It has long been argued that “judicious” use of debt increases firm value and, therefore, shareholder wealth. The widely accepted view of capital structure is that there exists some optimal range of debt levels that maximizes shareholder wealth.
However, a recent study by the authors does not support this view. Our results suggest that, within a large sample of firms over an extended period of time, firms with a lower percentage of debt have higher value. This implies that firms should reevaluate their use of debt.
Justifications for Debt
Several reasons typically are given for using debt. First, issuing new stock to meet financing needs can be costly, diluting the future earnings of the existing shareholders. It may also reduce management’s control. Given the conventional wisdom that firms should finance first with a combination of retained earnings and debt, and only under certain conditions with newly-issued equity, equity financing may send a negative signal to the market.
Second, optimal capital structure theory assumes that firms are valued in a world where all parties have the same information. This assumption may not hold at least part of the time. Managers should understand the companies they manage and their competitive environment better than anyone else. Institutional investors, who spend time and money obtaining information about companies, may come close to the managerial level of knowledge. Managers trying to maximize value for current stockholders, including themselves, may be reticent to issue additional stock if the prospects for the firm are good. They may prefer to finance with debt and reserve the future benefits for the current stockholders.
Third, the tax-deductibility of the interest paid on debt increases cash flow and makes debt a valuable financing tool. However, at some point debt will reach a level where the costs associated with financial distress will outweigh the tax benefits and adding more debt will decrease firm value. Financial distress includes all of the costs (both direct and indirect) associated with debt, up to, and including, bankruptcy. Unfortunately, the costs of financial distress are difficult to measure, so the optimal level of debt is difficult to determine.
Together all of these generally-accepted theories would argue that the financial manager, whose primary goal is to increase shareholder wealth, would want to keep debt as a part of the capital structure.
An Empirical Check on These Theories
Legitimate strategic and economic uses for debt do exist. However, a recent study conducted by the authors using data that cover a period of nine years (1987 – 1995) suggests that, in general, higher levels of debt are correlated with lower firm performance.
The data for the study were obtained primarily from Securities and Exchange Commission filings. In all, 11,379 observations were evaluated. Eleven industries, with each industry group including at least 500 companies, were represented. (Readers interested in the complete presentation of the data and statistical analysis may refer to a working paper by the authors.)
The relationship between three measures of debt (All Debt, Current Debt, and Long-term Debt) and six performance measures (firm value, earnings, cash flow, liquidity, institutional ownership, and managerial ownership) was examined. The study statistically controlled for the impact of factors such as type of industry, market and economic conditions, the riskiness of the firm, and firm size. In addition, the level of dividends paid by the firm and measures of the degree to which the firms made tax a tool, including the aggressive use of tax management programs and the amount of depreciation available as a tax shelter, were included. Finally, the relative percentage of the firm owned by institutional investors and by management was investigated to ascertain whether those with an information advantage had a higher stake in companies with higher debt levels.
If debt is desirable, then total firm value (measured as liabilities plus the market value of equity divided by total assets) should be higher in firms with more debt relative to their size. Instead, this study found that firm value is inversely related to the percentage of debt for all three debt measures. More specifically, firms with more total liabilities relative to their size had lower market values, cash flows, liquidity, and a lower fraction of institutional ownership. Using current debt as the measure of indebtedness, the same results were found, and additionally, current debt was negatively correlated with earnings. Firm value was also negatively correlated at a statistically-significant level when long-term debt was used as the measure of indebtedness. The other variables, however, did not meet the same level of significance, except for earnings. Earnings were positively correlated to long-term debt, the only positive relationship to emerge.
Higher debt level should be related to a higher level of managerial ownership if debt is used to help managers retain control. Yet the evidence shows no significant difference in managerial ownership based on the percentage of debt in the capital structure. Likewise, if knowledgeable investors prefer debt, we would expect to see institutional investors move toward firms with higher levels of debt. However, we see no such evidence. In fact, the level of institutional ownership is inversely related to total liabilities. Finally, if debt lowers taxes, then after-tax income should be higher in firms with more debt. Support for this supposition does exist, with the exception of long-term debt.
The costs of debt are also apparent in this analysis. Lower market valuation of free cash flow is associated with higher levels of debt. Since some would argue that free cash flows are a major component in valuing companies, wealth-maximizing managers should avoid any action which reduces the value the market places on them.
The research shows that firms with higher debt levels also have lower levels of liquidity. Firms often use long-term debt to finance long-term assets. However, the interest payable and any necessary sinking fund payments are current liabilities. The reduction in liquidity caused by the extra current obligation is a cost of debt.
Implications for Managers
Overall, these results demonstrate an inverse correlation between debt and firm performance. What does this say to managers? We believe that it says that if you can operate your business effectively without going into debt, do so. Avoid debt.
This may be particularly relevant today. Currently, the premium for debt (the difference between the prime rate and the rate of inflation) is close to its historic high. The prime rate has been insensitive to the decline in inflation thus far. While the current inflation rate is less than 2%, the prime rate remained at 8.5% until the first of October, when it dropped by a quarter of a point. This 6.5% differential is very high by historical standards, even factoring in the cut to 8.25%. (See Figure 1.) One would hypothesize that the negative aspects of debt noted earlier would be exacerbated by the high current interest premium over inflation.
Finally, our work suggests that there is a premium for firms that have less debt. They are valued more highly. If the goal is to maximize firm value, it would appear that one way to do this is to minimize debt. The optimal capital structure may be very close to zero-debt.