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The Other Side of Debt Financing

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The Other Side of Debt Financing

“How much debt is right for a company?” This is a question my friend asked me the other day when we had coffee together. Even though at that spot I answered him “it depends on the situation (industry, profitability, competitive position and sales volatility) the firm is in”, later that day this very brief conversation brings me back to the corporate finance class which I took some years before. What does an optimal capital structure look like? Is debt better than equity? What is the relationship between capital structure and firm value? How to make a wise investment decision? These were some of the questions which filled my mind right after that conversation. In a way to answer these and other questions I did some research about capital structure which becomes the foundation of this article.
The relative proportion of equity (E), debt (D) and other securities that a firm has outstanding constitutes its capital structure (an equity represents ownership interest of shareholders of a company whereas debt represent money borrowed by the company that must be repaid). When a corporation want to raise funds from outside investors, the most common choices are financing through equity alone or financing through a combination of equity and debt. However, some earlier research reveal that the total value of a firm, its share price and its cost of capital is independent of its choice of capital structure. This means, in a perfect capital markets (no taxes and transaction costs), capital structure merely allocates cash flows between debt and equity without affecting the total cash flows to the firm. But capital markets are not perfect in real world, so what is the significance of the (research) result? This is a very common question raised by many people. A brief response may be that all scientific theory begun with a set of idealized assumptions. It is only after we know this that we can measure how much closely the assumptions hold and consider consequence of any major deviations.
In a real world, the assertion that capital structure will not affect firm value is at odds when we observe that a lot of companies invest significant amount of time both in terms of managerial time and effort and investment banking fees to manage their capital structure. In fact, the choice of leverage is of critical importance to firms’ value and future success in many cases. For instance, in 2018 Awash, Abyssinia, Wegagen, United, Dashen, Oromia COPB and Addis Int bank (all Ethiopian’s banks) have different D to E ratio, though the variation is not as pronounced as firms in different industry (see the Figure 1 below). (Here readers should note that I am not implying any performance comparison by stating the D to E ratio).
If capital structure is unimportant regarding firm value, why we see consistent difference in capital structure across industries and firms? Many previous researches make it clear that capital structure is unimportant in a perfect capital market. Therefore, if capital structure matter, it must stem from market imperfections. One of the most important market imperfections that we will discuss in this text is taxes. Corporations must pay taxes on the income they earn. Because they pay taxes on their profit after interest payments are deducted, interest expense reduces the amount of corporate taxes a firm pay. This means the interest shields the tax the corporation must pay which is usually referred as the interest tax shield. This feature of the tax code creates an incentive to use more debt.
When a firm uses debt, the interest tax shield provides corporate tax benefits. This means a corporation will pay less taxes when it has debt and pays interest for that than it has no or low debt. This conclusion can easily be illustrated with the Pizza example. No matter how you slice the pizza, it is the same amount you have (a setting in a perfect capital markets). However, assume the tax man get a slice of the pizza as a tax payment for every slice equity holder get, but when debt holders get a slice, there is no tax payment. By allocating more pizza to debt holders, more pizza will be available to investors. Even though the total amount of the pizza does not change, there is more pizza left for investors because less pizza is consumed by the tax man as taxes (in other words the tax man gets a fraction of the smaller pizza allocated to equity holders).
