Blog 3- Equity or Debt?

A debate that has been going on for quite some time- since 1958 to be exact. Before Modigliani and Miller’s initial theory 60 years ago, there had been no real theory about capital structure. Should companies use debt finance or equity to raise cash?

Netflix has recently realised that their cash needs for the current year need to reach $3-$4 billion. To raise this they have planned to tap debt markets over equity saying that high-yield bonds are cheaper than selling shares. Is this correct and is there theory to support this? Netflix cannot afford to make mistakes after a pretty big miss on subscriber growth predictions for the second-quarter; with only 5 million people joining in contrast to the forecast 6 million.

The high-yield bonds- that are cheaper than selling shares- that Netflix are referring to are also known as Junk Bonds. Junk bonds have a credit rating of BB or lower by Standard & Poor’s, one of the credit reference agencies (also includes Moody’s and Fitches). Netflix itself is rated BB-. With equity risk premium, with high risk comes high returns and vice versa: low risk = low returns. Netflix chooses to put its money into junk bonds for the quick results and high returns. When Netflix buys a bond, this is essentially lending money to the bond issuer who then has to pay the money back on a specific date. The issuer attaches interest rates to the bond, to compensate the Netflix for buying. I can see why Netflix do this as junk bonds offer higher yields than bonds with higher credit ratings; they can demand that the bonds pay higher yields for compensation because of the high risk of the investment.

However, investing their money like this I feel is very risky. I’m not sure if I would see the high return as enough to put such a high risk on my business. Although, as it stands Netflix have found no problems doing this, which is why they think this is the appropriate method for raising their cash needs for the current year.

Netflix need to be aware of keeping their capital structure balanced when deciding how to finance their company. Capital structure is the mixture of sources of funds within a company and is about managing and enhancing the cost of capital.

Netflix need to make sure that their capital structure optimises wealth for themselves and their shareholders, therefore they must choose carefully how they wish to raise their cash, to make sure they do not unbalance their capital structure with the proportion of debt. If a company is heavily funded by debt, this poses a greater risk to investors… this is why Netflix is rated a junk bond by the credit reference agencies. There are many theories regarding optimal capital structure, however, most of these conflict each other and do not agree with one another.

For me, what’s interesting is that Netflix’s stock has recently tripled yet they still do not think that equity offering is the best way to go. Instead, adding to their already existing $8.4 billion worth junk bonds. This method must work for Netflix, why else would they do it? Costs of acquiring debt for a company are considerably lower than equity offerings. There are also real tax advantages of acquiring debt- with debt comes interest, this creates a tax deduction, borrowing creates a tax shield and this value is added to the value of the firm. Both are positives for Netflix’s preferred method of funding their business.

Companies should be trying to lower their cost of capital with their capital structure, issuing stock is more likely to do this than tapping debt markets; Netflix may not be choosing the method that is going to offer it the lowest cost of capital. There are also other negatives for Netflix of using debt to fund their cash needs: as the debt to equity ratio of the capital structure increases, the probability of bankruptcy also increases- this could be worrying for investors and for a company like Netflix that is already so cashflow negative, this could be a big problem. Another negative of the debt ratio being higher than equity is that the business can find itself with financial distress costs.

To make a decision on debt vs. equity I think it really depends on the specific company and what may work for one would not work for another. For Netflix’s current situation, my opinion would be to go with issuing stock this time. Although purchasing high-yield junk bonds has previously worked for Netflix, I believe that because they have had such a good year and their stock has tripled, that equity offering would be the best suggestion in this situation. Netflix should not let their capital structure get too geared towards debt and while they are in a strong position to do so, they should choose equity.