As a kid, I loved the Suze Orman show. My favourite segment involved callers asking Suze Orman if they could make a purchase, and Orman would tear into the obviously irresponsible purchases with a “DENIED”.
Most financial advice recommends that consumer debt should be kept down. There are some quibbles over good and bad debt, where some will argue that you should take a mortgage because of the historical trend of appreciating property prices. Many would argue that taking a loan out to buy consumer items with little chance of price appreciation – such as jewellery or a Scholars’ Gown – is a terrible idea.
For a company, cash is usually deployed for the sole purpose of growth. After all, no company needs consumption for utility’s sake. As such, cash raised from either debt or equity should be set to raise growth in the seeking of higher future returns.
A theoretical grounding
Below, I list some theorems pertinent to corporate finance that we study in the first year of Oxford’s Economics and Management course, as well as the perspectives in a real-world setting.
Modigliani-Miller proposition
Modigliani & Miller (1985) argued that whether a firm is financed by equity, debt, or a mix of both, its total value remains unchanged if there are no taxes, transaction costs, or bankruptcy risks, and markets operate efficiently. This is broken down into two propositions
MM Proposition I: Capital structure is irrelevant to firm value
MM Proposition II: As debt increases, equity becomes riskier, and investors demand higher returns.
If the cashflow of two firms is the same, but the firms are valued differently due to their debt and equity mix, an investor will simply arbitrage by buying shares in the lower-valued firm and selling shares in the higher-valued firm. The act of arbitrage hence equals the valuations of both firms’ equity, which proves MM Proposition I.
Proposition II is rooted in the different kinds of equity. When there is higher debt, the repayment obligations increase. Since debt holders are paid before equity holders, the risk naturally increases on the latter.
The key takeaway from the MM Propositions is that while equity holders will have different expected returns when it comes to the level of indebtedness, management of companies should not differentiate between the use of these two financing techniques.
Pecking order theory
The pecking order theory of finance explains how firms prioritise their sources of financing based on a hierarchy of preference. Proposed by Myers and Majluf in 1984, it suggests that firms prefer to fund new investments first through internal funds (cash or retained earnings) due to their minimal transaction costs and lack of signaling issues. If internal funds are insufficient, firms turn to debt, which is less risky and involves fewer adverse signals to the market compared to equity. Issuing new equity is considered the last resort because it signals to investors that the firm’s stock might be overvalued, potentially leading to a decline in its share price. This hierarchy arises due to information asymmetry between management (who know the firm’s true value) and external investors, making internal financing the least disruptive option for maintaining confidence and stability.
Debt overhang
The debt overhang problem occurs when a company has such a high level of existing debt that it discourages new investment or economic activity. For instance, a company owes money to Bank A and seeks to invest in a profitable investment – though it needs to raise cash through investment because it has no cash. The investment is risky, though it has a positive expected Net Present Value. However, because any positive cashflow will first go towards the old debt holders, shareholders will not inject new cash to invest in investments that are positive NPV but less than the investment amount + promised repayment to debt. Overall, investors are faced with a lower return but the same risk, since some of the promised cashflow goes towards paying off previous debt holders.
These theorems are hence arguing different points of view. Under a very strict theoretical model of MM, neither financing methods should not be preferred since the overall value to the firm is unaffected. However, pecking order theory suggests that there is an inherent value due to information asymmetry, which MM assumes does not exist. Meanwhile, the debt overhang issue suggests that the presence of debt can reduce the value of the firm.
Debt in a real world context
What debt is used for
Venture debt is one example, where startups grow enormously by taking on debt. This also allows founders to avoid ceding control over their startup, as long as they can meet the requisite payments. Private equity is notorious for taking on debt in order to acquire companies and turn them around. When the cash is deployed to investment opportunities that eventually reap a higher return that the interest rate, debt can help to act as a lever to help gain outsized profits.
Real-life dangers of debt: Perception becomes reality
Debt is often seen as a dangerous burden on balance sheets of company, and this fear means that it can become a self-fulfilling prophecy. There is always a financial risk of bankruptcy if the company is unable to meet mandated repayment schedules, which is further compounded by uncertain interest rates. An elevated debt can cause suppliers, customers, and financiers to grow wary of the company and shun doing business with it. This means high prices for procurement, having to give discounts to customers and paying higher interest rates in order to compensate the other parties for that added risk. As laid out in the Pecking Order Theorem, information asymmetry means that the presence of debt does convey some level of information.
For example, Evergrande, the Chinese property giant, faced significant financial distress in 2021 due to its enormous debt burden. The company’s inability to meet repayments triggered a liquidity crisis, causing suppliers and lenders to lose confidence. This not only worsened Evergrande’s situation but also sent shockwaves through the global financial markets.
Debt comes from many sources
Debt doesn’t just come from the bank. In fact, suppliers and customers can loan money to a company. For instance, when you buy a Starbucks gift card, you are making a pseudo-loan to Starbucks. In return, the card is a promise to pay you in-kind when you so desire. It also comes with the risk of debt: In the events that Starbucks goes bankrupt, holders of gift cards will find it an uphill struggle to get their money back or redeem their coffee. That is why most businesses offering such gift cards give a certain discount, since this is the “interest” that they pay for customers to accept a less-fungible form of currency.
Meanwhile, suppliers often extend credit, allowing their corporate customers to take delivery of goods before paying for the goods. For every day that both cash and goods sit with the buyer, the vendor is essentially loaning the company that sum of money. Consumers have buy-now-pay-later, but companies have implemented this for B2B transactions for a long time.
Financial liquidation
Companies can get away with liabilities by just shuttering. Unlike an individual that declares bankruptcy, and hence faces a lower quality of life due to restrictions, companies can do so quite easily. After all, limited liability was created as a concept to decrease the risks of innovation. In fact, liquidation is a manoeuvre that Johnson & Johnson sought to do to discharge its liabilities from lawsuits.
Debt – not a dirty word for companies
Debt has a poor reputation in personal finance, but for companies, it’s a tool with the potential to turbocharge growth. Theoretical models like Modigliani-Miller suggest that debt may not impact firm value under perfect conditions. Yet in the real world, debt’s dangers and benefits depend on its application.
When used strategically, debt can unlock opportunities for growth and competitive advantage. However, firms must tread carefully. Mismanagement can lead to instability, and the negative perception of debt can snowball into real financial distress if creditors think the debt is too high to be repaid.