What is the optimal debt or equity proportion, that’s the question

Too much of a good thing

The cost of equity has always been higher than cost of borrowing. It explains the leverage of some corporates, sometime up to a unreasonable level and with excess. Leveraging to maximize its WACC seems to be a good financial idea and a sort of best practice. However, crises have demonstrated and last COVID one that too much of a good thing can be dangerous too, when we face a liquidity risk, a credit crunch, or a freezing of the whole economy during a lockdown period. Academics and economists would claim that excessive leverage is the seed for enabling business to privatize gains while socializing losses. CFO’s must balance the desire of increasing shareholders’ return and the wish of mitigating risks of default. The alchemy is not purely mathematical and theoretical. It is much more complex than that. But the tax deduction for business interest can encourage C-level to borrow more than they otherwise would have done. Tax deduction could push managers to take the wrong decisions. However, BEPS translated rules are limiting in OECD countries the interest deductibility to a maximum. Men claim it remains theory as rates are so low or even negative, which is true in a sense. Please do not forget that paradox of such a rule: the lower the EBIT(D)A, the more difficulties a company is facing, the more loan it needs, while the less it will be able to deduct. Tax deduction would help the weakest, normally and will be capped under BEPS rules. It is an issue you do not have with raising equity. You only pay dividend if you can do it. It is less risky. Although debt can be good and is at the heart of Private Equity businesses, it is an explosive cocktail to use with precaution and without excess. PE’s force their assets to take debt to magnify financial returns and discipline the management to reduce costs all-in. Debt can go along with discipline and at the end of the day efficiency.

More favorable treatment of debt

It is fair to admit that debt is treated more favorably than equity, making interest (still) deductible (until a certain level versus EBITDA), but not dividends. The Belgian have invented the great concept of “notional interests”, adopted by some other countries although not that popular although so smart. It is also true to confess that with low and negative rates it does not fly anymore. But the idea was interesting to compensate equity penalty in granting notional interest deduction to equity too. The shareholders do not receive credit for corporate taxes paid. It may explain why companies prefer debt to equity. With similar treatment, it could change the whole approach. Nevertheless, when highly leveraged, a corporation has less buffer in equity to face the blow when business is bad or when COVID suddenly stops everything. By reducing interest deduction, somehow BEPS actions have given an incentive for borrowing less. A complete non-deduction seems inconceivable for many (good) reasons.

Of course, we could level the playing field by treating both more fairly. As always, the problems come when we have excesses in leveraging and zombie companies in low sub-investment grade areas. Non clearly framed and limited concepts exist, they can be stretched up to the maximum limits and when a significant issue arise like lockdown, the company may collapse and go bust soon. If excess debt is a problem, abolishing deductibility of interests is not a solution. Debt remains an important tool of our financial markets and principles. Changing such a fundamental principle would be risky. We won’t be able to answer the question of what is better or not and if such a difference is fully justified or not. However, changing the rules, in a more “normal” situation could only come from an alignment of capital notional interest deduction and not on the abolition of interest deduction, in my view. Even if the situation should be better balanced, I do not foresee major moves in Western countries, especially in regions with negative interest rates.

Fran?ois Masquelier, Simply TREASURY