Why companies use debt ?

[WneverLOSE]

This may sound kind of dumb, and it is probably is, but I am trying to understand why some companies like Berkshire, Moody's, General Electric and Procter & Gamble borrow money ? they have been in business for decades if not more and they produce huge amounts of cash flows. why do they need to borrow money at X% if they can pay it down and use their own money (which is free) ?

 

I am asking since when trying to discount all future cash flows to equity owners I assume that the company will hold its debt level forever, which seems to be the case in real life, but why is it ?

[doughishere]

Theres been a few times where Buffett uses it just in the short term...on at least one occasion hes said that if he needs to come due for something he can always sell stock in some of its holdings.

 

 

I tend to call debt leverage which is just borrowed funds to gain a very high return in relation to one's investment, to control a much larger investment, or to reduce one's own liability for any loss.

 

 

I am asking since when trying to discount all future cash flows to equity owners I assume that the company will hold its debt level forever, which seems to be the case in real life, but why is it ?

 

This is one assumption that you are just going to have to make. Buffett has decided to take the high road and not employ as much as others. Although I bet this thread will talk about the technicalities of "a float" and the DTAs....which there are some good points to make.

[benhacker]

W,

 

Your question to me is very strange because of the assumption you made, but don't take that as it is dumb to ask.  These basic things are often the most useful to think about from a standpoint of business.

 

why do they need to borrow money at X% if they can pay it down and use their own money (which is free) ?

 

Why would you consider the cash which a corporate owns is "free"?  The precise reason why you discount cash flows from the future to today to value them is because cash is most certainly *not* free.  If a company has $1m and they choose not to give that immediately to shareholders... well that has a cost (to shareholders) right?  We could all argue about what it is... but it's not free.

 

I am asking since when trying to discount all future cash flows to equity owners I assume that the company will hold its debt level forever, which seems to be the case in real life, but why is it ?

 

Well this is a separate issue.  If a company carries a bunch or debt into the future, or it decides to pay it down, I would think that the risk and magnitudes of the cash flows to owners would change, right (again, assuming identical company choosing two separate paths...)?  So if you make an assumption about a company maintaining / increasing it's debt, and then paying you some level of income, that's fine.  But if you believe that same business would endeavor to repay debt instead, you would have to guess the cash flows (again, to you as an owner) will be reduced right?

 

Let me know if this is a disagreeable assumption to you.  Don't confuse the way in which some folks value companies to the reality of how real companies work.  Shockingly, the two are somethings not even really closely related.

 

-- To directly answer your question --

 

There are a few direct reasons to why companies may borrow money, none of which are really addressed by my commentary above.  In no order:

 

1) To increase per share / shareholder returns - Generally, if a company can borrow below it's marginal rate of investment, and it can carry that debt through and not be caught out in a downturn and forced to liquidate or repay / dilute, then it would seem adding this leverage would increase returns to equity.

 

2) Increase equity asymmetry / Corporate Structure leverage - Some shareholders may appreciate the capped downside (you can only lose 100%) / unlimited upside of a corporate structure where you only own equity.  Leverage allows you to magnify this effect (you still only lose 100%, but can gain more via the leverage if things work out).  This is arguably most common private equity management strategy.

 

3) Corporate borrowing rates may be lower (at the same terms) cost than individual borrowing.  So it's not realistic for individuals to "tune" their leverage to their liking and having the corporation do it is better.

 

4) Corporations don't generally get a valuation premium for their equity if they don't use leverage, but bond investors will pay a valuation premium for contractural (debt) cash flows.  Thus, the low leverage equity implied valuation is lower than the equivalent leveraged bond position.  I think this is a structural inefficiency because the market for bonds and stocks are inherently different because of regulatory and psychological reasons.

 

5) Size - Management generally gets paid with size, so debt is a way to grow larger without tapping shareholders... so it is often done even if it doesn't make sense.

 

6) Fraud - High debt levels of debt generally muddy financial statements and allow for some shady activities, and also a way to transfer more $$$ in and out of the company.  You will rarely see frauds in non-levered companies.

 

7) Kind of implied in several items above, but investing is about risk / reward, so adding / removing debt allows dynamically setting of the proper risk / reward for shareholders.  Arguably there is some "optimal" point of leverage, but more realistically, there is a range that makes sense and a corporation can tune this risk / reward to what their shareholders want.  In reality the overall bubbliness of the industry / market / economy sets this more an industry and individual companies tend to move in the same direction over cycles (in my experience).

 

8) Debt is a deductible expense.

