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14.1 Debt Financing
At the end of this section, students should be able to meet the following objectives:
- List and explain the advantages of debt financing.
- List and explain the disadvantages of debt financing.
- Describe and illustrate the use of financial leverage.
- Define notes and bonds as used in debt financing.
The Cost and Risk of Debt
Question: Businesses and other organizations need monetary funds to finance their operations and possible expansions. Such amounts can be quite significant. A portion of these resources normally come from investors who choose to become owners through the purchase of shares of capital stock directly from the company. Monetary amounts can also be generated internally by means of profitable operations. If net income each period exceeds the dividends that are paid to stockholders, a company has an ongoing source of financing.
However, many companies obtain a large part of the funding needed to support themselves and their growth through borrowing. If those debts will not be paid within the following year, they are listed on the balance sheet as noncurrent liabilities. The Xerox Corporation, for example, listed noncurrent liabilities on its December 31, 2010, balance sheet of $11.7 billion.
Creditors expect their entire loan balance to be repaid plus interestThe charge for using money over time, often associated with long-term loans; even if not specifically mentioned in the debt agreement, financial accounting rules require it to be computed and reported based on a reasonable rate. at the specified due date. The money has to be available. Consequently, incurring debts of such large amounts exposes the organization to risks. What problems and potential dangers does an entity face when liabilities—especially those of significant size—are owed?
Answer: Few things in life are free. The most obvious problem with financing an organization through debt is that it has a cost. A bank or other creditor will demand interest in exchange for the use of its money. For example, Xerox Corporation reported interest expense for the year ending December 31, 2010, of approximately $592 million. The rate of interest charged on debt will vary based on economic conditions and the perceived financial health of the debtor. As should be expected, strong companies are able to borrow money at a lower rate than weaker ones.
In addition, debt brings risk. A business must be able to generate enough surplus cash to satisfy creditors as liabilities come due. Xerox owes noncurrent liabilities of $11.7 billion. Eventually, company officials will have to find sufficient money to satisfy these obligations. Those funds might well be generated by profitable operations or contributed by investors. Or Xerox may simply borrow more money to pay off debts as they mature. This type of rollover financing is common but only as long as the debtor remains economically strong. Whatever the approach, the company has to manage its financial resources in such a way that all debts are settled in a timely manner.
The most serious risk associated with debt financing is the possibility of bankruptcy. As has become unfortunately commonplace during the recent economic crisis, organizations that are unable to pay their liabilities can be forced into legal bankruptcy.A company can seek protection from its creditors by voluntarily asking the court to allow it to enter bankruptcy. Or, three creditors holding a minimum amount of debt can push a company into bankruptcy, an event known as an involuntary bankruptcy filing. The end result of bankruptcyA formal court process that often results in the liquidation of a debtor’s assets when it cannot pay liabilities as they come due; in some cases, bankrupt companies are allowed to reorganize their finances and continue operations so that liquidation is not necessary. is frequently the liquidation of company assets with the distribution of those proceeds to creditors. However, under U.S. law, financial reorganization and continued existence is also a possibility. When Circuit City entered bankruptcy, company officials tried to reorganize to save the company. Eventually, Circuit City sold its assets and went out of business. In contrast, Delta Air Lines was able to leave bankruptcy protection in 2007 as a business that had been completely reorganized in hopes of remaining a viable entity.Information on the bankruptcy and subsequent legal reorganization of Delta Air Lines can be found at http://money.cnn.com/2007/04/30/news/companies/delta_bankruptcy/index.htm.
Given the cost and risk associated with owing large amounts of debt, the desire of decision makers to receive adequate and clear information is understandable. Few areas of financial accounting have been more discussed over the decades than the reporting of noncurrent liabilities.
The Benefits of Debt Financing
Question: Debt is a costly and possibly risky method of financing a company’s operations and growth. Some advantages must exist or no company would ever incur any noncurrent liabilities. What are the advantages to an organization of using debt to generate funding for operations and other vital activities?
Answer: One advantage of borrowing money is that interest expense is tax deductible. A company will essentially recoup a significant portion of all interest costs from the government. As mentioned above, Xerox incurred interest expense of $592 million. This interest reduced the company’s taxable income by that amount. If the assumption is made that Xerox has an effective income tax rate of 35 percent, the total amount paid to the government is lowered by $207.2 million (35 percent times $592 million). Xerox pays interest of $592 million, which reduces its income taxes by $207.2 million so that the net cost of borrowing for the period was $384.8 million.
