Put yourself in the shoes of the CFO of a company. One major aspect you will be confronted with in your job will relate to the financing of your company's assets. Just like a plant needs water to grow, businesses need capital in order to expand. For this you have two basic choices, go to a bank and ask for a loan or sell a stake in your company to raise capital. Basically issue either debt or equity.
As a prudent CFO, you would be ideally looking for the cheapest source of finance. So as a general rule, which source is cheaper, debt or equity?
Well with all the IPOs doing the round these days, you must be thinking that equity is the cheaper source of finance. After all, promoters are just selling a small portion of their business. And with markets currently at lofty valuations, it may be a lot easier to get a handsome bargain. Some promoters even take on additional equity to pay off their debt lenders. So equity seems cheaper, right?
However, debt is actually the cheaper source of finance for a couple of reasons.
Tax benefit: The firm gets an income tax benefit on the interest component that is paid to the lender. Dividends to equity holders are not tax deductable.
Limited obligation to lenders: In the event of a firm going bankrupt, which is what happened with Lehman Brothers, equity holders lose everything. But, debt holders have the first claim on company assets (collateral), increasing their security. So since debt has limited risk, it is usually cheaper. Equity holders are taking on more risk, hence they need to be compensated for it with higher returns.
- Limited upside: Since the equity holder has a stake in the business; he can actually participate in the potential upside in earnings. PE, Venture Capital funds usually buy stakes in high potential companies at cheap valuations, and since they have a minority stake in the company, they are entitled to a share of the profits. Plus they can exit after a few years at a fantastic premium. On the other hand debt holders have an upside limited to the fixed rate of interest they receive every year.
However, taking on debt financing, though cheaper is not without risks for the firm taking on the debt (borrower). Or taking on debt may not be suitable in certain situations.
There is limited risk for the lender, but high risk for the borrower. This is because the debt needs to be serviced i.e. principal and interest repayments need to be made, irrespective of whether the firm is making a profit or a loss or general economic conditions. Firms with large debt balances during the economic crisis, felt tremendous pressure.
Taking on debt can be beneficial till a certain point. But when the company becomes over-leveraged, the cost of raising additional debt becomes more and more expensive. This is because the earlier lenders would have laid the first claim on the company's assets. The subsequent lenders will thus charge more interest as the lending becomes riskier. Credit ratings also deteriorate as more and more debt capital is raised.
- We often hear of massive amounts being raised through some IPOs. Coal India plans to raise US$ 3 bn. Petrobas in Brazil, raised US$ 70 bn in the world's largest IPO, recently. These companies can afford to raise this kind of money as the risk is relatively diversified among a large group of investors. A bank or even a group of banks would never lend such huge amounts to one borrower.
Now you know that debt is usually a cheaper source of finance than equity, but not always the case. So next time if you see debt on the balance sheet of a company you are looking at investing in, don't be too alarmed. If the quantum of debt is not too high and it is taken at cheap rates then it is a good, cheap alternative. The company's return on equity can even be enhanced through leverage.
However, this does not mean that taking on debt is suitable for all companies. And risks of over-leveraging are always there. Too much of a good thing is usually bad.