Superior Living How Can Using More Debt

Superior Living

How can using more debt impact a firm's capital structure?

The capital structure is comprised of debt and equity so inherently, any change to either will change the firm's capital structure. What is being proposed is that in advance of our IPO we will take on more debt. There are no universal truths as to what Wall Street might want to see in a capital structure, and for each firm the decision will be different, but it is important to understand what the changes to the company's capital structure mean. For the company, increasing debt increases the firm's leverage. The firm is therefore riskier, because more of the company's cash flows are dedicated to debt repayment or interest obligations. As such, there is less money left over for the firm's shareholders. However, once the fixed debt obligations are paid off, everything that is left over does go to the shareholders. As a result, for a successful firm, the ROE is going to be higher if the company has more debt in its capital structure (Loth, 2006).

The cost of debt is lower than the cost of equity, largely because the latter is subordinated to the former and therefore riskier. As a result, firms often prefer to take on some debt in order to lower their cost of capital. For some companies, however, having a lower cost of capital is not a major consideration and these companies may maintain a balance sheet with little or no debt. Ultimately, however, the company needs to strike a balance. Because debt is risky, having too much debt leaves the firm very susceptible to changes in its cash flows. Thus, only firms with very stable cash flows should have very high levels of debt. For other firms, such as ours, it is too dangerous to have too high a debt level, even though there are benefits to having some debt.

What are the tradeoffs between incremental IPO proceeds and debt financing?

The investment bankers believe that taking on more debt is a signal to the market that the firm is willing to become more aggressive, that is to say the firm is willing to take on more risk. This will generate more funds for the IPO. The firm will also have more funds available from the debt that it takes out. The downside of the debt is that it will add risk to the firm. The upside is that by taking out additional debt now, when the IPO comes through the firm may end up with the same capital structure as it currently does, because both debt and equity have been added. It is desirable to get more money in the IPO, but there is a tradeoff in that the company will have a higher level of risk. In addition, there is a cost attached to debt, although interest rates are at very low levels right now.

How would the company's balance sheet be impacted by debt financing rather than using cash?

If the company builds the plant with debt financing, the company's balance sheet would show more debt. The debt-equity ratio would be higher, and the level of cash would not change as the result of this transaction. If cash is used to build the plant, the level of cash would be depleted, but the company would have a lower overall level of debt. Again, if debt it used, this increases the risk that the company is facing. Future cash flows will be needed to pay back the loan, and that will reduce the amount of profit that is available to the shareholders.

How would the company's balance sheet be impacted by debt financing rather than using cash?

The return on equity would increase if the firm uses more debt. If debt is used for this project, what would happen is that the balance sheet would have more debt and less equity. As a result of this, the shareholders would see the value of their equity would shrink. The reason is that an asset is being added with no equity being added. The return that is left over after the debt payments are made is shared among fewer shareholders, and that increases the ROE. An equivalent profit shared among more shareholders would give a smaller return. Thus, adding debt increase the return on equity, even if it does not increase return on assets or return on investment.