Infinite Debt

Sometimes you are extremely privileged and have access to more debt than you'll ever need.

Unfortunately, this infinite financing can create the illusion that your cost of capital is much lower than it really is.

Last year a finance manager told me the following during some heated discussions:

"Your discount rate doesn't make sense [for the project being discussed]. I can borrow at 4.5% for pretty much anything. Our credit lines are pre-approved to $2b, so trust me, we are not running out of financing anytime soon. That's why I take on any project that yields at least 5.0% return; it always makes sense. My cost of capital on EVERY project IS 4.5%. The bank is financing 100% of these."

Was he right? This comment was so logical it definitely made me pause and question my entire training.

Something felt wrong though, and the only way I could make sense of this was by thinking about some extreme examples.

So I immediately asked, "Would the bank allow you to invest in high-risk projects at this rate?"

He wanted to say yes, but instead paused and muttered: "Well... the covenants only allow certain types of projects - they're lengthy, so let's not get into it..., I might have to increase our 'down payment' to convince the bank to fund it, but that's it, they'll fund it."

I think that kind of settles it.

Maybe the expected return IS 5.0%, but certainly, some projects will yield less, and some might even not yield anything at all. So if you are borrowing at 4.5%, who makes up the difference in cash for those failed projects?

YOU DO, with a 'reserve' portion of more expensive equity.

What do I mean YOU make up the rest?

Although at first blush his situation seems like an arbitrage opportunity, the 0.5% is really what you cover through your company's equity. It doesn't mean that you will not (on average) be able to cover your debts and create an extra 0.5% return, but that additional risk has an additional cost.

Every time a project fails you are still on the hook for that debt repayment!

That is why the covenants do not allow you to finance a 20.0% risk project with no skin in the game. You would quickly default on enough projects to make the bank rethink its arrangement with your firm.

ALSO, remember opportunity costs! Having to service debt with your own capital will prevent you from undergoing other investments at higher yields.

Opportunity cost is a real cost, and every time you invest in a 5.0% project, you forgo the opportunity to invest in a 6.0%, 7.0% --> 8.0% return project.

The lesson in all of this is that your cost of capital is not your borrowing rate

You are making up the risk gap indirectly with your equity, and unfortunately, there may be infinite debt, but not infinite equity, and definitely not infinite arbitrage!

And of course - AVOID THE TEMPTATION TO USE A DEBT PONZI SCHEME! Servicing failed debt with additional debt is dangerous and finite. While it can get you out of the hole, it can only be done a small number of times (if that).

So how does the story end?

We debated a bit more and he finally understood what I was saying. The risk of the project is not influenced by YOUR cost of capital. It is influenced by the payoff curve, which is correlated to risk, and correlated to the final rate of return - a market-level cost of capital.

Only risk-free projects will return the risk-free rate consistently and infinitely cover risk-free borrowing rates.

In the long run, the cost of capital will show its true colors, and you will get stuck with that debt payment despite no project cash flows to service it.