 

9) Liquidity - Many companies need a cushion in the short term in case there is a business disruption of any kind or a banking system seizes, etc.  Most companies for this reason always carry some minimum of cash (while also carrying debt).  This isn't because the cash earns anything, but it's because the cash is needed for liquidity buffer, or something else (regulatory, relationship, psychological etc etc)

 

I'm sure I missed some that others can throw out there.

[WneverLOSE]

Hi ben,

Thanks for trying to explain to me, I guess I still don't quite understand

 

When i am saying "free" I mean it in the sense that I don't have to pay for it. Cash has no cost to the company, while debt does have ( Let's say that a company ABC takes 100m in a 10% loan and just lets the money sit there for 10 years, the money is gone, total loss. while cash can sit on the balance sheet and 10 years from now it still will be worth 100m 2026 dollars).

 

Now my question is why companies that have 1B in cash on the balance sheet still carry debt of 1B ?

 

Think about it this way : Why would Adam take 100K loan from the bank at 10% interest in order to buy stocks that he think will earn him 12% while he has 200K on his checking account ?

 

With a loan he will only make 2% on his investment while using his own "free" funds he will earn the full 12%.

[rb]

Your example skews where you use 10% interest rate loan (who pays that?) skews the case. Anyway there are several reasons why a company may choose to borrow to invest instead of using own cash. A couple come to mind quickly.

 

1. Companies prefer to have a certain level of liquidity. For example Buffett doesn't want to drop below 20B in cash. The levels of liquidity proffered by companies are determined by requirements of day to day ops and are a cushion for some future adverse event. It's better to borrow now when you can. When that future adverse event comes and they need their cash they may not be able to borrow it.

 

2. Tax reasons. See big US tech companies. Huge holdings of overseas cash which can't be used because they would have to pay tax for it. So they borrow instead.

[scorpioncapital]

Buying debt at 1% - or negative rates in Europe is an investment, just like any investment a company would make with their cash on hand.

 

 

[TheAiGuy]

Think about it this way : Why would Adam take 100K loan from the bank at 10% interest in order to buy stocks that he think will earn him 12% while he has 200K on his checking account ?

 

With a loan he will only make 2% on his investment while using his own "free" funds he will earn the full 12%.

 

Assume Adam is guaranteed this 12% return.

 

Return without borrowing (annual)

$200k * 12% = $24k

 

Return with borrowing:

$100 * (12% - 10%) + $200k * 12% = $26

 

Even with the added cost of debt, using borrowed money increases his returns on equity if he can borrow at a lower cost than returns on capital.

 

Edit:

 

I guess if your question is "Adam has an opportunity of investing $100k for an annual return of 12%. Should he borrow at a rate of 10% to invest? Or should he use the $200k in his checking account?" then, yeah, borrowing isn't a great idea there. Borrowing makes sense when you can invest more money than you otherwise could (for one reason or another + ancillary (e.g. tax) benefits)).

[WneverLOSE]

Your example skews where you use 10% interest rate loan (who pays that?) skews the case. Anyway there are several reasons why a company may choose to borrow to invest instead of using own cash. A couple come to mind quickly.

 

1. Companies prefer to have a certain level of liquidity. For example Buffett doesn't want to drop below 20B in cash. The levels of liquidity proffered by companies are determined by requirements of day to day ops and are a cushion for some future adverse event. It's better to borrow now when you can. When that future adverse event comes and they need their cash they may not be able to borrow it.

 

2. Tax reasons. See big US tech companies. Huge holdings of overseas cash which can't be used because they would have to pay tax for it. So they borrow instead.

 

Thanks, got it.

Are there any reasons you can think off beside those 2 ? I would love to hear if there are any other ones

[ourkid8]

#3. Companies who can issue debt at a cheaper rate then their dividend yield e.g. Philip Morris international. They can issue long term debt below the price they pay out their dividend so for those scenarios it's truly a no brainer to issue debt to repurchase their stock.

 

Your example skews where you use 10% interest rate loan (who pays that?) skews the case. Anyway there are several reasons why a company may choose to borrow to invest instead of using own cash. A couple come to mind quickly.

 

1. Companies prefer to have a certain level of liquidity. For example Buffett doesn't want to drop below 20B in cash. The levels of liquidity proffered by companies are determined by requirements of day to day ops and are a cushion for some future adverse event. It's better to borrow now when you can. When that future adverse event comes and they need their cash they may not be able to borrow it.

 

2. Tax reasons. See big US tech companies. Huge holdings of overseas cash which can't be used because they would have to pay tax for it. So they borrow instead.