Another advantage associated with debt financing is that it can be eliminated. Liabilities are not permanent. If the economic situation changes, a company can rid itself of all debt by making payments as each balance comes due. In contrast, if money is raised by issuing capital stock, the new shareholders can maintain their ownership indefinitely.
However, the biggest advantage commonly linked to debt is the benefit provided by financial leverageA company’s ability to earn more on borrowed money than the associated interest cost so that net income increases; often viewed as a wise business strategy although risks (such as possible bankruptcy) are elevated.. This term refers to an organization’s ability to increase its reported net income by earning more money on borrowed funds than the associated cost of interest. For example, if a company borrows $1 million on a debt that charges interest of 5 percent per year, annual interest is $50,000. If the $1 million that is received can be used to generate profit of $80,000 (added revenue minus added operating expenses), net income has gone up $30,000 ($80,000 - $50,000) using funds provided solely by creditors. The owners did not have to contribute any additional funds to increase profits by $30,000.
Over the decades, many companies have adopted a strategy of being highly leveraged, meaning that most of their funds come from debt financing. If profitable, the owners can earn huge profits with little or no investment of their own. Unfortunately, companies that take this approach face a much greater risk of falling into bankruptcy because of the large amounts of interest that have to be paid at regular intervals.
James Thorpe invests $100,000 to start a new business. He immediately borrows another $400,000 at a 6 percent annual interest rate. The business earns a profit on its assets of 10 percent per year. At the end of one year, Thorpe liquidates all assets at book value and closes the business. What rate of return did he earn on this investment during this year of operations? Ignore income taxes.
- 10 percent
- 14 percent
- 15 percent
- 26 percent
The correct answer is choice d: 26 percent.
The business is heavily debt financed; 80 percent of assets came from debt. Assets of $500,000 earn a profit of 10 percent, or $50,000. Interest cost is only $24,000 ($400,000 × 6 percent). The profit is $26,000 ($50,000 less $24,000). A profit of $26,000 is earned from the owner’s investment of $100,000, a return of 26 percent in one year. A profit of 10 percent was made from borrowed funds that cost 6 percent to obtain. The residual profit goes to the owners. This is financial leverage.
Raising Funds by Issuing Notes and Bonds
Question: Long-term financing typically comes from the issuance of notes or bonds. What are notes and bonds and how do they differ from each other?
Answer: Both notes and bonds are written contracts (often referred to as indentures) that specify the payment of designated amounts of cash by the debtor on stated dates. The two terms have become somewhat interchangeable over the years and clear distinctions are not likely to be found in practice.
- In this textbook, for convenience, the term “note” is used when a contract is negotiated directly between two parties. For example, assume officials from Jones Company go to City Street Bank and borrow $1.2 million to construct a new warehouse. The contract between these parties to establish the specific requirements of this loan agreement will be referred to as a note.
- The term “bond” will be used to describe a contract or group of contracts created by a debtor and then issued for money, often to members of the general public. Jones Company could opt to raise the $1.2 million needed for its new warehouse by printing 1,200 $1,000 bonds that it then sells to a wide array of creditors around the world. Such bonds are prepared in a wide variety of denominations.
Typically, the issuance of debt to multiple parties enables a company to raise extremely large amounts of money. A news story from the end of 2010 confirms the magnitude of these transactions: “Corporate bond sales worldwide topped $3 trillion for a second straight year.”Tim Catts and Sapna Maheshwari, “GE Leads $3.19 Trillion in Corporate Bond Sales: Credit Markets,” December 30, 2010, http://www.bloomberg.com/news/2010-12-30/ge-leads-3-trillion-in-company-bond-sales-as-yields-fall-credit-markets.html. If securities are being issued to the public in this way, the legal rules and regulations of the U.S. Securities and Exchange Commission must be followed, which adds another layer of cost to the raising of funds.
Most companies have a periodic need to raise money for operations and capital improvements. Debt financing is common for this purpose, although it leads to an interest charge and increased risk, even the possibility of bankruptcy. The cost of debt is offset somewhat because interest expense is tax deductible. Incurring liabilities also allows a business to use financial leverage to boost reported profits but only if the proceeds received generate more income than the cost of the related interest. Notes and bonds are debt contracts that spell out the specific legal rights and responsibilities of both parties. In this textbook, notes will indicate that loans have been negotiated between two parties whereas bonds will refer to debt instruments that are issued, often to the public.