Debt is bad. At least that’s the conventional wisdom among most investors, especially in India. Yet in a survey conducted by Mckinsey, CFOs all over the world were asked to rate their choice of financing and the results were somewhat surprising:
- Retained Earnings
- Straight debt
- Convertible Debt
- External Common Equity
- Preferred Stock
- Convertible Preferred Stock
The financial hierarchy is also remarkably stable across industries and geographies. Clearly debt has its advantages. But conventional wisdom about debt can’t be ignored too.
Debt Financing: Advantages
- Tax Benefits: Let’s start with the easy one. To the extent that a company’s marginal tax rate is high, debt financing appears cheaper because interest payments are tax deductible.
- Adds management discipline: Considering that debt payments are periodic contractual obligations, they force the management to be more conservative in their choice of projects. This argument works best for conservatively held public companies with stocks held by millions of investors, none of whom own a large percent of the stock. In these companies, significant power is held by the management and this added discipline might be beneficial. Young companies are also better suited for equity financing as they may not be able to generate sufficient cash flows and also need to invest in risky projects in order to grow.
Debt Financing: Disadvantages
- Threat of Bankruptcy: As mentioned earlier debt payments are periodic contractual payments and failure to do so can lead to bankruptcy. Firms whose products are discretionary and which have high cash flow variance are more susceptible to bankruptcy. Also, the real cost of bankruptcy is reputation risk. Once people believe that you are in trouble, then you really are in trouble. Suppliers will demand advance payments and cost of financing will be significantly higher. Airline companies which rely more on reputation will be more affected as compared to a grocery business for example.
- Agency Cost: An agency cost arises whenever you hire someone else to do something for you. It arises because your interests may deviate from those of the person you hired. In the case of companies, when you lend money to a business your interests may vary from the interest of the stockholders. How?
- Lenders want their money back while stockholders want to maximize their wealth
- Equity holders might want to invest in riskier projects than what lenders would want them to
- Stockholders might want to pay themselves large dividends when lenders would want them to hold cash in the business
- Businesses will high tangible assets will have less agency cost compared to businesses whose main assets are intangible
- Loss of future financing flexibility: When a firm borrows upto its debt capacity it loses the flexibility of financing future projects with debt. Other things being equal, the more uncertain a firm is about its future financing requirements and projects , the less debt the firm will use for financing projects.
If all this feels a little abstract let’s take a live example, ITC Limited.
ITC: Financing Mix
ITC is one of India’s foremost private sector companies with a market capitalisation of US $ 50 billion and Gross Sales Value of US $ 10 billion. ITC has a diversified presence in FMCG, Hotels, Packaging, Paperboards & Specialty Papers and Agri-Business. ITC has almost no debt. It’s debt ratio (market value debt/market value of debt + market value of equity) is 0.12% which is negligible. But given the advantages of debt, I wanted to explore whether the company was being too conservative.
Let’s review the disadvantages of debt in relation to ITC. At its current stage the company is relatively certain about its future financing needs, hence the company shouldnt fear the loss of future financing flexibility. In any case, it can always raise more equity capital if it wants to later on. It has many tangible assets and hence shouldn’t fear agency cost, while bankruptcy looks out of the question right now.
ITC: Cost of Equity
The cost of equity should compensate investors for the systematic risk (non diversifiable risk) they take when they invest in the stock and is given by:
Cost of Equity=Risk Free Rate + β*(Equity Risk Premium)
The risk free rate is the latest ten year government bond yield for all practical purposes and the equity risk premium is the premium investors charge for choosing to invest in equities rather than the much safer government bond. This figure can range from 4-5% depending upon the risk free rate. Beta is generally calculated through a regression and generally depends on the following factors:
- Operating Leverage: The higher the fixed costs relative to variable costs, the greater the systematic risk. In the coronavirus crisis, manufacturing companies with higher fixed costs have been hurt more than others and hence have a higher beta.
- Financial Leverage: High debt to equity firms are riskier than low debt to equity firms and consequently will have a higher beta
- Discretionary spending: To the extent that consumers can do without a company’s products and services, the company will have a higher beta. This is why pharmaceutical companies will always have a low beta of less than one unless they have high financial leverage.