All the above discussion leads us to one critical question. “Do firms prefer debt as a source of funding for capital expenditure?” Though I could not find compiled data for Ethiopian companies, evidence of US corporation may give us some insight about firms’ behavior. Data from 1975-2011 shows when US firms want to raise new capital, they do so primarily by issuing new debt. But this does not mean that all firms sell debt to raise funds. There are many firms who sell equity to raise funds, but other firms are buying or repurchasing an equal or greater amount of equity. In other words, firms are net purchaser (rather than issuer) of equity whereas they are net issuer of debt. Hence for US firm’s debt is preferred as a source of external financing. However, companies only revert to external sources (E and D) of financing when the internal sources (retained earnings) are not enough. This means retained earnings is firm’s first choice when it comes to capital expenditure. In other words, a pecking order theory holds which says a manger prefer retained earnings and only issue new equity as a last resort.
Does this mean that firms should use more and more leverage because of the existence of tax advantages for debt financing? Not at all! Studies confirmed that companies should not use the maximum possible amount of debt in their capital structure. Companies should reserve flexibility, a substantial reserve of untapped borrowing power. This is achieved by limiting the amount of debt in capital structure to a certain level even if there is a possibility to borrow more. Excessive leverage may lead a company to financial distress: a situation where it is unable to pay its debt obligations. However, far more significant than financial distress and its attendant cost of bankruptcy is the fact that aggressive use of debt will likely limit the possibility to raise funds quickly on acceptable terms. This leads to liquidity constraints which will reduce the market value of the company. Managers fearful of incurring liquidity constraints will trim strategic expenditure and will not be aggressive in exploiting marketing and investment opportunity. Problems also arise with agency cost of monitoring loan covenants, property mortgages and performance management as the firm need guarantee proper payment of debt obligations. In fact, according to some research agency costs may become highly prohibitive especially as debt approaches 20% to 30% of the capital market value (debt as a fraction of total firm value).
Even financial distress and bankruptcy cost which we consider to be not significant, can sometimes be so significant that each may completely offset the benefit of interest tax shield. For instance, bankruptcy is a long and complicated process which imposes both direct and indirect costs on the firm and its investors. Though the bankruptcy code is designed to provide an orderly process for settling a firm’s debt, the process is still complex, time-consuming and costly. When a firm becomes financially distress, it usually hires outside professional including legal and accounting experts, consultants, appraisers and investment bankers which are usually costly. In addition to direct legal and administrative cost, there are also several indirect costs associated with financial distress whether a firm has filed for bankruptcy. Even though these costs are mostly difficult to measure they are much larger than the direct cost of bankruptcy. An example of these costs includes loss of customers, loss of suppliers, loss of employees and loss of receivables.
In summary, a company’s chief financial officer (CFO) need to ask a series of questions to determine the right amount of debt in the capital structure. These questions include but not limited to: how much additional money the company needs to raise in the next 3 to 5 years to carry out its strategies? Can it can be deferred without incurring large organizational and opportunity cost? What are the lending criteria of each target sources? Will the company debt policy allow a flow of funds to all strategically important programs even in the event of adversity? Will the company be competitively vulnerable if it achieves its target capital structure? This means a CFO need to weigh the tax benefit of debt against loss of flexibility and costs associated with bankruptcy and financial distress to determine the right amount of debt in the company. Nevertheless, in order to apply this core concept, it is needless to say that the existence of financial markets (capital markets) is indispensable. Unfortunately, as a nation we are new to financial markets and because of its nonexistence we lost many promising investment opportunities. On the contrary, we invest on many bad investments (sometimes) purely because of the lack of detail financial information. Hence, it is important to build awareness about financial engineering among all business stakeholders so that our industries may benefit from the resource effectiveness stemmed from the use of such value creation model.