 

Thanks, got it.

Are there any reasons you can think off beside those 2 ? I would love to hear if there are any other ones

[benhacker]

W,

 

I think some folks elaborated on my "liquidity" bullet which seems to get at what you are looking at.

 

But a basic question for you... do you have *any* debt of any kind personally that has some interest cost associated with it?

[Jurgis]

OT

 

You will rarely see frauds in non-levered companies.

 

Apart from Chinese reverse mergers, which pretty much all had no debt.

[benhacker]

Apart from Chinese reverse mergers, which pretty much all had no debt.

 

Very true.  But when cash balances aren't real and there is no extradition, I think you probably don't conform to many rules of thumb. :)

[rishig]

One reason not covered here on why certain companies take on leverage - to resurface value trapped in appreciated assets.

 

Let me give you an example. Say I own an asset that has contractual cash flows that are locked-in for the next 20 years. Say, I purchased the asset when it was "out-of-favor" i.e. the asset didn't have long-term contracts and I bought it at half the replacement cost. Now that the cash flows are contracted and locked-in with an investment credit counter-party, my asset has appreciated in value and at say 5% cap rate may be worth 2x of what I purchased it for. How do I get the "trapped" appreciated value out?

 

Option 1: Sell the asset at higher price.

Option 2: Don't sell the asset, because say there are organic growth opportunities to continue to grow the cash flows.

 

How do I surface the appreciated value if asset falls in #2 category? Putting on low cost debt with maturity profile that matches the contractual cash-flows of asset at 50% capitalization gets my initial capital out.

 

A few assets that have long-term contractual cash flows:  power plants, transmission lines, Grade A office buildings, ports, gas pipelines, specialized rail networks, toll roads. Brookfield is a value investor that is regularly buying these assets at below replacement cost when they are "out-of-favor", stabilizing them using their operating experience, and then resurfacing value using a conservative financial structure at the asset level that is non-recourse to the corporation.

[physcdisp]

Didn't find it here on my quick review of earlier messages - but it is convenient for multinationals to borrow if it plans growth or other uses of cash when cash on the B/S is trapped elsewhere on other jurisdictions.

[Simple Investor]

I am paraphrasing and going off memory.  But according Benjamin Graham if you have a stable business why should shareholders finance the entire business?  Another words a certain portion of the capital structure of a very good business should be debt and not 100% shareholder financed.  Wouldn’t using debt remove some of the risk for the shareholders and place it on the bond holders.  And as mentioned above increase the returns for the shareholders.  Lastly, Graham believed it imperative companies issue bonds for investors.  Almost like their duty.  Some investors need the safe return bonds offer (Pre 1.75% 10-year US treasury). 

 

If we started a biz using only equity and got it going to a fantastic going concern.  At some point it would be smart to take on debt and remove some equity off the table.  For companies like PG they should and will carry debt forever; and hopefully increasing amounts.  At PG the Net Income is 10-14 times interest payment.  Significantly safer than Grahams leverage recommendations. 

 

If I knew I was going to live forever and always make money I would probably always carry a mortgage (maybe 50% Debt to equity). 

 

[glorysk87]

This may sound kind of dumb, and it is probably is, but I am trying to understand why some companies like Berkshire, Moody's, General Electric and Procter & Gamble borrow money ? they have been in business for decades if not more and they produce huge amounts of cash flows. why do they need to borrow money at X% if they can pay it down and use their own money (which is free) ?

 

I am asking since when trying to discount all future cash flows to equity owners I assume that the company will hold its debt level forever, which seems to be the case in real life, but why is it ?

 

They teach the Modigliani-Miller theorem in the CFA program. Essentially (and there are numerous assumptions here, so you have to take it with a grain of salt) in a world with taxes, the value of a firm increases proportionally with how much debt is used to finance the business.  Meaning increasing the percentage of the capital structure comprised of debt increases the value of the business. Largely due to the tax deductible nature of debt.

[netnet]

Three additional, but similar reasons:

 

1. BRK has regulated subsidiaries, where (I believe) that debt is treated differently for rate setting purposes; in essence, the company gets a greater return by employing debt as interest payments are included in the rate structure.

2. For Treasury (internal company) purposes, you may have a net cash position, but you need debt to balance the flow of funds. 

3. Lastly, without the 'debt' (liability) of BRK's float the company would be a fraction of it's current size.  And no BRK does not have enough equity to refund all of its float, were it crazy enough to do so.  As Warren has said in many ways (low cost and stable or growing) float is better than equity!