Contrary to the prediction of doomsayers during the banking crisis of 2008, firms seem to be returning with a vengeance to the debt markets. Today's story in the Wall Street Journal provides some details:
Finding the right mix of debt and equity to fund a business remains one of the key components of corporate finance. The contours of the choices are clearly established.
On the plus side: Using debt instead of equity to fund investments generates tax benefits in most countries, since interest expenses are tax deductible and dividends are not. Debt may also provide some "discipline" to managers of mature companies with large positive cash flows.
On the minus side: Debt increases the possibility of financial distress and/or bankruptcy, with all its potential costs. The tussle between whats good for stockholders and bondholders' interests manifests itself in covenants that restrict investment and financing choices and in monitoring costs.
There are tools for assessing optimal capital structure as well. One is the cost of capital; in effect, the mix of debt and equity that yields the lowest cost of capital is the "optimal" mix. Another is Adjusted Present Value (APV), where a firm is first valued as if it were all equity funded (unlevered) and the net value added from debt is computed as the difference between the tax benefits and the expected bankruptcy costs. The mix that maximizes overall firm value is the "optimal" mix.
So, what has changed between a few months ago and now that would explain this surge of debt financing? It is unlikely that the tax benefits of borrowing have surged or that expected bankruptcy costs have dropped; the former explanation would have made sense if corporate tax rates were expected to rise in the future and the latter would have worked if the economy had strengthened significantly over the period. I think the answer lies in evidence that behavioral finance has uncovered about how companies make financing decisions; my colleague at NYU, Jeff Wurgler, has the seminal paper on the topic. Rather than weigh the costs and benefits of debt and come up with optimal or target debt ratios, firms seem to make their financing choices based upon perceptions of the cheapness (or costliness) or debt as opposed to equity. Thus, they tend to flood the market with bond offerings, when they perceive the cost of debt to be low and with equity offerings, when they perceive their stock to be over priced. I would term this "opportunistic capital structure". The drop in treasury bond rates and the decline in default spreads (as the Greek crisis has receded) has led to much lower borrowing rates, especially for highly rated companies.
What's wrong with this? There are two potential dangers:
a. Perception may not be reality: Perceiving the cost of debt is low does not make it so. When CFOs make assessments of the relative costs of debt and equity, they are trying to be market timers. Given the sorry track record that portfolio managers have on timing equity and bond markets, I would be wary about CFOs who claim special powers on this issue.
b. Short term gain versus long term pain: Even if CFOs are good market timers and the cost of debt is low (relative to equity), is it a good idea to go out and fund your projects predominantly with debt? I don't think so. Over time, the firm will end up with too much debt, and over time, the cost of debt will revert back to historic norms. As with homeowners who borrowed because rates were low between 2004 and 2007, the day of reckoning will come and it will be painful.
Here is my compromise solution. Rather than pick an optimal or target debt ratio, a firm should choose a range for the optimal; in other words, a 20-40% optimal debt ratio, rather than 30%. Firms can then be opportunistic but only within this range; thus, you would move to a 40% debt ratio, if you believe that that the cost of debt is low or to a 20% debt ratio, if you think your equity is over priced. That would constrain over confident CFOs from pushing the debt ratio to unsustainable levels.