Despite the several disadvantages to debt compared to equity, some managers still use more debt (although debt issues/usage varies according to the industry firm operates) in their capital structure for various reasons.  Firstly, some managers seem to capitalize on the tax-shield benefits of debt to increase firm value. Secondly, managers know that when additional capital is needed to finance profitable investments, raising debt is less complicated compared to equity. Third, managers know that interests on debt (except for variable debt loans) are known amounts which can be forecasted and plan for.  Therefore, managers can use debt to increase firm value, especially during economic boom period. As long as managers avoid excessive debt (considering their level of fixed assets, cash flow, size, etc.); they may benefits from using debt financing.                      

However, equity has its own several advantages over debt as well. It is not surprising that some researchers found that there are some firms using zero debt level in their capital structure.

I can see its almost not possible to find a universal reason behind such a financing behaviour Dr /or Prof or/ Mr Matemilola due to unique firm conditions as your answer suggest. Yes, its true that managers can use debt to increase firm value particularly in periods of economic boom taking into account prevailing levels of fixed assets, cash flow, size, etc.. I further suspect its also true that such a financing behavior may be driven by the need to align shareholders main objective with their responsibilities by virtue of the disciplining role that debt plays  in excessive owners discretionary power over free cash flows utilization on perk investment projects. But what if known future or fixed debt level is likely to impose treats of missing out on profitable investment opportunities due to large periodic debt commitment diverted at the expense of profitable opportunities? Collecting from you answer, I can see the reasons behind such financing behaviour could be vested in lucrative firm tax status, value of intangible and tangible assets and so on. I have gained so much insights from your answer. Thank you a lot Mr/or Dr/or Prof Matemilola. Thank you

Despite some theorems about Debt/Equity equivalence in the theory of a firm, real markets are often imperfect and thus difference exists. For example, asymmetric information already gives several reasons to choose debt or equity in certain conditions. Here are some examples.

If I am a manager of good firm but nobody knows that it is good, credit can be received only at too high interest rate that includes perceived risk premium. So if our team is future "Apple", it would be better to issue shares and to distribute them among friends.

Sometimes credit may be cheap. So why not to get it? It may be less costly for a good firm than to sell shares.

If a firm with good reputation soon will become bad (but only manager knows it), why not to sell shares (before they decline) instead of debt increase (and having a difficulty to repay it in future)?

Three issues for your consideration come to mind regarding choosing debt over equity. All conditions being equal, here are the three issues:

First, cost of equity is more expensive than cost of debt. Secondly, potential positive influence upon improvement of rating agency creditworthiness and relationship development. Finally, debt provides the capital structure more flexibility through various shelf registrations and issuances. For example, a medium term note shelf registration provides flexibility for future pricing issuances reflecting varying maturities, terms, and conditions which ultimately, provides more predictable and flexible cash flows. Some thoughts for consideration. Great questions and thank you for affording the opportunity to have a discussion.

Yes, i  agree with you 400% Prof Yegorov , capital markets are rarely perfect. Drawing from your argument, its welcoming for me to suggest that in developing capital markets ,particularly those in Africa,Malaysia,India and Brazil, transaction costs are likely to be very high depending on daily market liquidity. Therefore i guess continued damaging debt issues in such conditions is likely to invoke criticism to managers despite containable debt risk aversion of over equity depending on stock market daily turnovers in such markets . Of course the advantage of perceived debt flexibility with relatively  containable volatility and the  predictable nature of future debt commitments and firm cash flows as compared to stocks susceptible to shocks could be at the center of such a debt puzzle .Perhaps the perceived future value of such debt issues on a long term horizon outweigh proportionate disadvantage imposed by debt issues over equity  in the short term horizon. Thus the quality of debt market could not be overlooked in such dilemmas as debt tend to be relatively expensive IN emerging markets compared to developed capital markets such as the U.S. Thank you Prof Bauer. Your point  deserves  vigorous future investigations.Little has been said of it. But all these possibilities may trigger different financing behaviors in different context for correct and incorrect decisions in some cases. I have learnt so much from your suggested solutions guys,thank you a lot!

Debt is by and large much cheaper than equity. This more than compensates for the small probability that debt can lead to difficulties; the probability is indeed small if the business and management are good. 

It is obvious fact that there are mainly two reasons: one is that tax benefits of debt capital and the other is sharing corporate capital through debt issues mitigates financial risk. Damaging effect on firm value could be rarely as there are some bad corporate decisions. There are a number of research papers on this.   

I am taking home a lot  from your excellent contributions Gurbachan and Weerakoon . I agree with you Gurbachan,leverage is often cheaper than equity. And of course Weerakoon ,tax benefits of debt capital plays a very crucial role.However, realization of these tax shield is dependent  in a lot of factors making it a little a unrealistic for the real world practical firm despite several claims by the literature.To mention just a few ,in declining profits,  high growth opportunities and low asset collateral mangers do not want to miss out on profitable investment projects on the back of suppressed cash flow bank due to ongoing periodic debt repayments .It is these imperfections that tend to undermine potential capitalization of substantial  tax shield .

Managers are often at odds to a degree, with the owners.  Owners want ROI.  Managers want a good paying stable job

A firm's leverage level is also based on the relevant regulation and availability of the capitals.

In additon, the purpose of raising new capital and the potential risk/return of the new project will matter.

The cost of debt issue is cheaper when compared to equity issue. Also it is easier to raise a debenture especially with the emergence of Over-the-counter exchange than list your shares on the stock exchange.

Like most things in life; there is always a trade-off. On average, debt is cheaper than equity. However, if debt is "too high" cost of distress and or bankruptcy becomes high. This is why the issue of determining the optimal ratio is always important. There is no simple equation to determine such a ratio for any company. However, based on analysis of firms, we know what impacts their ratios. Rely on such "coefficients" to determine the ratio of your firm.

Preference differ from sector to sector, as for the IT sector there consist low debt component and for Power this component is high.This depends on the investment required. The main objective of organisation is to increase shareholder profit and to do so they prefer more debt as the return from the market is expected to be higher than interest to be paid on debt component. 

Dear Sandile Jabulane Magagula

Greetings,

I think it depend on the financial position of firms , such as  what is the percentage of debt and equity as mixed of capital structure ? , what is the picture of firm in the market , or compare with competitor and suppliers  , so if the cost of debt is low so may be prefer and if the conditions to have debt is more easier so also may be prefer .

Best Regards, 

Hi,

You may have a look at this paper:

Equity Raising by Asian Firms: Choosing Between PIPEs and SEOs

Original Research Article

In Press, Journal of Corporate Finance April 2017 forthcoming

Sandeep Dahiya, Leora Klapper, Harini Parthasarathy, Dorothe Singer

Best regards

I thank you many-fold Mr Navatte,you ve been a great help.

With a year passing from the last comment on this issue, question is, “what is the level of volatility in emerging markets over the last year vis-a-vis US money and capital markets?”

Interesting..