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24 February 2024

How debt is good for financial health

By Agencies
To many laymen, "debt" is a dirty word, and plenty of companies have indeed been dragged under by shouldering too much. But academics and other experts have long believed the opposite is true: Many companies take on too little debt, failing to fully exploit benefits like the tax deductions on interest payments.

Now, a new study by three Wharton faculty members shows companies are not, in fact, foolishly leaving tax deductions on the table. The findings, based on data compiled from thousands of firms between 1980 and 1994, should be especially valuable to outsiders – such as lenders, analysts, institutional investors and shareholders – trying to judge the wisdom of a firm's use of debt.

Previous studies have shown that many nonfinancial firms "are too conservative in their debt policies, meaning they could increase their debt levels to reap substantial tax benefits without significantly increasing the risk to their financial health", said Wayne R Guay, an accounting professor at Wharton.

"Our paper shows that previous research substantially overstates the tax benefits that some firms could achieve by increasing their debt levels," Guay said. "Our results also suggest that most corporations appear to adopt debt policies that efficiently trade off the tax benefits (of debt) with the risks to financial health."

Companies have various ways to raise money, but the most prominent are borrowing through the issue of corporate bonds or raising equity by selling new shares of stock. By selling new shares, a company avoids taking on a debt that must be repaid with interest. But increasing the number of shares dilutes the value of those already in circulation, so shareholders often oppose this approach. Debt does not dilute shareholder value, but payments to debt holders can become a fatal burden if revenues fall short.

Often, the company's choice comes down to federal tax issues: Interest on debt payments is tax deductible, while dividends paid to shareholders are not. For a company with no debt, the final dollar of earnings might shrink to only 65 cents once the corporate tax is paid. But if the company has a healthy dose of interest deductions from debt, that dollar may still be worth a dollar after tax time.

For decades, the academic literature and marketplace have clung to a belief that many companies fail to take full advantage of debt, which, in addition to tax deductions, can increase profits by enlarging a company's bets. Investing a dollar at a 10 per cent return produces a 10-cent profit. By borrowing an additional dollar and paying five per cent interest on the loan, the profit can be boosted to 15 cents, up 50 per cent. This process was behind the leveraged buy-out craze of the 1980s. Today, private equity firms use the same logic, Guay said.

"A major strategic objective of private equity firms is to buy under-leveraged companies and then leverage them up to gain the tax advantages," he noted. But this view may be mistaken. "With our research, what we feel comfortable saying is that the tax benefits of debt have been grossly overestimated in many cases."

Previous research exaggerated the benefits of debt because it underestimated the volatility of cash flows and earnings, according to Guay. He and his fellow researchers zeroed in on that factor, he added, noting that a company's borrowing issues are similar to a homeowner's. The home buyer who pays cash makes 10 per cent if the home's value rises 10 per cent, and loses 10 per cent if the value falls by that amount. But if the homeowner puts only 10 per cent down and borrows the rest, a 10 per cent gain in price means a 100 per cent gain in equity, and a 10 per cent decline means a 100 percent loss.

Previous studies have assessed volatility by looking at historical data. But they generally measured ups and downs in dollars, because tax issues, such as progressive tax rates, are determined by thresholds measured in actual earnings rather than percentage returns. This approach to volatility can distort the picture, since a given dollar amount is less and less significant as a company grows over the decades, Guay said. He and his colleagues got a different view by, essentially, looking at volatility in percentage terms, showing that companies with lots of leverage were more volatile.

In years when income is low, the tax benefits from interest payments are smaller since the company's tax rate will be lower. But even if the company loses money, the interest-rate deductions have value, since they deepen losses that can be carried forward and used to reduce taxable income in subsequent years. Better understanding of the volatility of future earnings makes it easier to see how well a future tax deduction will pay off.

Guay's co-author Jennifer Blouin cited the example of a start-up firm that has lots of debt and little or no revenue, meaning there is no taxable income. "They are generating interest deductions that don't do them any good today," she said. Previous research has underestimated the probability the firm will have losses in the future, she added. That makes the interest deduction carried forward seem more valuable than it may actually be, because it overstates the taxable income that the deduction can be used to reduce.

For a clearer view of this, she and her colleagues grouped similar firms together in their analysis. Like individual tax rates, corporate tax rates are on a progressive scale, with the rate rising as income goes up. Interest deductions have the most value when they reduce the income subject to the highest tax rate the firm pays. If the deduction is so big as to cut income to a level taxed at a lower rate, the deduction has less value. A deduction applied against income taxed at 35 per cent, for example, would save the company 35 cents on every dollar of income, while a deduction against income in the 25 per cent bracket would save just 25 cents. The researchers identified the point at which the deduction started to lose value – the "kink". They found that the firms they studied typically had just the right amount of debt to get the most out of their interest-rate deductions, while previous research that did not look as closely at income volatility had shown firms needed to more than double their debt loads to maximise their interest deductions.