Equity or Debt?

Equity or Debt? 

It always has debt about a company’s capital structure, about a company it needs more debt or equity, many theories discuss it and all of them can make sense, but what method is great? 

 

A company’s capital structure always has many different products, so for a company, it needs more debt or equity, many theories have a debate, but which method is great? 

I want to talk about the Netflix situation through what I learned this week. Recently, Netflix has to raise money so that it can finance its heavy spending on original movies and television shows. Netflix hit the corporate bond market again, with a plan to issue $2bn in the dollar and euro-denominated junk bonds. To fund this, Netflix always uses the debt rather than the equity market, even though its shares have surged more than 73% this year. It raised $1.9bn in April and $1.6bn in October last year finally. It borrows in the bond market to fund such spending and has accumulated $6.5bn in debt. It also likes to talk up a ratio of debt-to-market capitalization as if it measures financial health rather than the weight of fairy dust sprinkled on the stock. Why it calls junk bond because the debt rate is rated junk, as we all know, junk bonds have a credit rating of BB or lower (by standard&poor's, one of the credit reference agencies). Netflix's credit rating is BB-. The high yield bonds in Netflix, which are cheaper than selling shares. It is clear to see the reason that Netflix does this for junk bonds have higher yields than bonds with higher credit ratings. It is easier to raise money at the same time, compared with other higher credit rating bonds. However, as I just mentioned, Netflix has a great performance in the stock market, why the company would like to use the debt market rather than the equity? Actually, there is the value of the debt tax shelter. Since interest expense is tax deductible, then the more debt used by the firm, the more wealth created via lower tax payments. This is called the tax shield. As a firm uses more and more debt, the tax shield will become larger and larger, adding more value to the firm. So, Both the debt brings rate and tax deduction are the reasons for Netflix prefer to raise money in this way. 

  

So, should Netflix continue doing that?  Are its benefits for the company? The company has burning cash for many years, should we judge it on operating cash flow or free cash flow. However it hasn’t found it, this was shown in its continued use debt market to finance.   

I don’t think so. As for current conditions, Netflix ought to find a suitable capital structure to raise money and achieve shareholder wealth maximum. I have described the great performance in the stock of Netflix recently, in the current situation, my view on that is Netflix should increase its shares, issuing stocks rather than junk bonds. Issuing stocks would be a great suggestion for Netflix by thinking about its capital structure.  

However, different companies have different problems, about how to allocate debt and equity rate, I think, we need to make decisions by the company’s current situation.