What is the optimal level of corporate debt for our business?

1. Understanding Corporate Debt

CEOs, CFOs and Executive Board members often face the question: what is the optimal level of corporate debt for our business? Striking the right balance is challenging, as it requires weighing the advantages of accessing debt against the operational and agency costs that can arise from overleveraging your company. However, investing time and effort to properly answer this question can pay off as the benefits of achieving the optimal corporate debt structure can be significant.

Debt and Capital Structure

A well-optimized debt and capital structure helps reduce the cost of capital, improves financial flexibility, and boosts shareholder value. However, achieving that balance isn’t simple. It requires careful financial analysis to ensure that your company can sustain its corporate debt without placing unnecessary strain on its operations.

There are many reasons a company may choose to raise corporate debt. Those may include: funding growth, paying a one-time dividend to shareholders, buying out existing shareholders, financing an acquisition, refinancing existing debt, or positioning the company to navigate a challenging economic environment. In every instance, it may be challenging to understand how much corporate debt is optimal for your business. Yet choosing the right amount of debt at the right cost is critical for long-term success.

 2. The Advantages and Considerations of Corporate Debt

The benefits of corporate debt are quite compelling–there is a lower cost of capital when compared to equity, and it provides a tax advantage, as interest payments are tax-deductible. However, there can be hefty considerations, such as interest expense, risk of default, and reporting requirements.

That’s why it’s necessary to have a full picture of your financial health (which includes the health of the overall market and your specific industry/sector) before making any decisions.

Debt Financing Advantages

Debt financing typically has a lower cost of capital than raising equity, and it allows you to retain ownership, avoiding dilution of control. Interest on corporate debt may be tax-deductible, which could reduce your company’s tax burden.

• Lower cost of capital vs. raising equity: Debt financing typically offers a lower cost of capital compared to issuing equity, which makes it an attractive option
• Tax deductibility of interest expense: Interest payments on corporate debt might be tax-deductible, reducing your overall tax liability and freeing up cash for other strategic investments
• Higher shareholder return on equity: By using debt, you can increase returns on equity without diluting ownership
• Relative ease of refinancing at maturity: Corporate debt is relatively straightforward to refinance at maturity, which provides greater flexibility in managing a company’s financial obligations.
• No/minimal governance rights: Unlike equity capital, most corporate debt excludes governance rights for lenders, allowing you to maintain control over the strategic decisions of your company.

3. Debt Financing Considerations

While the advantages of corporate debt are numerous, there are also several considerations. Debt financing entails obligations to third parties and there are generally restrictions on how the capital can be used.

• Negative covenants (restrictions): Debt agreements include covenants that restrict certain business activities, limiting your ability to make operational changes without lender approval.
• Necessity to maintain financial covenants: Lenders require your company to meet specific financial conditions to remain in compliance with loan agreements. This adds pressure to maintain healthy financial ratios.
• Interest expense and agency costs: The cost of servicing debt, including interest and agency fees, can affect profitability and cash flow if not managed properly.
• Maturity schedule: You must manage your debt repayment schedule carefully to avoid liquidity issues.
• Risk of default/implications of default: Defaulting on debt obligations can severely damage your company’s financial standing and reputation and negatively impact your ability to secure future financing.
• Reporting requirements: Debt financing involves periodic reporting requirements to lenders, adding administrative overhead and the need for greater transparency.