Why do companies issue debt?
In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides insights into why companies issue bonds.
A company can finance its activities in different ways: by internal financing (self-financing) and by external financing comprising debt and equity. Often, internal funds are not sufficient. The company must therefore make a choice between raising debt and raising equity. So, it is necessary to ask what might lead a company to prefer one over the other.
The advantages of debt over equity for a company
Debt is often preferred to equity because it is structurally less costly for the following reasons:
– The interest on the debt is tax deductible. The debt therefore costs the interest minus the tax savings (assuming that the company makes profit and pays taxes…).
– Investing in stocks is riskier than investing in bonds because of a number of factors. For instance, the stock market has a higher volatility of returns than the bond market, capital gains are not a guarantee, dividends are discretionary, stockholders have a lower claim on company assets in case of company default. Therefore, investor expect higher returns to compensate it for the additional risk. Thus, for the company, financing itself through debt will be less expensive than through equity.
– The remuneration of the debt is not strictly proportional to the increase of the risk taken by the company, because there are multiple ways for lenders to take guarantees: leasing, mortgage….
Debt has other advantages over equity:
Debt can be used to gain leverage. It provides a leverage effect for shareholders who contribute only part of the sums mobilized in the investment. This effect is all the more important when the interest rate at which the debt is subscribed is low and the economic profitability of the investment is high.
Raising equity dilutes ownership of existing stockholders. When a company sells equity, it gives up ownership of its business. This has both financial and day-to-day operational implications for the business. Debt does not imply such a dilution effect.
There is a practical benefit for using debt. Issuing debt is easier than issuing equity in practice.
Finally, the terms of repayment of principal and interest payments are known in advance. This allows companies to anticipate future expenses.
The disadvantages of debt over equity
First, unlike equity, debt must be repaid at some point. This is because equity financing is like taking a share in the company in exchange for cash. Thus, where cash outflows are required to pay interest on debt and repay principal, this is not useful for equity.
Moreover, in equity financing, the risk is carried by the stockholders. If the company fails, they will lose their stake in the company. In contrast, in debt financing, creditors often require assets to be secured. Thus, if the company goes bankrupt, they can take the collateral.
Finally, the debt capacity of a company is limited. Indeed, the more debt a company takes on, the higher the risk of default. Thus, creditors will ask an already highly leveraged company for higher interest rates to compensate for the risk they are taking. Conversely, equity financing allows companies to improve their capital structure, and thus present better debt ratios to investors.
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About the author
Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).