How much debt is too much?

 Finding the correct balance between debt and equity is a problem commonly faced by many companies. Choosing to finance mainly through debt is often seen as the safer option as a large amount can be borrowed, for relatively low returns. In comparison, equity is more expensive and viewed as being more risky. Due to the increased risk, investors want higher returns and as a result reduce the owner’s control of the company. Additionally, debt is tax deductible, whereas dividends are not. By taking on more debt, the gearing of the company will increase, which will in turn reduce the Weighted Average Cost of Capital, increasing the overall value of the company.

So, everything is pointing towards using debt rather than equity, right? Unfortunately, it is not always that simple. American Apparel took on so much debt, that it had to file for bankruptcy in October 2015. A plan has been agreed with creditors to swap $200 million of debt for equity, and extension of $90 million in debtor-in-possession financing and $70 million in new capital. It is believed that this plan will help reduced the level of debt by 70% to $135 million and cut interest payment by $20 million. I think these figures truly highlight how wrong American Apparel had going with their financing and level of debt, and also show how damaging high levels of debt can be for a company. Quite how long it will take American Apparel to sort this out, if they can, I really don’t know. 

So, why would management at American Apparel allow such a highly geared capital structure? Modigliani and Miller argued in 1958 that the capital structure of a company has no impact on the WACC. Therefore the total market value of the company is not affected by the capital structure, whether this is financed through debt or equity. However, this theory was highly criticised, based on a number of assumption the M&M made. Notably, that there was no taxation and no costs of financial distress and liquidation. Following this, M&M revised their initial theory in 1963 and took a more real world approach, taking tax into account. Debt is a tax deductible expense, which is another added bonus to financing through debt, as opposed to equity. M&M (1963) suggested that if you increase the level of gearing within a company, WACC will be reduced, and as a result the total market value of the company will increase.

Taking this into account, I can understand the reasoning behind American Apparel’s financing. The after-tax cost of debt is cheaper than equity and ideally they just wanted to lower WACC and increase their market value. However, what was not taken into account was the cost of financial distress and potential for liquidation. American Apparel should have also looked into the market conditions and possibly how competitors were financing their companies, before taking on too much debt. 

Personally, I do not believe that financing a company solely using debt is a good idea. Yes, it may help reduce WACC and increase the market value in the long run, but how do you expect to attract potential investors when all you have backing you up is a whole lot of debt? Obviously, this is something that can vary drastically between industries and markets, but maybe in this case it should be more about fitting in with what others are doing, rather than trying to stand out.