Debt to Equity Proportions
DEBT TO EQUITY PROPORTIONS
In building the pool of funds for the business it is important to balance and optimize the proportions of debt and equity. The relationship between total debt and total equity is referred to as leverage or gearing. If there is too much debt, a business becomes highly leveraged with the implications of:
• Repayment risk. The risk to debt providers increases as there is less of an equity buffer to absorb losses that the business may make.
• Interest risk. The interest cost must be met before dividends can be paid to shareholders. If interest cannot be paid and there is a serious risk of the business not being able to repay the debt, funders will exercise rights in their loan agreements to force repayment from asset sales.
• Cost. With enhanced risk to debt providers the cost of the loans is likely to rise in the form of increased interest rates. If there is too little debt, shareholders lose out through dilution of earnings which limits their return by:
• Greater weighted average cost of capital (wacc). As equity is more expensive than debt, the business can lower its wacc by replacing equity with cheaper debt; the enhanced earnings can then be passed back to shareholders.
• Restrained growth. With too little borrowing the business may be operating sub-optimally as it could borrow more to fund expansion and achieve greater growth.
To prevent businesses from borrowing too much there are often covenants in a loan agreement that constrain the business. A common covenant is that a loan becomes immediately repayable if a certain debt to equity ratio is exceeded. The optimum leverage for a business is seen to be around 50% of total funds. At this level the interest rate on debt is optimized and the return on equity is maximized. There can be scenarios where a higher level of leverage can be tolerated without the interest rate rising. This might be for businesses that have significant infrastructure which has a potential tradable
In building the pool of funds for the business it is important to balance and optimize the proportions of debt and equity. The relationship between total debt and total equity is referred to as leverage or gearing. If there is too much debt, a business becomes highly leveraged with the implications of:
• Repayment risk. The risk to debt providers increases as there is less of an equity buffer to absorb losses that the business may make.
• Interest risk. The interest cost must be met before dividends can be paid to shareholders. If interest cannot be paid and there is a serious risk of the business not being able to repay the debt, funders will exercise rights in their loan agreements to force repayment from asset sales.
• Cost. With enhanced risk to debt providers the cost of the loans is likely to rise in the form of increased interest rates. If there is too little debt, shareholders lose out through dilution of earnings which limits their return by:
• Greater weighted average cost of capital (wacc). As equity is more expensive than debt, the business can lower its wacc by replacing equity with cheaper debt; the enhanced earnings can then be passed back to shareholders.
• Restrained growth. With too little borrowing the business may be operating sub-optimally as it could borrow more to fund expansion and achieve greater growth.
To prevent businesses from borrowing too much there are often covenants in a loan agreement that constrain the business. A common covenant is that a loan becomes immediately repayable if a certain debt to equity ratio is exceeded. The optimum leverage for a business is seen to be around 50% of total funds. At this level the interest rate on debt is optimized and the return on equity is maximized. There can be scenarios where a higher level of leverage can be tolerated without the interest rate rising. This might be for businesses that have significant infrastructure which has a potential tradable