Abiy Getachew is a consultant at HST consulting p.l.c.
You may reach him at abiy.getachew@hst-et.com

What African Art Needs Now

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Writing from Atlanta, where the African population including Ethiopian, Nigerian and Ghanaian in particular reside, there is a great love and appreciation for art and architecture evident in almost every area of the city. Atlanta is the historic home of Dr. Martin Luther King Jr.; a major city for filming blockbuster movies; a draw for hundreds every second Friday to the Castleberry Art Stroll; and abode for the prestigious High Museum and countless visual and performance artists of Africa and the Diaspora. It is the creations of Black people that is shaping up to be the art of the 21st century in the USA.
The New York Times recent opinion piece by Elizabeth Méndez Berry and Chi-hui Yang entitled “The Dominance of the White Male Critic” has lots to say about the possible trajectory in a frank commentary; food for thought if not action. So let’s start with the rise of black contemporary artists on the art scene in the USA and the role of reviews. Critiques are an important aspect of promoting exhibitions and artists, attracting viewers, influencing buyers, and documenting the impact of said art. Berry and Yang state, “It’s 2019 and we are in the middle of a renaissance in black artistic production. And you are telling me the best people to evaluate that are the same ones who basically ignored black artists for decades?” the art critic Antwaun Sargent tweeted in May. “The problem is not that these critics lack some essential connection with the work of artists of color,” the art critic Aruna D’Souza said in an interview. “It’s that many of them simply are not familiar with the intellectual, conceptual and artistic ideas that underlie the work.” The article goes on to say, “This matters because culture is a battleground where some narratives win and others lose. Whether we believe someone should be locked in a cage or not is shaped by the stories we absorb about one another, and whether they’re disrupted or not. At a time when inequality and white supremacy are soaring, collective opinion is born at monuments, museums, screens and stages – well before it’s confirmed at the ballot box.”
With the fast shifting sands on the continent and in the Diaspora including the launch of the African Continental Trade Agreement and Year of Return on one hand and political instability and rampant racism on the other, art remains a visual voice amidst the shouts. Hence, the role of critics to lead the discourse and to help decipher the influences and inspiration of Black art is crucial. So the premise of Berry and Yang’s commentary are on point. Its not that the white critics don’t have the qualification to critique the plethora of exhibitions, its more a mater of the disconnect and the perspective. After all, we view things from our own lens, naturally and expectedly. However, in a time when Black voices are being raised and the quest for equal rights and justice for all are being sought, art and the critics who write about art definitely need to get it right. Getting it right means relaying reviews which are relevant and beyond mere aesthetic assessment. It is also an opportunity for more black critics at home and abroad to write about art and for that matter, art schools in Africa need to offer writing classes to grow a new generation of art critics. But alas, that is merely my opinion and I do hope that those who can and are trusted with the power to shape art curricula, will. The future of black art depends on it.
I close with a quote from the same New York Times op-ed, “Art reviews matter because they can define aesthetic movements or dismiss them. Think of cultural criticism as a public utility, civic infrastructure that needs to be valued not based just on its monetary impact but also on its capacity to expand the collective conversation at a time when it is dangerously contracting. Arts writing fosters an engaged citizenry that participates in the making of its own story. Conversations about our monuments, museums, screens and stages have the same blind spots as our political discourse.” If the latter is true then it is certainly time to take off the blinders and ensure proper peripheral vision.

Dr. Desta Meghoo is a Jamaican born Creative Consultant, Curator and cultural promoter based in Ethiopia since 2005. She also serves as Liaison to the AU for the Ghana based, Diaspora African Forum.

The sale of King Tutankhamun’s 3,000-year-old statue restarts debate on whether ancient artefacts belong to their country of origin

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The sale of King Tutankhamun’s 3,000-year-old statue restarts debate on whether ancient artefacts belong to their country of origin

