Analyzing the term structure of debt of a company, deciding when to go long and when to temporize with a short-term issue in the hope that long-term rates will fall, is simpler than the debt-equity sequence decision. There are some aspects of risk and flexibility involved, of course. Lenders might find themselves in a credit pinch and be reluctant to renew a short-term credit. The company’s financial position might degenerate, making the conversion to long-term debt impossible. But, compared to the basic debt-or-equity question, the problem is primarily one of cost with only a mild seasoning of risk exposure.
The cost of a poor term-structure decision is more than it might appear because of two factors.
Differential cost of a mistake in issuing long-term debt:
First, the differential cost of a mistake in issuing long-term debt is more than just the interest differential between the actual issue and the lower-cost opportunity that was missed. On a $1 million loan, for example, the difference between 6 percent and 7 percent is $10,000 a year before taxes and $6,000 after 40-percent taxes. The total difference is $120,000 if the loan is for 20 years with no sinking fund. The $120,000 also must be financed to keep the resources available to the company at the equivalent level under both options. Interest (and other costs) on this additional financing brings the total to over $180,000.
Keep the debt-capital ratio the same:
Second, to keep the debt-capital ratio the same, some proportion of these extra costs must be financed with equity. A $180,000 direct-interest-cost differential will require a company capitalized at 70 percent equity to issue (or retain) an additional $126,000 of equity to finance the equity part of the shortfall. (This figure would have to be adjusted for any differential between the interest assumption and dividends on the common stock.) Great care in considering the future of interest rates is thus clearly required for the decision when to issue long-term debt.