The past few years have seen a rush of innovation in financial markets, especially in the corporate bond sector. A lot of these innovations have been designed to give firms more flexibility in designing cash flows on borrowings, allowing them to match up cash flows on financing with the cash flows on assets, increasing their debt capacity. For the most part these innovations have been a boon for the firms but the relentless torrent of innovation has also resulted in some firms misusing these new and complex securities. Firms until the mid seventies had fairly simple choices. They could raise equity by issuing common stock or debt by borrowing from a bank or issuing bonds.

The surge in inflation during the late seventies and the concurrent increase in the volatility of interest rates created the first wave of innovation in debt securities with the floating wave debt becoming a preferred choice of borrowers. Much of this innovation was enhanced by the greater understanding of the incorporation of multiple options into borrowing options and the pricing of these complex securities. Through the nineties, corporate finance departments have provided their customers new and different ways of raising funds. Securities without being convertible into equity (like convertible bonds) are still considered hybrid securities. They preserve the tax advantage associated with debt and bring in cash flow that can make them seem more like equity securities.

A rationale for Debt/Equity securities

Debt has a tax advantage but it brings with it a greater risk of bankruptcy for the firm because of the requirement to make fixed payments remains even when the earnings are negative or low. The optimal debt ratio is one where the net difference between the tax benefits and the expected bankruptcy is cost maximized:

Value of levered firm = Value of unlevered firm + PV of tax benefits - PV of expected bankruptcy cost

The firms should match up their cash flows on assets to cash flows on liabilities because the firm value is defined as the present value of the assets owned by the firm. This firm value varies over time, as a function of firm-specific factors such as project success and also a function of broader macro economic variables such as interest rates, inflation rates etc.

This figure assumes that all the changes in a firm's value occur due to macro economics variables.

The firm in the figure given above can choose to finance these assets with any financing mix. The value of equity at any point is the difference between the value of the firm and the value of the outstanding debt.

Figure two provides firm value, debt value and equity value over time for the firm.

There are three periods when the firm value drops below the debt value which would suggest that the firm is in and out of bankruptcy in those periods. Firms that weigh this outcome will therefore borrow much less.

A firm that finances itself with debt that matches exactly to the assets, in terms of cash flows, and also in terms of the sensitivity of debt value to changes in macro economic variables will allow the firm to carry more debt, and that added debt will provide tax benefits that will make the firm more valuable. Thus, matching the liability cash flows to asset cash flows allows firms to have higher optimal debt ratios. Figure 3 is given to illustrate the above point.

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