Any major capital structure decision in business requires an in-depth analysis to determine the optimal capital structure. The word "debt" for some has only negative connotations but there are tax and monetary benefits to debt equity financing. The trick is to do determine the correct amount of debt to use in any corporate financing decision. If you use 100% debt or equity in these decisions, you are not maximizing the advantages of the debt equity financing decision.
There are several prominent economic theories that influence corporate financing decisions, the pecking order and trade-off theories to name two. However, with so many outside factors like government regulations governing interest rates and the financial viability of your company, it is ultimately a fluid situation where there is no right answer, only one that's best for your company. No matter what the financial circumstances of your company, there are a few items to consider before making any corporate financing decisions:
1. Understand the benefits of corporate debt.
2. Use the pecking order theory to analyze debt financing decisions.
3. Utilize the trade-off theory to offer an alternative view of corporate financing decisions.
Study the business tax code and corporate debtThe main benefit of corporate debt is the tax advantages for your company because the debt is deductible from the year-end tax figure. However, regulations governing this advantage have changed over time and will continue to change. That is why any business should research current tax laws before making any debt financing decisions. The primary drawback is that your business will now owe another entity for this debt and be liable for terms of the debt financing agreement.
IRS has detailed information that can help a business understand just how the tax laws impact debt decisions.
Examine the pecking order theory and how it applies to corporate financingThe pecking order theory states that corporate financing needs should come from cash, debt and equity in that order. In the pecking order theory, corporate financing decisions come through the path of least resistance and to only use equity financing as a last resort.
Evaluate the use of the trade-off theory in corporate financing decisionsTo attain optimal financing decisions using the trade-off theory of capital financing, you need to understand the principles behind the theory. The trade-off theory states that a corporation should use a balance of debt and equity in all corporate financing decisions. The trade-off theory also espouses the tax benefits of debt financing. This theory is a competitor to the pecking order theory.
- Corporate financing decisions not only affect the corporate bottom line but the stock price of the business if it is a publicly traded company. Too much financed debt can cause investors to be wary of that stock. Conversely, too little debt gives rise to shareholder concern over proper use of the credit system. It is important to find the right balance to make current and potential shareholders content.