This is to summarize and synthesize the contents of the following articles: “The Party is over”, “Debt is Good for You” and “Debtor’s Prison”. The paper will also conclude with an opinion on how the information from the three articles will affect the capital structure decisions of this researcher as a financial manager. Is there a basis to use more or less debt as suggested by Modigliani and Miller capital structure model and Trade-off (static) models of capital structure, and why?
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Analysis and Discussion
“Debt is Good for You” argues that debt is good based on the theory of Modigliani and Miller’s capital structure model where they say that it does not matter whether a company borrows or uses equity as a source of financing its capital requirements. It appears that many have believed in the theory in addition to its other benefits, which has resulted in many companies having resorted to more borrowing or debt over equity financing. There was also low inflation in the 1970s and the early 1980s that may have caused increased borrowings from companies then since they could afford to borrow more. The situation when recession sets in however may be different.
In “Party is Over”, the argument that debt was good for companies was considered over and that several companies need to consider the trade-off static model capital structure which supports the need to balance the increased risk in case of more borrowing with more equity. This second article modifies the position taken in the first article where having now targeted capital structure has the effect of minimizing the cost of capital, which will be akin to meeting the finance objective of wealth maximization as measured in high prices of the companies’ stocks.
In “Debtors’ Prison”, the strategic reasons for taking on debt have expounded including the use of the same to help management attain the objective of increasing earnings per share when the management borrows money to finance stock repurchase from some stockholders. However, the same article has pointed the possible frauds that may have happened by resorting to debt financing about managers’ self-interest.
These managers may appear to have met quarterly profit targets of their companies in terms of higher earnings per share, but unknown to stockholders would be corresponding motivations about share options, which are usually offered to managers to address possible violations of the agency theory. By so making more debt financing over equity, the managers are placing a better position than stockholders because increase debt over equity or making the company more financially leveraged, by benefitting more from the tax-deductibility of interest expense,
the decision is on the other hand increasing volatility which makes the share options to become more valuable.
The reality of ‘prison’ created by debt may not have been noticeable during good times but recession, which is an economic phenomenon will surely come to pass which would reveal the dangers of resorting more than necessary in debt financing and disregarding the level of equity needed to keep a balance or to attain the static trade-off in capital structure. With the rapid increase in the default rate on debt issuers during the credit crunch, it becomes more dangerous for companies to just consider debt financing because there is also the increased tendency for suppliers of debt to demand liquidation of their credits to companies that may have been possibly made possible for failure to comply conditions in debt-contracts entered into by issuers of debt or bonds and the said suppliers. The effect would be also felt in downgraded shares of stocks of these issuers and thereby working against the very theory of Modigliani and Miller that the relationship of debt and equity is irrelevant.
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It can be concluded that blindly taking the advice the credit is good could be a sure way to perdition not only in terms of the companies who failed to recover from the fall of their stock prices when the recession has set in but also in the greater danger that may come from the possible abuse of retorting to debt in violation of the agency theory where management would prioritize first their interest above the stockholders. There is therefore reason to measure the financial strength of a company in terms of its capital structure where the more highly leveraged ones would be nearer to bankruptcy, which in turn increases the risk and in turn increase the cost of capital. Naturally, increasing the cost of capital would be against the wealth maximization objective of the organization. As a finance manager, this researcher must keep in balance the debt and equity requirements of the organization being served. It would be a great violation of this researcher’s duty if the lessons from these readings would be disregarded.
- The Economist, 2001 “The Party is over”
- The Economist, 2001, “Debt is Good for You”
- The Economist, 2009 “Debtor’s Prison”