ABSTRACT

Now, it is often suggested that firms can use the ‘wedge’ between the lower return on debt and the higher return required by equity holders tominimize the overall cost of financing their productive activities. We can illustrate the reasoning that lies behind this idea by supposing a firm is initially financed completely by equity. If the firm issues a small amount of debt and uses the proceeds to redeem (i.e. retire) some of its equity then the firm’s cost of capital will decline because the return it has to pay to its new debt holders will be less than the return it would have had to pay to its former equity holders. The downside to replacing debt with equity is that the firm can always omit dividend payments to its equity holders during times of financial stress. In contrast, it must always pay the interest due to its debt holders – irrespective of how difficult its financial position might become. But since the debt issued by the firm is relatively small in relation to the equity it has on issue, there ought to be no significant increases in the firm’s overall risk from this new debt issue. So, we have a marginally lower cost of servicing the firm’s capital without any appreciable increase in risk as a result of replacing a small proportion of the firm’s equity with this new issue of debt.