NEAS,

According to the textbook "Companies repurchase shares... when they wish to increase their debt levels."

Can you explain the logic of this action?

Thanks.

[NEAS: Suppose a firm starts out with all equity financing, of 1 million shares at $10 a share. When the firm begins, it has a good business plan but no years of stable earnings, so a venture capital firm helps it get started, but it can’t borrow at affordable rates yet.

After five years, the firm has retained earnings of $20 million and can now borrow at 8% per annum. Its stock is worth $30 a share. It wants a 50%-50% split of debt and equity, so it borrows $15 million and repurchases $15 million of shares.]

NEAS,

Thanks for the response. But I am still confused. Can you explain how repurchasing shares would increase debt levels? Also why a company would want to increase debt levels here? How is this going to be beneficial for the company?

[NEAS: Modigliani and Miller and other financial economists explain that firms have optimal debt-to-equity ratios, depending on various attributes of the firm and the environment, such as tax rates, costs of bankruptcy, agency costs, and pecking order characteristics. There are advantages to debt (lower taxes), but not all firms can use them, sometimes because they can’t get debt financing at low enough rates.

A start-up often must use all-equity financing, since no bank will lend money. The start-up can not take advantage of the tax deductions from debt. But this is not that much of a problem, since the firm may not have positive taxable income yet.

When the firm starts earning positive income and can get bank loans at better rates, it wants to switch to a higher debt-to-equity ratio to get the tax advantages. It does so by issuing debt and repurchasing stock. If it just issued debt and did not repurchase stock, it would have too much cash, on which it would incur double taxation.]