Because interest payments on debt are tax-deductible, debt provides a tax benefit over equity when used to finance a firm. So what stops a firm from having a capital structure that is mostly debt? In a downturn, a firm financed with equity will stay solvent because the required returns that shareholders expect do not have to be paid out in cash. However, interest payments on debt are fixed - if the firm’s cash flows drop, it still must meet all of its current obligations. If too much of the firm is financed through debt, the firm may have trouble always meeting its interest payments and accounts payable when they become due. In this situation, tax savings from the use of debt are offset by what we call financial distress costs.
Financial distress occurs when a firm does not have enough cash to meet its current obligations. During financial distress, a firm must make decisions such as selling off assets to cover its cash shortfall. These decisions may erode the value of the firm, and are choices the firm would not make without the presence of a cash shortfall.
Firms may deal with financial distress in many ways. In addition to selling off assets, a firm may also reduce capital spending and research and development. The firm may also undergo a financial restructuring by negotiating with banks and other creditors, exchanging its equity for outstanding debt, and filing for bankruptcy protection or bankruptcy.
A firm will go into bankruptcy when it becomes insolvent, and a firm can be insolvent in two ways. Stock-based insolvency occurs when the firm’s debt is greater then the firm’s net assets. As a result, the firm will have a negative value for its equity. Flow-based insolvency occurs when the firm’s cash flows drop below its current contractual obligations.
When a firm files a voluntary petition for bankruptcy, or is forced into bankruptcy by an involuntary petition filed against it, a trustee-in-bankruptcy will be elected by the firm’s creditors to administrate the liquidation of the firm’s assets. Typically the claims against the firm will be paid out from the proceeds from selling the assets in the following order:
- Administrative and other expenses associated with bankruptcy
- Wages, salaries and commissions
- Municipal tax claims
- Judgments against the firm such as claims from employee injuries
- Unsecured creditors*
- Preferred shareholders
- Common shareholders
*Secured creditors are paid out of the proceeds from the sale of specific assets. Any amount owed to secured creditors once these specified assets are liquidated is lumped in with unsecured creditors.
Although the use of debt provides a tax benefit, when the level of debt becomes too high, financial distress costs offset these savings. Having a high level of debt makes the firm more risky, because interest payments are fixed, and must be paid even in a downturn. &As a result, most firms limit their use of debt.