5. Moral Hazard

Executive bonuses often depend on EPS (earnings per share). And EPS are closely watched by stock markets. In normal times, the more debt (borrowing) is used to finance a business, rather than shareholders’ funds, the higher will be EPS afterwards. Debt-funded acquisitions allow executives to achieve a rapid increase in the ratio of debt to equity in the acquirer’s balance sheet, and thereby magnify EPS. And the benefits of debt are reinforced by a number of privileges and subsidies which accompany debt finance. While diminished overall equity – a weaker balance sheet – increases downside risk, this potential downside of debt for shareholders is reduced by limited liability – a privilege which rewards shareholders with the whole upside of their business but limits their exposure should it fail. This means that other stakeholders carry much of the risk burden. For example, merging firms have exploited their increased market power to impose longer payment delays on suppliers: in effect this means that trade creditors provide free loans to their customers. And a target with an under funded pension scheme may be acquired with little equity invested - the acquirer simply takes over the business including liabilities for the pension scheme, which often do not have to be met until years later.