debt

Examples of debt in the following topics:

• Total Debt to Total Assets

  • The debt ratio is expressed as Total debt / Total assets.
  • Debt ratios measure the firm's ability to repay long-term debt.
  • The debt/asset ratio shows the proportion of a company's assets which are financed through debt.
  • If the ratio is greater than 0.5, most of the company's assets are financed through debt.
  • A company with a high debt ratio (highly leveraged) could be in danger if creditors start to demand repayment of debt.

• Debt to Equity

  • The debt-to-equity ratio (D/E) indicates the relative proportion of shareholder's equity and debt used to finance a company's assets.
  • The formula of debt/equity ratio: D/E = Debt (liabilities) / equity.
  • A similar ratio is the ratio of debt-to-capital (D/C), where capital is the sum of debt and equity:D/C = total liabilities / total capital = debt / (debt + equity)
  • The debt-to-total assets (D/A) is defined asD/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)
  • Debt to equity can also be reformulated in terms of assets or debt: D/E = D /(A – D) = (A – E) / E

• Striking Agreements to Avoid Bankruptcy

  • In general, creditors understand that bankruptcy is an option for debtors with excessive debt.
  • A debt restructuring is usually less expensive than bankruptcy.
  • Debt restructurings typically involve a reduction of debt and an extension of payment terms.
  • A debtor and creditor could also agree to a debt-for-equity swap, wherein a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company.
  • This simplifies the debtor's obligations and can result in faster debt repayment.

• Types of Private Financing Deals: Going Private and Leveraged Buyouts

  • LBOs use debt to secure an acquisition and the acquired assets service the debt.
  • As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with the increasing debt.
  • In turn, this then led to insolvency or to debt-to-equity swaps, in which the equity owners lose control over the business and the debt providers assume the equity.
  • Senior debt: This debt is secured with the assets of the target company and has the lowest interest margin
  • Junior debt: This debt usually has no securities and bears a higher interest margin

• Trade-Off Consideration

  • It states that there is an advantage to financing with debt—the tax benefits of debt, and there is a cost of financing with debt—the cost of financial distress including bankruptcy.
  • The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases.
  • Of course, using equity is initially more expensive than debt because it is ineligible for the same tax savings, but becomes more favorable in comparison to higher levels of debt because it does not carry the same financial risk.
  • Therefore, one would think that firms would use much more debt than they do in reality.
  • Describe the balancing act between debt and equity for a company as described by the "trade-off" theory

• The Cost of Debt

  • Since in most cases debt expense is tax deductible, the cost of debt is computed as an after-tax cost to make it comparable with the cost of equity.
  • Thus, for profitable firms, debt is discounted by the tax rate .
  • The cost of debt can also be calculated by dividing the annual interest payment of the debt by its market value.
  • Cost of debt is equal to the annual interest payment of the debt divided by its market value.
  • Cost of debt equals the interest rate of the debt (composed of the risk-free rate and a credit risk premium) times one, minus the corporate tax rate.

• Debt

  • Debt is usually granted with expected repayment.
  • This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment--the more debt per equity, the riskier.
  • A company uses various kinds of debt to finance its operations.
  • The various types of debt can generally be categorized into:
  • Treasury bills are one kind of debt issued by the U.S.

• Deciding to Refund Bonds

  • Refunding occurs when an entity that has issued callable bonds calls those debt securities to issue new debt at a lower coupon rate.
  • Refunding occurs when an entity that has issued callable bonds calls those debt securities from the debt holders with the express purpose of reissuing new debt at a lower coupon rate.
  • In essence, the issue of new, lower-interest debt allows the company to prematurely refund the older, higher-interest debt.
  • The decision of whether to refund a particular debt issue is usually based on a capital budgeting (present value) analysis.

• Problems with WACC

  • The primary variables to be determined in order to calculate weighted average cost of capital are the relative debt and equity values, the cost of debt, and the cost of equity.
  • While the relative debt and equity values can be easily determined, calculating the costs of debt and equity can be problematic.
  • To calculate cost of debt, we add a default premium to the risk-free rate.
  • It will rise as the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises) .
  • These terms may not always adequately match the term of our company's debt.

• Tax Considerations

  • Taxation implications which change when using equity or debt for financing play a major role in deciding how the firm will finance assets.
  • When the theory is extended to include taxes and risky debt, things change.
  • Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases.
  • There is much debate over how changing corporate tax rates would affect debt usage in capital structure.
  • That is why, while many believe that taxes don't really affect the amount of debt used, they actually do.