This is not the first time Egypt has demanded the return of an artefact. Neither is it likely to be the last. Countries world over, including India, have been demanding that artefacts – several of which were looted during the colonial period – be brought back to their countries of origin.
Around 11 inches tall and carved from brown quartzite, when the 3,000-year-old bust of Egyptian god Amen – sculpted with features of the pharaoh Tutankhamun – was sold by Christie’s for £ 4.7 million on July 4, it turned several heads. The sale followed weeks of to and fro between activists and the Egyptian government and the auction house, to which they pleaded to cancel the sale of the relic. The government cited that it was probably stolen from an Egyptian temple during the ’70s. Christie’s, however, went ahead with the sale, issuing details of the provenance, tracing it back to the collection of German aristocrat Prinz Wilhelm von Thurn in the ’60s. It was bought from him by Vienna-based gallerist Josef Messina in 1973 or 1974, reads the detail of the lot. The auction house stated that the relic had never been the subject of an investigation and that it would not have been sold if there were legitimate concerns. The National Committee for Antiquities Repatriation (Egypt), on Monday, discussed the legal measures to be taken by the Egyptian authorities for the same.
This is not the first time Egypt has demanded the return of an artefact. Neither is it likely to be the last. Countries world over, including India, have been demanding that artefacts – several of which were looted during the colonial period – be brought back to their countries of origin. Requests for repatriation have been pouring in from across the world, including Nigeria, Greece, Thailand, Benin and Ethiopia. India’s request for the return of the Koh-i-Noor diamond and the Sultanganj Buddha have been repeatedly rejected by Britain. The country often cites the British Museum Act 1963 which forbids the British Museum from disposing off its holdings.The sale of several articles of historical significance at auctions, however, makes matters more complex. For one, the articles are not owned by public institutions nor are they usually meant for public display. The repatriation negotiations would be vastly different when dealing with private collectors. Moreover, there is also a distinction between when the article was taken out of the country while it was under foreign rule and those smuggled out otherwise.
While in 2018 an auction house in the United Kingdom sold a bronze relic suspected to have been taken from Beijing’s Old Summer Palace in 1860, despite calls from China to withdraw its sale, in 2004, Vijay Mallya famously bought the sword of Mysore King Tipu Sultan at an auction for Rs 1.5 crore. The whereabouts of the sword though aren’t known.
More recently, in March, despite several concerns raised, Berkshire-based Antony Cribb Ltd auctioneers, who specialise in arms and armory related sales, auctioned items from Tipu Sultan’s armory worth £107,000. The highlight was a silver-mounted 20-bore flintlock gun and bayonet that came under the hammer for £60,000. The lot description read: “Unlike other Tipu Sultan guns this one exhibits clear signs of having been badly damaged in its past… rather than being taken directly from the rack after the fall of Seringapatam it appears to have been collected from the battlefield.”
The Indian High Commission in London had been reportedly made aware of the sale by India Pride Project, a group of volunteers “that tracks and brings back India’s stolen heritage”. It was instrumental in the repatriation of a 12th century Buddha statue allegedly stolen from Nalanda in Bihar nearly 60 years last year, and the 11th century Chola statue of a dancing Shiva that was brought back to India from Australia in 2014. “Indian art is in various museums and we have to study their documents and provenances carefully. It is the same for auctions,” stated Anuraag Saxena, co-founder of India Pride Project, in an earlier interview to The Indian Express. He added, “Our history is being illegally smuggled out to private collectors and museums across the world and we want to bring this look back.
(The Indian Express)

