Debt wins, why?

How does a company realize what is good for their company? Financing through debt or through equity?

As we all know, debt is always cheaper and also riskier because through debt financing, the debt interested is deductible. Also, through debt financing, however, if you hold a lot of debt, you will be seen as a risky company, showing investors that if you have problems regarding your cash flows, you will have trouble paying back the loan.

Financing through equity, on the other hand, has a major advantage which a company do not need to repay the money that investors have invested in the company, but, of course in investors' point of view, they hope to regain their investment through future profits from the company.

Weighted average cost of capital (WACC), can be difficult to calculate because it considers both cost of debt and cost of equity. While cost of debt is easier to be calculated, cost of equity is a harder way to calculate because it has various forms of calculating where different company will use different methods to calculate it.  Companies can either use capital asset pricing model, dividend growth model or bond yield plus risk premium method to calculate cost of equity. The main problem of calculating cost of equity is that there are at least one component in these formula which is an estimate, hence, giving a different result of estimates of cost of equity which is not accurate.  

Question is, are these businesses confident that their cost of capital estimates are correct on their decision on strategic investments? A survey was generated from 424 responses back in 2013 and the response was, many were not confident with their cost of capital estimates which can define the future of their company.  

Why weren't those businesses confident? 

• Small fluctuations in the cost of capital actually affect the discounted cash flow and strategic decision of the future investments and acquisitions.
• Weighted average cost of capital were not used by businesses to be calculated.
• Many organisations are using cap or floor on the risk-free rate 
• Many organisations prefer to use Capital Asset Pricing Model (CAPM) to estimate cost of equity.

In the context of Modigliani and Miller (M&M) in 1958, they argued that capital structure has no impact on WACC because they assumed that there are no transaction costs, no taxation and have perfect capital markets.  But in the real world, these are impossible.  

However, many financial managers have used WACC in decision making because it lowers the cost of equity by lowering the beta of the company, thus, increasing shareholder value.  Besides that, by lowering cost of debt, it lowers the gearing level to avoid financial distress.  Also, by issuing bond, companies are exempted from tax interest because it is deductible. And finally, increasing optimal leverage by lowering credit spreads and cost of equity, resulting an increase in relative tax shield. An increase in leverage increases shareholder values.

We all love money, don't we?

The Love of Money

Lehman Brothers' was one of the largest investment banks in the United States.  The investment bank filed for bankruptcy in year 2008 as the former CEO of the company, known as Dick Fuld, had thrown a large amount of borrowed loans into investments such as housing-related assets, making it at risk to a downturn in the market.

Lehman Brothers collapse due to rushing into subprime mortgage market while the U.S housing market fall tremendously. The subprime mortgage crisis happened in the year 2007 to year 2009. The crisis was triggered by a large decline in housing prices which led to mortgage error and the devaluation of housing-related securities.  However, during the housing boom in the U.S. in year 2003, Lehman acquired 5 mortgage lenders, including subprime lender.  Lehman definitely made a huge profit out of this as the housing value was at an inclined rate at that moment.

As Lehman continued to borrow more money, Lehman is left with small amount of capital as to the amount that they owed which was at a ratio of 20:1.  Lehman used borrowed money to play with the property market. It is true that they were earning from it, but as the housing market fall, they made losses.  So, is it true that Dick Fuld was too greedy for his own good at that moment?

As for the Federal Reserve, Hank Paulson as the U.S. Secretary of the Treasury, made it clear that the government is not going to bailout Lehman.  Is it true that there was nothing the Fed could have done to bailout Lehman, or if there was, did the Fed make the right decision for not bailing Lehman out? It could be a lesson to large investment banks or companies that no matter how big of a company you are, you will still fail, without the help of other banks or government.

Merrill Lynch, on the other hand, made a great deal by cutting off a deal with Bank of America, which led Lehman Brothers being unable to fund themselves.

We all love money, don't we? Any financial intermediaries/institutions are bound to take on higher risk as all they care about is gaining profits.  As they may say it is to increase shareholder value, but in my opinion, they are just gambling with the public's money, to increase net income.  As at the end of the documentary, the attorney of Lehman Brothers said "you don't finance long-term investment with short-term money," which is really true, because what comes out of it was the collapse of Lehman Brothers.