Kerwin Hamil: Debt or equity: Which creates more wealth?
Published:Wednesday | February 12, 2020 | 12:16 AM
OP-ED CONTRIBUTION: COMPANY FINANCING
Franco Modigliani and Merton Miller, who were highly instrumental in the development of modern capital structure theory hypothesised that in a perfect capital market, the issue of debt and/or equity is irrelevant to the value of the firm as well as the shareholder wealth-maximisation process.
The basic assumptions that unpinned the theory were predicated on the fact that in perfect or efficient capital markets, the absence of taxes, transactions costs, bankruptcy cost and asymmetric information, the value of a firm is unaffected by its owners or shareholders’ decisions on how to finance a firm’s operations.
In fact, the theory further indicated that the value of a firm is contingent on the present value of all its future cash flows rather than the use of debt or equity to finance its operations. Modigliani & Miller’s initial work was later coined the ‘Capital Structure Irrelevance Theory’.
Theoretically, there are two principal methods of financing firms’ capital structures: debt and equity. The capital structure of a firm is the mix of debt and equity used to finance its operations.
Debts are present obligation arising from past transactions or events, the servicing of which will results in future economic benefits flowing outside of the firm. In short, these are obligations owing by a firm, such as bank loans, trade payables, leases, mortgages and bonds. Equities are residual interest within a firm after deducting assets from liabilities. These can take the form of ordinary or preference shares held in a company.
Capital market imperfections
Capital markets are not always perfect or highly efficient as alluded to by Modigliani & Miller theory. In that, in most capital markets such as Jamaica, there are numerous taxes, transactions fees ––such as bank charges – bankruptcy costs and information asymmetries, which generally make capital markets imperfect. For example, there are fees to originate and execute loans. Attorneys, accountants and other professionals charge substantial fees to assist with bankruptcy processes.
In addition, the rate of corporate tax in Jamaica is 25 per cent for small unregulated companies and 33.33 per cent for companies regulated by authorities such as Bank of Jamaica, the Financial Services Commission and Office of Utilities Regulation.
Moreover, some market participants possess information that others do not have, which results in information asymmetries and imbalances within capital markets.
As a result of these market imperfections, debt as a method of financing could be deemed more beneficial, especially in imperfect capital markets such as Jamaica, despite the naivety and unwillingness of some business owners to use this avenue to assist with financing.
Benefits of borrowing
The cost of obtaining debt financing is in most cases cheaper than issuing equity. This is owing to the fact that equity holders bear greater risk on their investments, which generally means, they will invariably require higher rates of return. This is consistent with the capital asset pricing theory, or CAPM, which suggests there is a direct relationship between risk and rewards.
Furthermore, the cost of debt is deductible for income tax purposes. Section 13 of the income of the Jamaican Income Tax Act has provisions, which indicate that interest expenses incurred on debt which is used as capital employed to finance operations are deductible in arriving at taxable profits. These deductions reduce taxable profits and potentially decreases corporate taxation. Reduced corporate taxes tend to increase shareholder wealth where firms reinvest the savings in profitable capital projects.
Issuing equity potentially dilutes existing shareholder interest in a company. To assist with financing the operations of firms, founders may decide to obtain additional capital through initial public offerings, by selling shares in the company to stock market investors. That effectively reduces the ownership interests of the existing shareholders. In IPOs done via the Jamaica Stock Exchange, the owners must offer at least 20 per cent of their company to investors.
Going public not only dilutes their interest, but also makes the company susceptible to the risk of corporate takeovers, which could be executed with a level of hostility.
If the owners decide to issue debt or borrow, the holders of the debt will not have any ownership interest in the company, hence, the possibility of dilution would be deemed remote. The holders debt securities or lenders are merely creditors to firms, rather than shareholders.
However, notwithstanding the many benefits, there are risks such as bankruptcy that are associated with debt, if not utilised appropriately.
Nevertheless, where prudent financial management strategies are employed by firms, the benefits associated with debt as a method of financing could be integral not only to a firm’s success, but to shareholder wealth maximisation and the Jamaican economy.
Kerwin D. Hamil is Programme Director at the School of Business Administration, University of Technology, Jamaica -Western Campus.