What is the optimal
combination of debt and equity for financing an expansion project?
How does this decision relate to the initial financing structure of
the firm, prior to implementing the expansion project?
This topic has been
explored by Sudipto Sarkar in a recent article in the International
Review of Finance.
The author describes
first the arguments that guide the decision to finance through debt
or equity:
Tax advantage vs.
bankruptcy risk trade-off
From a shareholder
perspective, the advantage of a high portion of debt financing is
twofold. First, deducting interest from the firm's taxable income,
debt provides an important tax shield. Second, a high portion of debt
financing leads to a wealth transfer from debt-holders to
shareholders.
On the other hand, the
main backdrop of debt financing is that the post-expansion default
trigger will be higher, resulting in a higher probability of default
or earlier default and, thus, to higher expected bankruptcy costs.
As a consequence,
shareholders must make a trade-off between tax benefit and increased
bankruptcy risk and cost linked to debt financing.
Agency problem of debt
Debt
allows the transfer of wealth from debt-holders to shareholders.
Therefore, the agency incentive to use more debt to finance the
expansion increases with the initial debt level.
Thus, the agency effect works in the opposite direction to
the traditional trade-off theory, in which higher debt levels lead to
reduced debt usage for the expansion.
Sarkar’s major
findings
The major findings of
Sarkar’s quantitative analysis are fourfold:
- A high equity portion in the expansion financing package leads to under-investment whereas a high portion of debt in the package leads to over-investment.
- The higher the initial leverage ratio is, the lower is the debt component in the expansion financing package.
- The higher the project's volatility and the cost of implementing the project are, the higher is the debt component in the expansion financing package.
- Companies with large growth opportunities tend to use less debt and more equity to finance expansions.
The importance of
contractual covenants
In this context, Sarkar
refers to the importance of contractual covenants that (partially)
rule out future debt issues and, therefore, imply that the expansion
has to be financed predominantly with equity.
Contractual covenants
under LMA standard
I would like to take this
opportunity to briefly outline the major contractual covenants that
the standard leveraged finance facility agreement, as recommended by
the loan market association (LMA), provides for.
Obviously, only yearly
capital expenditure limits have a direct influence on the borrower’s
possibility to carry out expansion projects. However, a distinction
between debt and equity financing of such expansion project is only
relevant in case the firm has negotiated the optional carve out
related to Capex funded by new shareholder injections. Otherwise,
capital expenditure will be limited altogether, irrespective of the
nature of its underlying financing.
As regards financial
ratios, the minimum cash flow cover will be mostly concerned: Not
only will the cash flow numerator be adjusted for the total amount of
capital expenditure, business acquisition, and joint venture
investment, but also the debt service denominator will increase
depending on the extent of debt in the expansion financing mix.
The other financial
ratios are also affected, but a a lower extend:
First, maximum senior
leverage and maximum leverage ratios will be affected by the debt /
equity mix for expansion projects because the ratios’ numerator
will consider the total amount of debt whereas their EBITDA
denominator will not take capital expenditure into account.
Second, minimum senior
interest cover and minimum interest cover ratios will be altered as
well. As a matter of fact, the ratios’ numerator will remain
unaffected as opposed to its denominator that will increase,
corresponding to an increasing portion of debt in the expansion
financing structure.
Resources:
- Sarkar in International Review of Finance 2011, 57 et seq.
- LMA Leveraged Finance Facility Agreement dated January, 20, 2012
