The effects of debt Essay Example | Topics and Well Written Essays - 2000 words

The effects of debt - Essay Example Thus investors can receive a higher return on their investment. However, debt also leads to higher chance of bankruptcy and may restrict managerial behaviours. Thus the firm becomes more risky and on lower levels of return the earns to stock holders declines. The effects of debt on weighted average cost of capital (WACC) are uncertain. It is known that debt reduces the weighted average cost of capital since debt is cheaper than common equity due to tax saving. But since a higher return is demanded from common stock holders the actual effect is not know. Agency costs as well as financial distress may limit the usage of debt. Distress costs are usually higher for firms with significant intangible assets. The precise identification of a firm's optimal capital structure is impossible. There is also no exact measure for the effects of capital structure of a firm on its cost of capital or on the firm's stock prices. Based on this we can only estimate to an extent only what the optimum capital structure would be. The trade-off theory of leverage is one in which a firm trades off the favourable corporate tax treatments, that are, the benefits of debt financing, against high interest rates and costs of bankruptcies. Thus the firm optimizes the capital structure of the firm and balances the debt and equity in an optimum ratio. The trade off theory in effect realizes that agency cos... The higher the leverage of the firm the higher are the chances of distress faced by the managers. Thus as the level of debt increases in the firm, the cost of debt also increases. This makes debt more expensive as we take more debt. Similar is the case with equity as the debt level increases in the firm, the return on equity demanded by common stock holders increases. The salient features and implications of the trade-off theory are: 1. Debt becomes less expensive than common or preferred stock as interest paid on it is a deductible expense and thus debt provides tax shelters. However, firms do not use 100% debt since this increases the risk of the firm and thus to reduce costs of bankruptcies. 2. The tax benefits attained from low levels of leverage outweigh the bankruptcy costs but the bankruptcy costs outweigh the tax benefits at high levels of leverage. Thus a balance of the leverage in a firm has to be kept. 3. Nonetheless optimal capital structures do exist that can balance the benefits of tax shelters attained from leverage against its bankruptcy costs. The method adopted to minimize the weighted average cost of capital is as follows: The cost of debt and the cost of equity is evaluated at different levels or ratios of debt. Based on this a weighted average cost of capital (WACC) is calculated by assigning market value of capital and market value of debt. This then gives the point where WACC can be minimized. This point is the optimum capital structure. Agency Costs of Free Cash Flow Jensen explains that excess cash flow is the excess cash flow over the required to fund all projects with a positive net present value. Thus essentially free cash flow is the cash flow available for dividend payout.