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The Goal of Debt Management
The goal of debt management is to maximize shareholder wealth by minimizing the firm's after-tax cost of its debt. Therefore, a firm should choose the set of after-tax interest and principal payments with the smallest present value.
Debt management consists of two phases: (1) design decisions made before incurring the debt and (2) managerial decisions made afterward. In the first phase, the issuer must decide on the debt type, the terms, and where to borrow. The design must meet the issuer's financial objectives within the realities of the capital market. We refer to this activity as the new-issue-design decision.
In the second phase, the issuer should minimize the cost of the outstanding debt. The issuer should actively seek opportunities to redeem and replace, that is, refund, outstanding debt that will increase shareholder wealth by reducing the cost of the debt. Such decisions include which debt to redeem and, how much of it to retire early, when to redeem it, and how to redeem and replace it most cost-effectively. We refer to this activity as the refunding decision.
The two phases of debt management are related, of course. If a firm wants to be able to redeem bonds at its option prior to maturity, the bond indenture must include a call option. Because the call option is costly, a benefit analysis is needed.
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Both phases include looking for positive-net-present-value (positive-NPV) opportunities, that is, opportunities that are worth more than they cost. For example, a design that attracts a class of bond investors who are willing to pay more (accept a lower coupon rate) than they would for an otherwise identical conventional based bond issue is a positive-NPV opportunity.
Debt Versus Equity
Debt is a contract to pay interest and repay principal; it is thus a legal obligation and is enforceable in court. Failure to comply with the contract can lead to bankruptcy. Debtholders have first claim on the firm's cash and any cash derived from the sale of other assets. Equity is a form of ownership. The equity holders are the residual claimants; they get what is left after the debtholders have been paid. The bond indenture (contract) has the information needed to value a bond.
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| The issuer should actively seek opportunities to redeem and replace, that is, refund, outstanding debt that will increase shareholder wealth by reducing the cost of the debt. | |
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| —Finnerty & Emery |
Debt offers investors a more predictable and hence less risky pattern of cash flow and a less variable rate of return than equity securities. The debt's required rate of return (required return) depends on the yields available on other debt of identical risk and characteristics.
Debt has an important tax advantage over equity: Interest on debt is tax deductible, but dividend payments are not. Therefore, securities that qualify as equity for certain purposes, such as bank regulatory capital requirements, but have tax deductible interest payments are sought after. Such hybrid securities show that in practice, the distinction between debt and equity sometimes gets blurred. In fact, the Internal Revenue Service (IRS) has tried several times to impose a well-defined tax boundary between debt and equity. Each time it has encountered stiff opposition to the proposed regulations and has withdrawn the proposal.
Debt accounts for most of the short- and intermediate-term external financing for U.S. firms and approximately 80 percent of long-term funds. Equity accounts for the remainder, with new issues of common stock being about 14 percent and preferred stock accounting for about 6 percent of the long-term external funds. U.S. firms typically issue more than $500 billion of new long-term debt annually.
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What Makes a Lender Lend?
Excerpted with permission from Debt Management: A Practitioner's Guide, HBSP/Oxford University Press, 2001
There is an extensive long-term debt capital market in the United States, Europe, and Japan. The market includes financial institutions, such as life insurance companies and pension funds, which provide fixed-interest-rate financing, and commercial banks, which provide floating-interest-rate financing. There are also developing capital markets in many emerging nations, which can provide cost-effective financing for local subsidiaries or local projects. These regional markets consist of local institutions, which usually have a preference for floating rate lending, especially when the country periodically experiences relatively high inflation rates.
Several factors affect investor willingness to lend:
Profitability of the firm. As a general rule, lenders want to know how loan proceeds will be used, so they can assess the likelihood of default. They will not lend unless they believe the firm will generate enough cash flow to pay interest and principal on the debt.
Leverage. Lenders want to know about the firm's other debt obligations that could contribute to default.
Assessment of risk. Lenders insist on being fully compensated for all risks. Their assessment of each type of risk affects the rate of interest they are willing to accept.
Credit standing of the borrower. As a matter of statute or policy, some lenders, such as many public pension funds, will not purchase corporate bonds that are not rated single-A or better by the major rating agencies (Fitch, Moody's and S&P).
Liquidity of the debt securities. The lack of liquidity inherent in privately placed, unregistered securities significantly affects the interest rate that lenders will accept. Nevertheless, younger firms are generally restricted to the private placement market because of their riskiness and the relatively small amounts of debt they want to sell.
Interest rate on the debt. The interest rate must be high enough to compensate lenders for the perceived risk of default and illiquidity.