Debt-equity comparisons considering WACC, corporate tax, leverage, cost of debt

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a) Why us debt a comparative cheaper form of finance than equity?

Debt is Cheaper than Equity--to a Point
Capital structure refers to the relative proportions of a company's different funding sources, which include debt, equity, and hybrid instruments such as convertible bonds (discussed below). A simple measure of capital structure is the ratio of long-term debt to total capital.

Because the cost of equity is not explicitly displayed on the income statement--whereas the cost of debt (interest expense) is itemized--it is easy to forget that debt is a cheaper source of funding for the company than equity. Debt is cheaper for two reasons. First, because debtors have a prior claim if the company goes bankrupt, debt is safer than equity and therefore warrants investors a lower return; for the company, this translates into an interest rate that is lower than the expected total shareholder return (TSR) on equity. Second, interest paid is tax deductible to the company; and a lower tax bill effectively creates cash.

b) If debt is cheaper than equity, why do companies approach the equity markets?

Suppose our company is financed entirely by ordinary shares (equity). What would be the effects of issuing some debt capital? The main advantage of borrowing is that debt has a cheaper direct cost than equity. There are two distinct reasons for this:
i. debt is less risky to the investor than equity (low risk results in a low required return); and
ii. interest payments are allowable against corporate taxation, whereas dividends are not.

However, borrowing has two distinct disadvantages. Firstly it causes shareholders to suffer increased volatility of earnings. This is known as financial leverage. For example, if a firm is financed entirely by equity, a 10% reduction in operating earnings will result in a 10% reduction in earnings per share. But if the firm is financed by debt as well as equity, a 10% reduction in operating earnings causes a greater reduction in earnings per share than 10%, because debt interest does not reduce in line with operating earnings.

The increased volatility to shareholders returns resulting from financial leverage causes shareholders to demand a higher rate of return in compensation. In other words, any borrowing at all will cause the cost of equity capital to rise, off-setting the cheap direct cost of debt.

The second disadvantage of borrowing is that if the company borrows too much, it increases its bankruptcy risks. At reasonable levels of gearing this effect will be imperceptible, but it becomes significant for highly geared companies and results in a range of risks and costs which have the effect of increasing the company's cost of capital.

The optimal capital structure--that is, the ideal ratio of long-term debt to total capital--is hard to estimate. It depends on at least two factors, but keep in mind that the following are general principles:
Â? First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property, & equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally utilize more long-term debt.
Â? Second, capital structure tends to track with the company's growth cycle. Rapidly growing start ups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments--as these companies are growth stocks--in favor of future price returns. High-growth companies do not need to give these shareholders "cash today", whereas lenders would expect semi-annual or quarterly interest payments.

c) Can one minimizing WACC then there is a constraint on raising debt? If so, how?

When a company issues new long-term debt, it's important for investors to understand the reason. Companies should give explanations of new debt's specific purpose rather than vague boilerplate such as "it will be used to fund general business needs." The most common purposes of new debt include the following:
1. To fund growth: The cash ...