Rapidly Rising Corporate Debt: Are Firms Now Vulnerable to an Economic Slowdown

Topics: Stock market, Debt, Stock Pages: 6 (2097 words) Published: March 27, 2014
Question no. 01. Did the authors conclude that firms had been using significantly higher level of debt from 1995 through 1999? Ans. Yes, the authors concluded that firms had been using significantly higher level of debt from 1995 through 1999. According to the authors, the build-up of debt in the late 1990s raised concerns about the U.S. nonfinancial corporate sector’s health and vulnerability to economic downturns. It had been seen that, between 1995 and 1999 the outstanding debt of nonfinancial corporations rose a weighty 46 percent- a trend typified by last year’s increase of 12 percent. Viewed as a share of GDP, such debt had reached to an extraordinary height at that time. This rapid growth in corporate debt also advanced some questions about the financial health of the sector and indirectly, about the sensitivity of other sectors to economic troubles. This seemingly high level of debt had concerned some observers, who wandered whether it had made the nonfinancial corporate sector financially weak and vulnerable to economic downturns. Such concerns had gained credibility from the recent worsening of other gauges of corporate health, notably default rates and recovery rates on defaulted debts.

Question no. 02 (a). Has debt been rising relative to the level of market value of equity during the study period? Ans. No, debt has not been rising relative to the level of market value of equity during the study period. To illuminate this statement, we can recall to what the authors have said about this. To show the relationship between borrowing and market value of equity, the authors have used the “leverage ratio”. Leverage can be thought of as the ratio of a corporation’s debt to its long run earning capacity. They have used a firm’s long-plus short term debt as a share of its stock market value to find out the leverage. Then to cumulate individual firm’s leverage ratios into a sector wide average, they weighted firms by their stock market value. Calculated in this way, average leverage for nonfinancial firms declined fairly steadily from 0.35 in late 1995 to 0.22 in September 1999- despite the coexisting rise in overall debt. In essence of this, nonfinancial corporations in September 1999 on average had debt liabilities with a face value only slightly more than one-fifth the value of their outstanding equity. Moreover, average corporate leverage for the nonfinancial sector was rather low relative to the post 1974 average of 0.47. So the borrowing by the nonfinancial corporate sector has been moderate relative to equity growth.

Question no. 02 (b). What implication might that have for a firm’s weighted average cost of capital? Ans. We know, Ka = Wi Ki + Ws Ks + Wp Kp.
Where, Ka = weighted average cost of capital.
Wi = proportion of long-term debt in the capital structure
Ki = cost of long-term debt
Ws = proportion of common stock in the capital structure
Ks = cost of common stock
Wp = proportion of preferred stock in the capital structure
Kp = cost of preferred stock
Now cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. As we have seen in the article that the build-up of debt in the late 1990s on the nonfinancial corporate sector reached an extraordinary height. This seemingly high level of debt concerned some observers who wondered whether it made the nonfinancial corporate sector financially weak and vulnerable to economic downturns. From the above definition it is clearly understandable that, the effect of long-term or short-term debt on capital structure is...
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