A company has an option to fund operations with its own cash or borrow money. Corporations can tap the capital markets by issuing stock to shareholders to raise money or issue corporate bonds. These decisions relate to a company's capital structure, or the mix between debt and equity. A company may prefer long-term debt because of the tax deduction on interest payments, but it depends on the company's corporate finance policy; too much debt raises default risk.
Long-term debt has a distinct advantage over equity financing because of a deduction companies receive for interest payments. If a company's long-term borrowing cost is 9 percent and its tax rate is 31 percent, its effective borrowing cost is 9 percent multiplied by 1 minus its tax rate, which equals 6.2 percent. Companies have an incentive to borrow money because of this tax advantage. However, as a general rule of thumb, a company should only use long-term debt to fund projects that provide a return on investment above its borrowing costs. For example, if the company projects that new equipment is likely to raise productivity and earn a 15 percent return on the investment, then borrowing money at an effective interest rate of 6.2 percent is worth the investment.
Corporate executives, lenders and investors use debt ratios to determine whether the company is over-leveraged. A high debt ratio signifies that the company relies too heavily on debt and can spell trouble. Common debt ratios include the debt-to-equity ratio, debt-to-total assets, or debt ratio, and interest coverage ratio, which is earnings before interest and taxes divided by interest expense. A company may prefer to use long-term debt but faces the possibility of increasing the company's default risk, as evidenced by the company's debt ratios.
A company's capital structure is of importance to management, lenders and investors. Capital structure refers to how a company chooses to fund itself to sustain operations. A company can choose to fund operations using no debt and all equity or a combination of both. The key is finding the optimal capital structure and investing in projects that provide a return above the company's cost of capital. In other words, even though interest payments are tax deductible, the company must find the right balance of debt and equity without skewing its debt ratios. It is not uncommon for lenders to enforce debt covenants, which are financial operational guidelines that assure lenders will get their money back. Examples of debt covenants include maintenance of minimum working capital requirements, restrictions on borrowings and maintenance of net worth.
Weighted Average Cost of Capital
It is unrealistic and risky for a company to use all debt to finance its operations. In corporate finance, the focus is on the total cost of borrowing including debt and equity. The weight-average cost of capital, or WACC, is the formula used to calculate a company's total cost of borrowing. The formula for WACC is required return of debt financing multiplied by 1, minus the tax rate multiplied by the ratio of debt to total value of the company, plus the cost of equity multiplied by the ratio of equity to total company value.
A company has a total capitalization of $100 million of which $25 million represents long-term debt and $75 million is the market value of equity. The ratio of debt to total firm value is 25 percent or $25 million divided by $100 million. The ratio of equity to total firm value is 75 percent. The company's tax rate is 31 percent and its long-term borrowing cost is 9 percent. The cost of equity is 15 percent. According to WACC, the company's cost of capital is 12.8 percent (9 percent times (1 - (31 percent)) times ($25 million/$100 million) plus 15 percent times ($75 million/$100 million)). In this case, the company can still purchase the equipment with an expected return of 15 percent because it still provides a return above its WACC of 12.8 percent.
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