.investopedia.com/terms/d/debtequityratio.asp
[26 August 2006]

Lumby, S. and Jones, C. (2003). Corporate Finance Theory and Practice, Seventh Edition, Thomson: London

Poulson, A. (2006). Corporate Debt
URL: http://www.econlib.org/library/enc/corporatedebt.html
[26 August 2006]

RWE Group (2006). Annual Report 2005, RWE Group: Essen, Germany