Advantages of Debt

Etb's picture
Rank: Senior Monkey | banana points 76

Hi,

why is having a certain amount of debt being preferred to having none? I get that interest expense is tax-deductible but isn't my net income always lower when having debt as opposed to having no debt?

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Comments (16)

Dec 3, 2018

There used to exist this thing called positive leverage. Where by using debt you would decrease the equity contribution used to make an acquisition. With a certain level of debt the payments minus the net cash flow while less than just the net cash flow would yield a greater return due to the equity contribution being lessened. So with less equity you are able to increase your returns more so than outright making an acquisition.

Dec 3, 2018

I bet it is too complex of an issue to make a simple numbers example, isn't it?

Most Helpful
Dec 4, 2018

Very simple example...
Scenario 1: I buy an asset for $100 using $100 of equity. 1 year later, I sell the asset for $120. The return on my equity is 20% (20/100).

Scenario 2: I buy the same asset for $100, using $80 of debt and $20 of equity. 1 year later, I sell this same asset for $120. I pay off the $80 of debt yielding $40 for myself. I double my equity return (40/20).

Question for you - does your profile suggest you are in PE or that you're aspiring to be? This is a fundamental premise of PE.

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Dec 4, 2018

No, but I stumbled over it in the context of LBOs :)

Dec 4, 2018

Guess what confused me is reading about tax "savings". I always thought that would mean you're eventually better off as without the respective expense.

As I've understood it now it is more like that you have to pay sth (i.e. 5k interest) anyway, which will eventually lead to less net income compared to a szenario without the expense, but at least you can subtract it from your taxes due (so you don't pay 5k but rather 5k*(1-t)).

Could you describe it like that?

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Dec 4, 2018

Think about it in terms of if you are an outside investor and a creditor (and thus receive the interest payment). The higher the debt load, the greater interest you receive as the creditor and then since that is tax deductible, that is less taxable income that you realize as an equity holder.

I.E.
Imagine a $10 enterprise, funded completely by you with $5 in equity and $5 in debt. And say the debt charges 20% (for simplicity in the calculation) and the tax rate is 40% (again for simplicity). Also your EBIT is $10 (bear with me). So the company pays $1 in interest to the creditor and the EBT is $9 and after taxes the equity holder receives $5.40 -> total tax to the enterprise is $3.60. The creditor is likely taxed in a different bracket than the enterprise and that is likely a separate calculation. But if you had no leverage, then your EBT would be $10 and you would have paid $4 in taxes, all flowing through to the equity holder. So yes, as an equity holder your NI is lower, but if you think about in the context of a holistic investment, you receive $6.40 ($5.40 in RE and $1 in interest).

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Dec 4, 2018

Thx for the explanation. However the last sentence confuses me. By more holistic you mean that one would take the role of an equity and debt investor? Is that commonly done?

Dec 4, 2018

I wouldn't say "commonly". This is a really academic way to think about it; what's taught in corporate finance classes. But that doesn't mean that some funds don't take multiple positions in the capital structure.

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Dec 3, 2018

CoC is generally lower than equity with some amount of debt due to the tax advantage, but that advantage goes away with too much debt due to the potential cost of financial distress. This is why companies look for an optimal capital structure.

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Dec 3, 2018

Several reasons:

  1. More debt = more money to expand your business = more revenue -> generally, more net income. If you can get a bank loan of $100 (interest rate of 10%/year) now but you're sure you you can make $150 by the end of the year (which is enough to pay both the principle + interest), does it make sense for you to do it?

Also, the way you framed the example is as follows: company A has equity of $100, no debt, while company B has equity of $80 and $20, so yes, assuming that no dividends are paid and the EBIT line is the same for both companies, then company A will have higher net income.

Then what about this scenario: company A has equity of $100, no debt, while company B has equity of $100 and debt of $100?

  1. Cost of equity is generally higher than cost of debt (when the debt level is low) -> to achieve an optimal capital structure (it's like a U curve where WACC is at the lowest point), therefore a mix of debt and equity is preferred
  2. It's much faster to acquire additional capital by getting bank loans than issuing new shares (at least in my country)
  3. It's not mandatory to pay dividends to shareholders, but when dividends are paid, they are not tax-deductible -> debt is cheaper
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Dec 3, 2018

If your business is big enough to secure non-recourse debt and you have a valid way of using it, then you should always use it because you can pay yourself more in the interim and use leverage to execute on growth initiatives without really increasing risk to the co unless you get excessive leverage.

Being able to pay yourself more in the interim = derisking too. That's why PE funds use divi recaps when interest rates make sense.

Dec 4, 2018

Feel like the majority has been mentioned above so far, but also inflation works to your advantage as a borrower... $1 today is not worth a $1 in a year as you slowly repay that loan.

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Dec 4, 2018

this is a good point, the government targets 2% inflation, so you already have tailwinds structured in, in the event the governments debt burden gets out of control and their only option is quantitative easing, well, then hyper inflation starts making debt look pretty nice. As baby boomer's social security obligations start piling up, I am happy to be holding loads of debt :)

EDIT: Safe levels of investment debt, consumer debt is a poor mans game, investment debt is the rich mans game

Dec 4, 2018

Using someone else's money is always better...

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Dec 4, 2018

As a consumer, having multiple diverse lines of credit increases your credit score. With everything else mentioned above, it's always good to have access to some form of credit.

Dec 4, 2018

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