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Debt Financing Definition
Businesses can raise operational capital (or other sorts of capital) by selling debt instruments like bonds, debentures, and other types of debt security. The act of raising capital by selling debt instruments is called “debt financing”. The individuals and organizations become creditors of the issuing company by lending capital against the debt instruments. The creditors are entitled to receive interest against the loan and get back the principal amount after a specific period of time.
A Little More About Debt Financing
Companies sell debt instruments in forms of bond, note or bills in the market to raise capital for running the operations of the company and to expand it. Those can be purchased by individuals or by investing firms. The creditors have a greater claim on the liquidated assets than that of the shareholders during of insolvency.
Another way of raising capital in the debt market is issuing equity shares in the market. That is called equity financing. Equity shares represent a percentage of the ownership of the company. The shareholders are entitled to receive a percentage from the company’s future revenues, but they do not get back the principal amount. In case of insolvency, the shareholders are the last ones to receive any money.
Debt in the Capital Structure
A company’s capital structure is comprised of equity and debt. A percentage of the revenue is paid to the equity shareholders as dividends, on the other hand, the bondholders receive interests against the loan. The former is called the cost of equity and the later is known as the cost of debt. This comprises the company’s cost of capital. A company needs to ensure they can cover the cost of capital with their return. They strategize all their expenditure, expansion and investments keeping this in mind. If a company fails to generate positive income for its financiers, they need to review their capital structure.
Calculating Cost of Debt
The formula for calculating the cost of debt financing is,
Cost of debt = Interest Expense * (1 – Tax Rate)
The interest rate is generally tax deductible, so the interest expense is calculated after deducting the tax amount.
A company’s debt financing is measured by debt-to-equity ratio. It is a ratio of the capital raised by selling equity shares and the capital raised by selling debt instruments. Generally, a low debt-to-equity ratio is preferred by the businesses but the tolerance to the debt depends on the industry.
There are certain rules to be followed by a borrower company regarding financial performance, those are known as covenants. A company needs to adhere to these rules in order to secure their debt financing.
References for Debt Financing
Academic Research on Debt Financing
Debt financing: Does it boost or hurt firm performance in product markets?, Campello, M. (2006). Journal of Financial Economics, 82(1), 135-172. This paper examines how debt affects a company’s sales performance. The author finds that moderate debt leads to sales gains while greater debt leads to poor performance.
Asset substitution and the agencycosts of debt financing, Green, R. C., & Talmor, E. (1986). Journal of Banking & Finance, 10(3), 391-399. Agency costs arise when management decisions conflict with shareholder desires to maximize value. This paper questions whether these costs increase with increases in corporate debt.
Financing the small firm start-up: Determinants of debt use, Scherr, F. C., Sugrue, T. F., & Ward, J. B. (1993). The Journal of Entrepreneurial Finance, 3(1), 17-36. This study examines the use of debt by small start-up companies in relation to various factors including the age, race, and marital status of the owner; and the industry in which the firm does business.
An equilibrium analysis of debt financing under costly tax arbitrage and agency problems, Barnea, A., Haugen, R. A., & Senbet, L. W. (1981). The journal of finance, 36(3), 569-581. This paper is concerned with the difference between taxable and non-taxable corporate bonds as it relates to the issuance of corporate debt.
Capital structure and the market for corporate control: The defensive role of debt financing, Israel, R. (1991). The Journal of Finance, 46(4), 1391-1409. This paper examines the relationship between a company’s debt and the likelihood that it will be acquired by another firm. It finds that the probability that a firm will be acquired decreases as its debt increases. Further, as the target firm’s debt increases, the acquiring firm gets a greater share of equity.
Why firms issue convertible bonds: the matching of financial and real investment options, Mayers, D. (1998). Journal of financial economics, 47(1), 83-102. Corporations may issue bonds that can later be converted into stock (convertible) and bought back at a premium (callable). This paper argues that these features reduce the costs associated with issuing the bonds while reducing the incentive for managers to overinvest the company’s resources.
Agency problems and debt financing: leadership structure effects, Fosberg, R. H. (2004). Corporate Governance: The international journal of business in society, 4(1), 31-38. This author tests the hypothesis that when top managers of a firm have a lot personally invested in that company, the firm carries less debt than is optimal. He validates the hypothesis, finding that as the percentage of stock held by top managers increases, the company’s level of debt decreases.
Disentangling patterns of state debt financing, Clingermayer, J. C., & Wood, B. D. (1995). American Political Science Review, 89(1), 108-120. This paper examines the drivers of changes in state government debt. It finds that economic conditions are the main factors, but many political factors are also found to play a part.
The value of financial statement verification in debt financing: Evidence from private US firms, Minnis, M. (2011). Journal of accounting research, 49(2), 457-506. This paper examines the effects of audited financial statements on debt costs (interest rates). The author finds that audited firms have lower debt costs, and that audited debt statements are better predictors of future revenue.
Debt financing, corporate governance and market valuation of listed companies, Hui, W. (2003). Economic Research Journal, 8, 28-35. This paper investigates the relationship between debt financing, corporate governance and stock market value of a set of companies. The author finds that the companies have a small amount of debt relative to their assets. He finds strong relationships between debt and corporate governance, and debt and stock market value.
Debt financing and financial flexibility evidence from proactive leverage increases, Denis, D. J., & McKeon, S. B. (2012). The Review of Financial Studies, 25(6), 1897-1929. This paper finds that companies that issue a lot of debt do so mostly to cover operating expenses. Moving forward, they do not have a strategy for reducing their debt beyond paying it down when they are profitable. This paper also shows that these companies will issue more debt to cover subsequent deficits.
Industry conditions, growth opportunities and market reactions to convertible debt financing decisions, Lewis, C. M., Rogalski, R. J., & Seward, J. K. (2003). Journal of Banking & Finance, 27(1), 153-181. This paper examines the costs associated with bonds that can later be converted to stocks (convertible debt). The authors provide a framework for designing convertible debt in order to reduce the associated costs. They also show that the relationships among various financial factors are more complex for companies that issue convertible debts than they are for companies that issue standard stocks and bonds.