How Much Debt is Enough
We struggle with debt. We don’t like it, but it allows the firm to grow more deliberately and quickly. The drawback is the increased probability of financial distress with increasing levels of borrowing.
The interest on debt is an expense of the firm, and as a tax shield, interest has incremental value over equity financing on a risk adjusted basis. Thus, the greater the levels of debt, the greater the value of the firm. Also, higher income tax rates lead to greater value for greater debt levels (vis a vis equity).
How much debt is too much debt? At the point the tax shielding benefits of interest on debt are offset by the probability adjusted present value of financial distress costs, the debt levels have reached maximum benefit to the value of the firm.
Debt levels matter — both good and bad.
Posted on Fri, April 23, 2010
by Timothy E. Moffit