I estimate the unlevered (without financial leverage) beta for ITC at 0.9 for the company. As my debt rises my levered beta will rise as follows:
Levered Beta= Unlevered Beta*[1+(1-tax rate)*Debt/Equity]
ITC: Cost of Debt
The cost of debt shall also rise as debt increases. Lenders won’t want to lend to companies with a high amount of leverage. To estimate my cost of debt I use the interest coverage ratios at different levels of debt to assign a synthetic rating to the company. This synthetic rating shall give me my credit spread over the risk free rate which in turn will give me my interest expense for next year.
ITC: Recapitalization Exercise
The weighted average cost of capital (WACC) is the weighted average of the cost of debt and equity. The weights are the market values of debt and equity and not the book values of debt and equity. Please refer to the recapitalization sheet below:
The tax rate starts to decline after a debt ratio of 50%. This is because after this, the interest expense becomes more than the operating income. The interest expense each year is calculated by multiplying the pre-tax cost of debt by the amount of debt that year. The interest coverage ratio gives the synthetic debt rating which in turn is used to calculate the cost of debt each year.
As can be seen in the last row, the cost of capital first declines until the 30% Debt Ratio to 9.85% and then moves sharply upward. Needless to say, if you have to make an error, it’s better to make an error being conservative than being aggressive given the surge in the cost of capital. But from the sheet, one can observe that the cost of capital at 30% debt is less than the current cost of capital.
What does it mean for value creation?
The current enterprise value of ITC is about 2,24,514 crores. The cost of financing is 10.05%. Post recapitalization, at 30% Debt Ratio the cost of financing drops to 9.85%. This results in an increase in annual savings. Using a terminal growth rate of 4% in the terminal value equation can give us the overall gain in value by changing the financing mix as shown below:
What can go wrong?
From my calculations, I want the ITC management to wake up tomorrow and take up around 70,000 crores of debt. To put it mildly, they might have some reservations about it and rightly so. I can think of two:
- What if the operating income goes down? If the operating income declines, the interest coverage ratio shall decline leading to worse ratings and higher cost of debt. Considering the scope of growth in all of ITC’s businesses I don’t think there should be a downturn. But still, I decided to take a look at the last 12 years results.
Considering that in the last ten years, ITC’s revenues have only increased and bulk of the revenues come from non discretionary products, this isn’t likely to be a relevant factor.
- Debt Rating at optimal debt ratio: The debt rating for ITC at a 30% debt ratio amounts to A3/A-. It’s still above investment grade but there is little room for error. As I said earlier, it’s better to make an error being conservative than being overly aggressive. Hence, I choose a debt ratio for 20% as the optimal debt ratio for ITC instead of the 30% I chose earlier. I get a double A rating but my increase in value drops from 7,780 crores to 6,750 crores, which amounts to about INR 5.5 per share.
What should ITC do?
ITC should borrow about 46,500 crores and give it away to investors as dividends or buybacks. Considering the tax effects of dividends & the drop in share price recently, buybacks seems to be a better option. At what price you might ask? The price should be such that the shareholders who sell and the shareholders who remain are indifferent. Given the current stock price of 188.15 and the increase in value of INR 5.5 per share, a buyback price of INR 193.65 would mean that the investors who sell and the investors who remain get the same share of the increase in value. Investors who sell get the benefit of selling at a higher price and the investors who remain benefit because of the reduction in the number of shares.
But let’s say no one wants to sell their shares because they feel that the company is undervalued. In that case borrowing and giving away dividends seems like a better thing to do. This would amount to a cash dividend of INR 37.63 per share. That’s a one time dividend yield of 20%. This dividend yield of 20% along with the expected price appreciation if the stock is undervalued can be pure gold for investors.
Why don’t CFOs do this all the time?
The answer to this is a little tricky. Companies generally want to replicate what their peers do in the market. The bulk of ITC’s revenues come from the cigarettes business and the FMCG business. The top companies in both the sectors have negligible debt. There is also a sense of ego. Companies take pride in being triple A rated. But the advantage of being AAA rated is that you can get cheap debt. However once you take this debt your rating drops. In my view it’s better to borrow cheaply than to have the option of borrowing cheaply.
The optimal debt ratio will vary for different companies. Companies should look for a way to achieve a financing mix which generates the maximum value for investors irrespective of the stigma associated with debt.