Question

24. Robyn Manning is the CFO of Tectronics International, a young financial software platform firm. Ms. Manning is considering several projects in newly opening markets in Western Africa. She believes that her firm should take advantage of the current low interest rates before the Federal Reserve starts increasing rates. Thus, she would like to increase the debt-equity ratio of the firm but is concerned about the consequences of increasing leverage. Knowing that you have recently taken a class in corporate finance, Ms. Miller has come to you for advice and a quick refresher in capital structure theory. What would you tell her?

Answer 1

Since she is planning to increase her debt-equity ratio, the advice would be:

Higher debt results in higher financial leverage causing the firm to be perceived as more risky (especially during a downturn in the business cycle). Further, debt holders have to be paid interest costs that fall due irrespective of whether the firm makes profits or losses. Since she is planning to enter new markets, there is a high probability that the firm wouldn't be profitable in the first few years. Consequently, despite current low interest rates in the US, higher fixed financing costs towards servicing debt may weaken the balance sheet.

That said, if the firm is/remains profitable, debt financing (as compared to equity financing) increases the earnings per share (EPS) for stockholders, which may have a positive impact on the stock price.

Lastly, the type of debt assumed (whether term loan or bonds) also plays an important role in determining the liquidity position of the firm going forward.

A term loan is an amortizing loan where both principal & interest has to be paid periodically (usually annually), whereas in the case of bonds only interest is paid periodically with the entire principal due as a lumpsum amount on maturity.

Hope this helps!