This paper seeks to enquire how far the title of this essay "In today's economic climate, any company that hasn't borrowed as much as it can is crazy" is relevant within the context of corporate finance principles. That is, when business opportunities abound, is it wise on the part of the firms to watch as silent spectators without grabbing them and execute them by means of borrowed capital. The title raises two hypotheses, debt is preferred to equity and in spite of sufficient equity available, a company should borrow maximum possible in the pretext of the resultant economic climate of liberal consumption.
Firms should invest money only if the project earns more than the hurdle rate which is generally higher in projects with high risks and investment pattern will be reflected in the ratio of financing mix of equity and debt. Cash flows and their timing determine rate of return on projects. If there are no profitable investments available, the stock holders' funds must be returned to them. Objective behind these principles is maximising the value of the firm as per the traditional theory of corporate finance. ...
Borrowing facilitates availing of tax benefit and it is higher in case of higher tax rate. It creates a disciplining environment by which greater separation between management and stock holder is achieved which is a greater benefit as per the principles of corporate governance. Disadvantages are firms are exposed to bankruptcy cost due to higher business risk, agency cost due to greater separation stock holders and lenders and financing flexibility for the future is lost because of greater uncertainty regarding future financing requirements. A debt carries with it a commitment to make future payments which are tax deductible and future defaults in payments can result in loss of control to the lenders. In a hypothetical situation of no taxes (tax free), no separation between managers and stockholders, no default probability, and presence of certainty in future funds requirements, default risk, agency cost and capital structure become irrelevant and firm value is divested of its debt ratio as posited by the Miller-Modigliani theorem. According to this theorem, firm value will be decided by cash flows and there will be no question of leverage. (Damodaran)
In the present economic scenario of mergers and acquisitions for bailing out weak firms or as an exercise of creating a competitive advantage, companies require large volume of funds and committed bank facilities are useful in financing their real options to carry out M & A transactions. In 2000, Bank of America advanced bridge loan to Club Corp for debt acquisition as part of M & A exercise. Similarly Bank of America provided Ferrellgas a bridge loan of $ 175 million to carry out acquisition of Thermogas. (Patrick C 2000)
This is the ratio of