Framework for assessment of corporate leverage: Costs and benefits of debt

Abstract

There has been a lot of work done in terms of empirical findings about how firms make their capital structure decisions. Alongside, there have been many different theories and reasons that been suggested to explain the findings. However, there still remains a lot of empirical evidence that has not been linked to any specific theories. We begin with a literature survey to provide a brief overview of the major theories that explain the effect of leverage decisions. After literature survey we move to a more analytical approach and try to analyze the capital structure of a firm based on simulating the future earnings. One of the key impacts of leverage decisions lies in the tax advantages of debt. We attempt to construct tax benefit functions for a firm to assess the extent to which it is utilizing the possible tax advantages of debt. This model is based on John Graham’s work1 . We modify the model as per the Indian laws and present our finding that the model is not very useful in the Indian context. We also create a bankruptcy?probability model as a modification of the above model. This model takes a different view of debt and relates it to the probability of bankruptcy for any firm. We then move on to applying the models for select Indian firms, viz. Bharti Airtel, and Jet Airways. The idea is to look at two very different firms (in terms of capital structure) and to explain their capital structure in terms of tax benefits. Then, we depart from the approach of simulating earnings and try to forecast earnings using conventional estimation methods. Based on these forecasts we attempt to assess the right level of debt for the firms under study. We go back to the ideas discussed under literature survey and try to relate them to our findings. The key underlying idea is that though many different things affect capital structure; they all work together, and impact different firms differently. This may depend upon the conditions, including firm?specific requirements, industry scenario, capital market scenario, management’s beliefs and plans, etc. The need is to understand the issues in conjunction with one another and decide on a capital structure on a case?by?case basis. Finally, using these estimations and analyses as basis, we try to come up with managerial insights for these firms and present our suggestions about the range of leverage they should aim for.