Introduction to Long-Term Financing

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J: U.S. Census data reveal that the median selling price for new homes sold in the United States in the month June 2018 was $310,000. [https://www.census.gov/construction/nrs/pdf/uspricemon.pdf]

K: One of the key questions in Corporate Finance is whether you can impact the value of an asset, such as a house or an entire company, by strategically choosing the mix of borrowing and owner investment used to finance the purchase of the asset. This topic area is called “Capital Structure.”

J: Let’s illustrate this topic of “Capital Structure” using a hypothetical house costing $310,000. Assume that we have two ways to finance the purchase of the house:

K: Number 1: Use personal savings to pay cash for the entire amount. So, you have no mortgage loan on the house at all. You own the house “free and clear.”

J: Number 2: Use personal savings to pay for a small amount of the purchase price, say $30,000, and take out a LARGE mortgage loan for the remaining $280,000.

K: OK, let’s think about your personal experience with this house and consider whether that experience differs depending on how you financed the purchase of the house: Number 1, you now own it “free and clear” and, Number 2, you have a large mortgage loan of $280,000 on the house.

J: So, how about the livability of the house? The floor plan? The view? The amount you have to pay for utilities each month? Are these things impacted by whether you have a mortgage loan on the house? No.

K: How about the quality of the local schools? The “niceness” of your neighbors across the street? Are these things impacted by whether you have a mortgage loan on the house? No.

J: So really, the house, as a house, as a place to live, is not impacted by whether you own the house “free and clear” compared to having a large mortgage loan on the house. – Are there ANY differences?

K: Absolutely. The probability that financial distress could cause you to lose the house is MUCH greater if you have a mortgage loan. If you can’t make your mortgage payments, eventually you are going to lose the house. If you own the house “free and clear,” you don’t have to worry about making payments. So this suggests that you are better off to have a very SMALL mortgage on your house.

J: On the other hand, at least in the United States any interest you pay on your mortgage loan gives you an income tax deduction. Each year you will pay less income tax to the government if you have a larger mortgage loan. So this suggests that you are better off to have a very LARGE mortgage on your house.

K: Those are the conflicting forces: a SMALL mortgage reduces the risk of losing your house because of financial distress, but a LARGE mortgage reduces the amount of income taxes you pay to the government. Same house, but the total “value” of the house depends on how you finance the purchase.

J: When applied to the financing of purchasing the assets for an entire company, THIS is the issue of “Capital Structure,” one of the most important in the field of Corporate Finance.