Let’s say you’re in need of $1000 for some requirement, and you need to take a loan for the same. You approach various banks and you boil down to two banks: Bank A is ready to give you a maximum loan of $300 at 3% interest and Bank B is ready to give you a maximum loan of $1000 at 5% interest. How would you distribute your loan? Will you take all $1000 from Bank B or would you take $300 from Bank A and $700 from Bank B. No brainer, obviously, you’ll take $300 loan from Bank A at lower interest (to max low interest debt) and then take the remaining $700 from Bank B. We do this so that the weighted interest cost (cost of capital) is the lowest possible.

Companies do the same too. Companies borrow from two different types of capital sources: Equity and Debt. And they’re always looking to optimize the cost of borrowing capital between the two such that the weighted cost of capital is the lowest for the company. For debt, the cost of capital is straight-forward and that is nothing but the interest charged by the loaner. For equity, the cost of capital is not straight-forward. Refer this model to understand how cost of equity is calculated.

But, the above is too simple a view. In reality, the inter-play between debt and equity is such that it will force you to strike a balance as you’ll see in this article.

Normally, the cost of debt is always higher than the cost of debt. Because debt has less risk, the equity investors will always expect a higher return than the debt investors who are not taking the risk as debt is a legal binding obligation.

Why then should companies fund with equity instead of going with all debt model? The problem with increasing debt is its servicability. Can the company service the debt as it keeps taking more? Also, as you take more debt, the cost of your overall capital will always increase because the prospective equity investors will look at the huge portion of debt as a big risk and will ask for a higher return for their equity.

So, the lowest possible Weighted Average Cost of Capital (WACC) for a company does not happen at 100% debt. As debt increases, creditors become nervous that the company will not be able to cover its liabilities. Consequently, new debt issued by the company gets lower rating by credit agencies. Interest expense for new loan rises. Cost of debt thus increases. Equity holders also view the increasing debt as a risk increment, and they demand a higher return, thus increasing the cost of equity. As interest increases, Earnings per Share (EPS) decreases which leads to lower valuation. The main benefit of increased debt is from the interest expense as it reduces taxable income, but that is only to a certain extent. Exceedingly more debt means more liabilities on the balance sheet, making it more difficult to satisfy the all-important solvency test (solvency ratios).

100% debt is theoretically feasible if lenders would permit that. In reality, if you’ve 100% debt, you may not be able to service both the interest and the principal. Over-leverage increases Return on Equity (ROE) but creates debt-service problem. Under-leverage lowers ROE but can service the debt. This implies there is an optimum capital structure for a value. If company takes more and more debt, financiers will raise the cost of debt due to higher debt levels in the company. So at some point of time cost of debt will be more than cost of equity.

-David Friedman, ex-Citigroup & Bloomberg

Which is more riskier for the company looking for finance?

As a company looking to get financing, debt financing is riskier. You’re binding yourself to a fixed payment schedule which may or may not relate to your revenue stream. Debt payments are due, whether you earn money or not. Have a bad month? Still need to make that interest payment to your loaner.

On the other hand, if you’re on the other (investor) side of the transaction, it’s reversed. Equity financing is riskier. Your return is not linked to a fixed schedule, but to the ups and downs of the company. From an investor point of view, any type of debt, subordinated or otherwise is less risky than equity capital. Equity is the most subordinated type of capital and as such, is a claim on the residual assets of a company after all other claims, including debt claims, have been settled. So, for a company debt is always more riskier. But at the same time if it is used in a measurable way, it can help drive down the overall cost of capital for the company.

So, in the ideal good world, when the company is raising equity it should be worried about dilution and the high cost of equity, and when the company is raising debt it should be ideally thinking about raising optimum debt to have the lowest weighted cost of capital. However, in the real bad world, what happens is: companies raise equity thinking that there is no risk and obligation and you can burn it, and companies raise debt not because they want to optimize on cost of capital but because equity is taking lots of time.

What is the maximum debt that a company can take on its books?

Normally, loans are issued after evaluation of the assets, cash-flow plan for next 3 years and the balance sheet situation. But, we also see in India, a high proportion of corruption, politics and a higher approach taken by corporates to acquire big unsecured loans which are not in proportion with the actual company’s assets. When these companies file for bankruptcy, banks realize that their actual assets are not even one-third of what was declared.

The general thumbrule for debt:equity for a company that even banks evaluate for loans is 2:1. However, it has to be seen along with the cashflows of the company. If the company is not struggling with cashflows and has a healthy cash balance and future cash-flows, then banks won’t be worried about giving more debt capital. It is the same as for an individual having a strong income and asking for an additional loan. Banks will look at cash flow and whether the individual or a company can service their interest and principal payout or not.

Sometimes banks tell companies to raise more equity before they can provide more debt, why is that?

If banks find that a company is over-leveraged with debt and is poor on cash-flows, then banks may deny additional debt and ask the company to raise further equity to be able to raise more debt. This is primarily because: banks are worried about interest payments, but they’re more worried about the principal repayment. Any new infusion of equity capital will help the company temporarily to use the equity capital for some of its expenses and have more cash to pay bank repayments (interest and principal). This is an indirect way of equity funding debt repayments and it is very expensive, but that’s what companies do when the business is not generating enough cash-flow.

In conclusion, there is no such hard and fast rule that a company cannot take more than a certain percentage of debt. In practice, the ratio of debt:equity varies a lot basis cash flows, the company’s business model, the industry, etc., however, the traditional 2:1 ratio of debt:equity is still a good indicator even in practice. You won’t be grossly wrong basis this thumbrule.

Hope this is useful, thank you.