Like most important aspects of treasury, corporate debt has its benefits and drawbacks. The main benefit is saving tax. The main drawback is added risk for all the company’s stakeholders.
Corporate value is optimised when these offsetting factors are appropriately balanced. Finding this balance is a fundamentally important challenge for companies and corporate treasurers.
Many companies are financed by debt as well as equity. Interest and related costs will normally be tax-deductible, while equity dividends are not.
All other things being equal, debt-financed companies normally pay less tax than all equity-financed ones. This is because taxable profits are sheltered, or ‘shielded’, by tax-deductible interest and related costs.
Let’s say we are a profitable non-financial company, paying corporation tax at 19%. All of our debt interest is tax-deductible. This means every £10m of debt interest reduces our taxable profits by £10m.
The saving in tax is £10m x 19% = £1.9m. When our tax bill falls by £1.9m, cash flows available for our investors rise by £1.9m. This gain for investors is known as a ‘tax shield’.
The essential difference between debt and equity is that debt repayments are mandatory. Any failures by a debt issuer can potentially lead to corporate insolvency. Carillion and many other corporate failures have been triggered by the risks of too much debt.
The costs of excessive debt are sometimes known as ‘financial distress costs’ or ‘bankruptcy costs’. They increase sharply as debt levels increase.
Equity dividends, on the other hand, are discretionary. Under financial stress, companies can cut or skip equity dividends (though they aim to avoid doing so in practice). This is why equity is lower risk for issuers.
An appropriate level of debt depends on the stability of our profits and cash flows, our risk appetite and any tax or other regulation. In practice, companies may target a particular credit rating or other financial measure, or a tax limit.
Before borrowing, we need to assure ourselves that we can service all our company’s debt safely, even under any future financial stress. Then we must provide our investors and the markets with the right information in the right way, so they can be confident about this, too.
Our investors’ risk profile is the other way round. Debt transfers risk from the investor to the issuer. So debt investments are lower risk for investors, and equity is higher risk for the investor.
Treasury learning reduces risk for your organisation and enhances investors’ confidence. ACT qualifications equip you with knowledge and tactical ‘hands-on’ skills. Click here for further details.
As a qualified treasurer, you will play a key role in debt investor relations (IR) in particular. Deepen your understanding of debt IR by taking a look at this page of the Treasurer's Wiki.
A few thoughts from Funding and Risk Management Solutions specialist James Lockyer ACA FCT…
If investor confidence is lost, all is lost. In my experience, many finance managers know astonishingly little about investors’ legitimate expectations.
Without treasury training or experience, they often haven’t the foggiest notion of how investors look at the company. Nor how to present financial information in a way that informs and inspires the potential investor.
Gain practical skills to support every level of your career. Click here for details.
Doug Williamson FCT is a treasury and finance coach
This article was taken from the December 2018/January 2019 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership