What are differences between the good and bad debt?
What are differences between the good and bad debt?
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This is a fairly ridiculous question, but the best answer is:
Good debt is debt you can reasonably expect to pay off on time.
Bad debt is debt you cannot.
There are also a lot of other factors involved like relative cost of capital, tax shields, etc.
While it is a ridic question, captk is incorrect. "good debt" is debt that you use for capex at a rate that significantly reduces the WACC. While debt will always lower the WACC when compared to using more equity, good debt is the debt that balances your capital structure and allows you to use some leverage in your future projects. Bad debt is generally debt you must write-off. I could go on, but I am at work and have to format slides.
This is far from correct. Debt will not always lower your WACC when compared to using more equity.
@nystateofmind: given that equity is usually more expensive than debt, more leverage tends to lead to a lower WACC. Unless you're talking about start-ups?
Do you have any idea what you're talking about beyond a textbook paragraph?
The poster clearly needed a simple explanation (this is his only post) so that's what I gave him, and I stand by what I wrote. You'll also notice my footnote about relative cost of capital, tax shields, etc.
I'm wrong? Let's dissect the ways you're wrong.
1.) "Debt will always lower WACC compared to equity" - Wrong. There is a breakpoint where your company is too highly levered and your debt will be more expensive. This is when your debtors become more uncertain that you can pay off your debts. Thus my comment about debt "you can reasonably expect to pay off".
2.) "Bad debt is debt you must write off" - Why are you speaking from a creditor's point of view? The first part of your comment is clearly from a borrowers point of view. Perhaps you've seen a "allowance for doubtful accounts" line in your brother's finance book, and that's where this is coming from?
3.) "I have to format slides" - You're not formatting slides. That's what I do. You're printing and binding my slides. Please don't fuck up my books. And email when they're ready.
.
to a certain point, yes you're right more debt will lower your wacc. but there is typically a point where more debt drives up your wacc. think about it, once a given firm has a certain level of debt, equity holders and future debt holders are going to up their respective required rates of return and drive up the wacc.
Well yeah, once a company becomes too leveraged. Ok, I agree.
In Miller and Modigliani's Nobel-winning paper, they show that in theory: using debt v. equity should not matter (oh god nerding it up here).
The point of their paper though, is not to imagine the world as a perfect place with:
-not taxes -no transaction costs -no chance of bankrupty
The point is that in the real world, these concerns are the main focus of using leverage, and will effect how the capital structure is built. The main focus is the tax benefit and the downside, risk of bankrupty as the D/E ratio increases.
A good way to think about it is through APV (adjusted present value), a different form of DCF where:
PVfirm= sum(FCFF/ke) + sum(PV of the tax shield) - (probability of bankruptcy) x (cost of bankruptcy)
Where the probability of bankruptcy is usually proxied by historical default rates given different grades of credit.
Think about it: people like gio might say that "debt will always lower the cost of capital because it is cheaper than equity", but of course, as we know, there is a downside in that the chance of bankrupty/default increases as the firm is leveraged up.
Always. From a firms perspective, things can be more RISKY if it takes on too much debt (as we have seen in this bubble), however, debt is always cheaper than equity.
Since in the event of bankrupcy, the equity holders are screwed, the debt holders are safe (e.g. bear stears). Also, equity is inheritly riskier than debt, thus debt issuers will always require a lower RR or return.
This is not to say a firm should utilize all debt, because if it cannot pay its interest payments, shit happens.
hahahhaha.. wow, you are dumb.
the beta of whatever company determines to some extent how how heavily equity will raise the WACC
Higher debt has several implications on WACC. Cost of debt is lower than cost of equity. So, to the extent debt is a greater portion of the cap. structure, WACC is lowered. However, according to MM, cost of equity will correspondingly go up and, theoretically, will offset all benefits of higher debt, resulting in same WACC. HOWEVER, since debt is tax-deductible, WACC is lowered by the tax benefit of debt. If we focus on the numerator of DCF (i.e. cash flow), higher debt could be beneficial in that it focuses management to run a better operation, but on the flip side, limits their flexibility in making investing decisions. Obviously, we need to layer in the cost of distress in highly levered situations
Depends on your perspective. "Good" debt for one player (i.e. PE fund) might be considered "toxic" debt for another (i.e. Bank).
Generally speaking...and based on my complex financial excel model...supported by sound textbook finance theories and empirical data...
Debt supported by cash flow and liquidity is good. Debt not supported by cash flow and liquidity is not good.
Alliance Boots second lien at 85 is better debt than lafarge at 30 even though lafarge gives you the chance for a tremendous IRR!
Very simply, when you think of a good credit you divorce thoughts of how good the company is in and of itself, and evaluate the quality of the "credit." When I do this I think of things like asset cover (how much of the cap structure is covered by the company's balance sheet), how leveraged is the company, is the debt still in the money? What's the pricing? How good is mgmt? How incentivised is mgmt? What's cash flow conversion of EBITDA?
Often, in the same company, good debt can be the mezz while bad debt can be the senior depending on pricing/leverage or vice versa. Ultimately, debt investors want to see that they will get their money back with as little headache as possible along the way.
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