How Does Debt Increase a Firm's Value?
It is intuitive that a firm should decrease in value if it incurs additional debt. While this might seem sensible, the opposite is true; a firm will actually increase in value if it takes on additional debt. This is demonstrated by the Modigliani-Miller theorem which earned its creators the 1985 Nobel Prize in Economics.
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Capital Structure
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The capital structure of the firm is its composition of its financing. A firm can be funded from two sources: debt--meaning money that the firm borrows--or equity--meaning investments from shareholders. The capital structure of the firm is the ratio of debt to equity in a firm.
Without Taxes, Structure is Irrelevant
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The Modigliani-Miller theorem asserts that in a world without taxes it does not matter whether a firm is structured with debts, equity or a certain combination of the two. This is because the value of the firm is unaffected by capital structure in a world without taxes. This is because the cost of capital is the same for either debt or equity.
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With Taxes, Debt Creates Value
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In the real world, corporations must pay taxes. Consequently the capital structure of a firm is important. This is because debt is tax-deductible. This means that a firm that is financed with debt will have greater tax savings than a firm that is financed with equity. As a result, increasing debt will actually increase firm value.
Limitations
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In theory it would seem that the ideal capital structure for a firm would be 100 percent debt and no equity. In reality this is not the case because an increase in debt will also increase risk. This is because operating with a high level of debt and a low level of equity reduces the liquidity of a firm, meaning that it is more difficult for the firm to pay its debts in the event of unforeseen circumstances.
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References
- Photo Credit to have money to burn image by Andrey Andreev from Fotolia.com