Once up on a time…

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Adapted from an old local public story
(Last part)
Last week we left off with the first part while Almaz’s husband, Simegnew, was ringing the gate bell. Then Almaz would walk over to the gate to answer the knock. Meanwhile Arabu (Ali) was grinding shiro in the inner kitchen… Here follows the second and last part…
By Haile-Gebriel Endeshaw
“Why is all this delay, lady?… Should the big man wait for hours like a stranger till somebody comes to open his own gate?…” Simegnew looked with weary eyes at his wife who left the wicket ajar. He was carrying long whip hanging on his broad shoulder.
“My dear, I am sorry for being late to answer to your knocking… I was in the inner kitchen cooking and making injera. You know how busy your lady is! … Did you have a good time out in the farm?” She opened the wicket wider for him.
“Everything is fine except the weariness of your man.” He released long breath and walked into the compound with his muddy boots.
At home he took a seat on a big and dwarf stool. Almaz gave him a jug full of water which he scooped and rubbed his rough hands with. Then she served him injera with red sauce of lentil. There is also cheese and yoghurt placed on the injera that was spread over the tray. Simegnew was so hungry that he ate his fill and drank a tin full of tella (local beer). When he was about to leave for his farm, Almaz said that coffee was ready, and he should drink the abol (the first cup) …
Simegnew walked out, put on his boots and seated himself under the veranda at a medeb (cow dung smeared seat made of earth). Almaz placed before him a small coffee table, which contains clean cups, fresh mint and smoking incense… There is also a coffee pot with mouther tilted down near the coffee table. While sipping at the black coffee, Simegnew heard the sound of the stone mill far inside the kitchen. Shurrrrr… shurrrr… shurrrrr…. “Who is there inside grinding?” he inquired.
“I have a hired lady labourer giving me a hand in grinding the shiro. I am too tired to do it all by myself. I told you I should have one such maid,” Almaz replied.
Simegnew did not comment anything. After having his second cup of coffee, he grabbed his whip (he uses to lash the team of oxen with) and left for the farmland. The moment the big gate closed behind him, Ali who was grinding the shiro gushed out a sigh of relief. He took no time before he threw away the dirt netela he shrouded his neck and hands with and walked out of the compound. Almaz bade him farewell with her pretty face gleaming with smile.
The other day when Almaz was at Arabu’s shop to do her shopping, Ali took hold of her slim and soft hand as usual and kissed it. “Almu, konjo! Do you know how Ali loves you? …Don’t you understand that?” He caressed her smooth long hair. Almaz smiled with a look of tacit agreement.
“Almu, please smile. Let me see your milk white teeth… Almu, konjo…” He tried to hug and kiss her on her lips. But she resisted. “I want you to stop that nonsense, Ali! … People are watching what you are doing here! …”
“I can’t, Almu. I am in love with you. … I will come today… wait for me at home, please! This time I will have to come earlier… eshi (ok)? … Please, I am in love with you, Almu!”
“No, if you want to come, I want you to do it after 11:00 AM. I have many things to accomplish at home. I don’t think my man will come home today.”
…Hours later, while the two were having coffee and snack at home, the gate bell tolled. Ali sprang up and ran in to the inner room. He shrouded himself with netela and started grinding the shiro… This time, after having his lunch and coffee, Simegnew stayed at home for a long time. This was unusual. Most of the time he would leave after he was served his lunch and coffee. Then a couple of hours later, he grabbed his gun from the wall it was hanging on. He pulled the trigger which produced a simple click sound. He was whistling while fondling and wiping the gun. His wife was very alarmed. She crossed herself and stared at him… “What are you going to do with that Satan thing, my dear?”
“Nothing… I have a plan to go somewhere for a long trip. I just want to check this friend of mine that will accompany me during such time. Sometimes the gun needs dismantling and oiling… otherwise, it gets stuck…” Long whistle… Then, he bounced up to his feet… squinted his left eye…put his index finger against the trigger and took aim at the vacant air… Then he placed the gun back to its usual place.
Ali was listening to their chat. He stopped crushing the shiro when he heard the click sound of the gun. He was alarmed. His heart almost stopped beating. He has already started shivering. His entire body streamed with sweat. Then, when he lost their voice, he started grinding the shiro. This time the ground shiro was piling up. Poor Ali was so tired that he could hardly grip the small stone and push it against the big mother stone beneath… Now he was hearing stifling voices of the couple. “You know how much I love you, honey…” It was Simegnew… “Yes, I know my dear. I love you too. I have no one but you!” Almaz’s soft and weak sound came next. Then, long silence mingling with interval breaths … Ali was very sad. He said his prayer to Alah… pleading to snatch him out of that cottage…
The other day when Almaz was at the arb bet, Ali seemed quite different. He was cool and gentle. This time he did not come out of the balcony to touch her hand as usual. He was solely looking at her with blurring sight. He was dumbfounded. Almaz was confused.
“Ali?” she called staring at him with her bulging out eyeballs.
He looked at her silently. His mouth was closed like a sealed box.
“What happened, Ali? Are you sick? …Come on, give me your hand. Let me see your face…” She stretched her hand out for him.
Ali remained silent. Almaz walked closer and touched him by his shoulder. “No!” he jumped and screamed. It seemed he was touched on the sore part of his body…
“What’s wrong, Ali? … Are you sick? Tell me, please. Why are you so dumb? Say something, please! … I need you to come home. I shall wait for you at home… My husband will be away till tomorrow. We have a free full day… Can you hear me?” she shouted.
At last Ali cleared his voice and said, “… Do you really want me to come home again?… Do you think I am that much fool. I want you to know that I am not the other Mamo qillo. I think you must have much shiro that has not yet been crushed… Have you not yet finished that shiro to be ground? Do you need Ali to come for the third time and crush it for you?! … look at this!” he stretched out his palms that were spotted with blisters. “Go and search for another fool! …Dear Almaz, this poor Ali wants to live longer. Please, leave his shop now. Go back to your man…”

Address your comment to the writer through gizaw.haile@yahoo.com

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