Corporate Finance and Its Structure

There is an opinion article today in the Financial Times that is misguided.  Mr. Schoenmaker proposes that we end the tax credit for debt financing.  He believes it was the tax credit for debt financing that caused the extreme amounts of leverage that lead to the worldwide banking crisis.

 He states,

“High debt-to-equity ratios can cause multiple bankruptcies. Equity acts as a buffer, as it can absorb losses. After its equity is extinguished, a company will go bankrupt. It is therefore important that banks and corporates operate with sufficiently high equity buffers (that is, low leverage ratios). High leverage encourages excessive risk-taking by shareholders at the expense of creditors and governments.”

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and goes on to say

“Our proposal is to reform corporate tax in order to remove the structural bias towards debt financing. As governments have to tighten fiscal policy anyway, now is a good time to reform corporate tax. It is a historical accident that interest, alongside other costs such as wages and depreciation of fixed assets, is deductible from corporate tax.”

I wholeheartedly disagree with his analysis.

First, it wasn’t the tax incentives that caused firms to take on too much debt. The reason they did was that governments kept the cost of debt at extraordinarily low levels. They combined the cheap cost of debt with a government backstop in the form of Freddie Mac and Fannie Mae that banks could off load their portfolios to.
The opportunity cost of borrowing versus issuing equity went in favor of borrowing. Certainly tax incentives are figured into the cost, but they are not generally the tipping point that favors one action over another.

Secondly, there are hidden costs to issuing equity that are not contemplated in the article. One is the loss of control over the company. Issuing equity to a bunch of shareholders means a company’s management team has to answer to them. There are operational costs to the firm to be at the beck and call of shareholders.

Other hidden costs to issuing equity are the government regulations and restrictions that the firm is now accountable for. Ask any CEO about the increased accounting costs for complying with Sarbanes-Oxley. In some cases, the costs are triple.

Debt or equity issues each have transaction costs associated with them. The firm must include the costs of each when contemplating what financing strategy to pursue. Equity costs include the fees to the banks, the road show and selling of the shares, the listing fees and support costs of underwriting the equity. Debt can sometimes be cheaper to issue.

Lastly, the growth of the firm may be stunted if they are left to pursue a straight equity, or a limited debt financial structure. Leverage magnifies returns. It allows companies to grow faster. Corporate finance is also a strategic strategy. Limiting the issuance of debt via government fiat limits the growth of the over all economy.

Let individual firms decide on their capital structure and strategy for growth. The broader market will analyze their structure and assign a value to it. If a company loads up with too much debt, they will pay. Either in a far lower stock price, or by going out of business.

If we want to regulate, let’s regulate on the side of more financial statement disclosure. Sunshine spreads happiness. If we learned anything from the financial crisis its that poor disclosure lead to poor analysis.

The other remedy is to eliminate the government subsidies in the form of all the agencies that backstop the debt. Change those kinds of incentives and company behavior will change. Merely passing another regulation will only add to the costs of the corporation, making it less efficient. Less efficient companies lead to higher unemployment, slower growth, and less robust economies.

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