C8I 2001 Question

[Datatarium]

Can someone tell me how does issuing a lot of debt affect the ROE? The sample soln was able to come up with a numerical answer. I think that the ROE should not be affected. Issuing debt could decrease your cost of capital if you use the debt to purchase back the stocks. The objective is to earn more then your cost of capital but I don't think it is reflected in the ATStockEarning or GAAPEquity. Therefore I don't think the ROE should change. Can some one clear this up for me?

[mayreeh]

Atkinson and Dallas has an example on page 924 that backs this up. I can't find any formula in the book that addresses this, but the bottom line is that if you add debt, then you lower earnings by the cost of the debt and you decrease equity by the amount of the debt. Result, higher ROE.

The old course 220 had a book on corporate finance that covered three "levers" of the ROE - and debt was one of them. The more debt, the higher ROE. At least until you hit an unreasonable amount and you cease to be a good credit risk.

[Abducens]

>>Can someone tell me how does issuing a lot of debt affect the ROE?

I may be wrong but I am guessing that at the very least, the interest you have to pay on the debt reduces ROE.

[julieml]

Theoretically, you have to pay for capital of any kind, either through interest payments on Debt or dividends and higher required returns on equity. The real factor that causes debt to increase ROE (see Megginson's Corporate Finance Theory from course 8F material) is the tax deduction allowed on the debt interest payment. According to these theories, firm value rises as debt/equity rises, and before considering cost of bankruptcy, etc., the optimal debt/equity ratio is 100% debt.

[Dr T Non-Fan]

The implication is that you're expecting some kind of return to pay off the debt, or some kind of return above the ROE if issuing equity.

In other words, you're not just issuing debt and using the proceeds to stuff a pillow.

If I recall properly, and I seem to remember doing well on those parts of 220, the "Bridge Book" (so named because there was a picture of a bridge on the front) by Higgins noted that for financing projects with expected returns above current ROIC, issue debt; for those below, issue equity.

[Datatarium]

The real factor that causes debt to increase ROE (see Megginson's Corporate Finance Theory from course 8F material) is the tax deduction allowed on the debt interest payment.

Actually, I do remember reading that if a stand alone company issues debt it will be treated like a liability. But I sensed a negative connotation from it b/c it later recommended for a holding company to issue debt for the subsidiary and provide the subsidiary with capital by purchasing the subsidiary’s equity with the money raised from issuing debt. But why did they say to do that if debt increases GAAP ROE? Doesn’t the company want that? Anyone have any clue?

[julieml]

Now we're getting into the drawbacks of debt. Without the risk of bankruptcy, you want to borrow as much as possible (for the tax savings). When you consider the extra risk caused by extra leverage, you want to limit your amount of debt and strike a balance between debt and equity. As you borrow more (and risk not being able to pay it back), your cost of capital increases making debt less advantageous. Your cost of debt is a function of: the amount of debt you already have, the nature of your assets (liquid, tabgible, etc.), and the risk/volatility of your cash flows.

It's probable that the holding company has more stable earnings and can borrow debt at a lower cost. Therefore, it's best for the holding company to borrow and pass it on to the subsidiary.

They say you should borrow when you don't need the money, and avoid debt when you need it. (Funny, right). Anyway, I would imagine in the scenario you're referring to, the subsidiary needs the money and has too much earnings volatility (and not enough tangible assets) to borrow at a low cost.

[Datatarium]

Thanks julieml and everyone, it's all coming together now.

:)