I’ve talked more recently about somewhat advanced topics that may go above and beyond what the typical reader may care about. So I want to get back to my roots today and translate some normal business topics into terms that people outside of Wall Street would actually pay attention to.
In personal finance, debt is considered the most evil thing on the planet. It should be avoided at all costs. To an extent, I can agree with that. That is for a couple of reasons. For one, the average Joe can’t be trusted to manage his money. If he could, there wouldn’t be a personal finance media industry that even this humble blogger belongs to. It’s built upon the idea that people are bad with money, and will continue to be. The other reason is that debt does shackle you and hold you back. You make regular payments to some kind of financial company and that’s money that could be in your pocket.
Businesses look at debt in a completely different light. Perhaps they’d like to avoid it, because they do have to make payments, but at the same time debt allows them to do things they wouldn’t normally be able to do.
Businesses that are owned by shareholders only have two sources of money to make things happen. They can borrow money from banks and bondholders, or get it from investors. In both cases they must return this money. This is different from when you get paid. You get paid and then you have to pay your debts, but you don’t have to give anything to your parents (who may be your only “investors”). Like debt holders, shareholders expect to receive a certain portion of their money back in regular increments. This may come in the form of dividends, or in the appreciation of the value of the stock. The stock price goes up when the company gets more and more profitable.
There are expected rates of return for the shareholders and debt holders. This rate of return is called the cost of capital. The cost of capital for shareholders can be very high. This is to account for certain risks. If a company goes bankrupt the shareholders may not get anything, and the business can always refuse to pay the money back (though investors will sell their shares and the company will suffer in other ways). The cost of capital on debt is much lower than on shareholders (also referred to as equity). The cost of capital on debt may be 5%, but for equity it can be 15%. Companies must consider the cost of capital when evaluating projects.
Say the company has $10 million, $5 million from debt, and $5 million from equity. They have a project in mind that is expected to return 9% on their investment. Should they do it? The answer is no because when it’s all said and done they won’t be able to generate enough return to pay investors and debt holders. The average cost of capital for the company is 10% ((15+5)/2). This project would technically lose money for the company.
But they can use debt to make the project profitable. If they borrowed another $1 million at 5% and used it to buy back $1 million in shares from their investors, they would then have 60% debt and 40% equity. The weighted average cost of capital (referred to as WACC) is now 9%. They would have return 9% to their sources of money, and the project returns 9%. This is a now project that would break even.
You might be thinking to yourself, why not just find a project that could return 10%? Well first of all there’s never a guarantee of returns, it’s a best guess. And second of all 9% may be the best out there without taking serious risks. In an economic environment such as today, they may only be able to get 9%. Businesses will use debt to lower their cost of capital.
This has its risks of course. You don’t have to pay back shareholders, or you can at least push it back if you need to. Debt owners want their money and they want it when you say you’re going to pay it.
It’s amazing today that companies aren’t taking more advantage of this. With interest rates are record lows, companies with good credit can borrow money for next to nothing. But as many company bosses have said, they don’t have anything to spend it on. There just aren’t many good projects out there where they can make a decent return.
Now just because I said companies like debt, doesn’t mean they all use it or want to use it. Apple for example has no debt, and mountains of cash. They actually have so much cash that investors are getting angry that they aren’t doing anything with it. Microsoft doesn’t have much debt, and they’re actually considering borrowing a little bit more to pay back shareholders (and lower their cost of capital). Perhaps they have their eye on some lower return projects. Businesses embrace debt more often than a fiscally conservative Average Joe, but as we’ll see tomorrow, there are times when Average Joe should embrace debt too.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
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