When is Debt Good?

Most of us don’t care for debt. We hear about the crushing effect of consumer debt on our economy. So why is debt for a business a good thing? There are two reasons why a company should use debt to finance a large portion of its business.

First, the government encourages businesses to use debt by allowing them to deduct the interest on the debt from corporate income taxes. With the corporate tax rate at 30% that deduction is quite enticing. It is not uncommon for a company’s cost of debt to be below five percent after considering the tax break associated with interest.

Second, debt is a much cheaper form of financing than equity. It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return.

Debt is much less risky for the investor because the firm is legally obligated to pay it. In addition, shareholders (those that provided the equity funding) are the first to lose their investments when a firm goes bankrupt. Finally, much of the return on equity is tied up in stock appreciation, which requires a company to grow revenue, profit and cash flow.

An investor typically wants at least a 10% return due to these risks, while debt can usually be found at a lower rate.

Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money.

So why not finance a business entirely with debt?

Because all debt, or even 90% debt, would be too risky to those providing the financing. A business needs to balance the use of debt and equity to keep the average cost of capital at its minimum. We call that the weighed average cost of capital or WACC.

For more information reach out to CA Neetu Jain