The Costs and Benefits of Corporate Borrowing

For the typical near-equilibrium firm, an optimal capital structure increases the firm's value by 4.5 percent of book value.

In The Cost of Debt (NBER Working Paper No. 16023), co-authors Jules van Binsbergen, John Graham, and Jie Yang use a financial model to estimate the marginal cost curve for corporate debt, including in their model such financial characteristics as asset collateral, firm size, book-to-market ratio, asset tangibility, cash flow, and dividend payouts. They also estimate the marginal net tax benefit of corporate debt --debt typically produces tax savings because interest on it is deductible. By considering both the costs and benefits, the authors’ can approximate the optimal capital structure for a given firm.

The researchers estimate that the optimal capitalized net benefits of debt are typically about 3.5 percent of asset value averaged across all firms, resulting from an estimated gross benefit of debt of 10.4 percent of book value and an estimated cost of debt of 6.9 percent. For firms that choose capital structures near the optimum, an optimal capital structure increases the firm's value by 4.5 percent of book value, and by 5.9 percent of book assets for high net benefit firms. The authors also conclude that “the cost of being over levered appears to be more severe than (that of) being under levered.” They note that the default cost of debt amounts to approximately half the total cost of debt -- agency costs and other non-default costs contribute the other half.

The sample of firms that the authors study is taken from financial statements representing nearly 80,000 “firm years” of companies that meet their criteria, and is drawn from Standard & Poor’s Compustat database for the period 1980 to 2007. In the main part of their analysis, they simulate tax benefit functions using a firm’s actual debt choice in a given year, based on the assumption that it represents the equilibrium intersection of the marginal cost and benefit of debt functions, including expected costs that managers trade off against tax benefits in order to choose an optimal capital structure. As the benefit functions shift and the cost function remains steady, the location of the cost-of-debt function is inferred as what the marginal cost of debt must be in order to rationalize the typical firm’s capital structure choices.

-- Frank Byrt

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