(a)
The two articles “Debt is Good for You" and “Debtors’ Prison" explore the use of debt financing by corporations and contrast it to equity financing, as well as investigate the implications of excess borrowing.
“Debt is Good for You" discusses debt and equity financing by providing a brief overview of the scientific research in this area. It uses the paper by Modigliani and Miller, who claimed that the proportions of equity and debt have no effect on the firm’s value, as a reference point for further discussion and shows the evolution of the theory related to company financing. In particular, the authors introduce the “trade-off theory”, which considers the effect of the risk related to the nature of the evaluated business on the financing options of a company. While this theory reflects the complexity of choosing the right financing method better than that of Modigliani-Miller, it does not provide a direct mechanism for deciding on the best financing option.
Some people believe that target credit rating helps companies to determine the optimal level of debt financing, however Stephen Kealhofer in his research denies targeting behavior among firms. Instead, he suggests “the pecking-order theory”, which explains the reluctance of companies to use equity financing through the information asymmetry between managers and external shareholders. However, the abovementioned theories do not allow evaluating whether the level of debt should be higher or lower, that is why the article concludes by discussing Robert Merton’s contingent claims analysis, which suggests analyzing debtholders’ and shareholders’ claims on a firm using the option theory. This approach is helpful in evaluating company’s creditworthiness and allows estimating the probability of a firm to default by considering business volatility, the level of debt, as well as the equity price. While this theory is not very intuitive, it can nevertheless explain the situation in the corporate-bond market.
The article “Debtors' Prison” elaborates further on the practical issues related to the conclusions of Modigliani and Miller in relation to the irrelevance of the debt and equity proportions for the success and value of the company. The author(s) of this article complements the discussion by suggesting that debt was often preferred by the companies due to tax and operational advantages. However, one of the main drivers for choosing debt financing, according to the article, is self-interest. High growth based on debt financing usually yields higher remuneration for managers and enhances company’s external image, as well as generates fees for outside advisers.
Decades of overreliance on debt financing have led to the accumulation of excessive debt, in particular by private households, which is hard to manage in the times of economic turmoil and profit decline. Credit crunch and low trust of lending institutions combined with numerous defaults make it hard for companies to repay current debts by additional borrowing. In this situation equity financing is hardly a viable solution as well due to the low confidence of potential investors and low share prices.
The two articles “Debt is Good for You" and “Debtors’ Prison" discuss the theoretical framework as well as the issues related to capital structure decisions. They demonstrate the complexity of the financial system and the inability of any theory to give a comprehensive answer to the question of the optimal debt level. However, the vast number of factors that affect risk levels in the market indicates that Modigliani-Miller and Trade-off models tend to underestimate the potential hazards of debt financing. That is why financial managers should be more careful in choosing financing options and try to limit company’s level of borrowing even if debt helps to maximize short-term financial performance.
(b)
“The gods strike back” adds to the discussion of capital structures by explaining market mechanisms behind the events that eventually led to the economic turmoil in 2007-2009. Firstly, the article demonstrates that the current overreliance on mathematical models in predicting financial risks fosters riskier behaviour in the market. In the light of the recent events it has become clear that mathematical formulas cannot give a clear prediction of the risk level, therefore it is important to use judgement in evaluating the optimal level of debt in the capital structure.
Another reason for underestimating the level of risk in the market is information asymmetry. This fact contributed to the underestimation of the risk of the debt, thus suggesting that companies should borrow more than they would have done in case of full information disclosure.
The complexity of the financial system also creates additional risks for debt financing, which are usually not considered in the mathematical models used for risk evaluation. Thus, the pressure to perform better than competitors and to maximize value pushed banks to undertake riskier deals, thus accumulating additional risks. Moreover, cross-ownership and network systems among banks facilitated a “chain reaction”, which amplified problems of individual market players and transferred them to the partner institutions. Moreover, even diversification, the mechanism that is designed to reduce risk, has contributed to risk increase, since most organizations invested in the same type of securities. Hence, even a small distress in this area could have a detrimental effect on all the participants.
While the article discusses the macro view of the financial markets, it helps to understand better the complexity of capital structure decisions within companies. Hence, it leads to an important conclusion that the level of risk is often underestimated by the market and the perceived safety of debt financing is deceptive, thus making it more attractive than it actually is.
References
Debtors' prison. (2009, February 19). The Economist, Retrieved from
http://www.economist.com/node/13145730
Debt is good for you. (2001, January 25). The Economist, Retrieved from
http://www.economist.com/node/483923
The gods strike back. (2010, February 13). The Economist, 1-4.
