What is the proper amount of debt for your company to borrow?
The correct answer is c. In fact, for every company, there is an optimal amount of leverage that results in the highest return on the shareholders’ investment. The trick is to figure out what your company’s appropriate capital structure.
To determine how much your company should borrow, it is imperative to understand an esoteric financial concept known as the cost of equity. We all recognize the cost of debt, which is the interest rate. But contrary to popular belief, equity capital is not without cost.
Understanding this concept can have an enormous impact on the returns a business owner achieves. Roberto Goizueta increased the stock price of Coca-Cola over tenfold during his tenure as CEO, and much of this appreciation can be attributed to the fact that he understood the financial merits of appropriate leverage.
In layman’s terms, the cost of equity for your company is the return that you would demand from an “arms-length” investment in another company with a similar risk profile. From an academic standpoint, you can estimate your company’s cost of equity as follows:
Begin with the return that is available on a long-term, risk-free security. The best proxy for this is a long-term Treasury bond, which currently is yielding about five percent.
Then, add the premium over long-term Treasuries that has historically been required to invest in stocks, which is approximately eight percent. If your industry is more cyclical or volatile than average, this premium will be higher, say 10 percent to 12 percent.
Finally, academic studies show that small companies are inherently riskier than larger companies, and that businesses with revenues less than $100 million require an additional premium of four percent to attract investors.
The sum of the above factors in today’s market approaches 20 percent. But that is the return rational investors would require on a marketable interest in the equity of a small company. If your company is privately owned, its stock is probably not readily marketable. When you add an appropriate premium for lack of marketability, the cost of equity in a typical private company is somewhere in the range of 25 percent. Clearly, equity is a lot more expensive form of capital than borrowing from the bank.
If a rational investor would require a 25 percent return to invest in your company, why shouldn’t you? One possible answer is that you are not rational. Or, more likely, until now you were not cognizant of the return you should expect from your investment in your business.
Computing your return on capital
The performance measure that approximates the cash flow that a business generates which is available to shareholders and lenders, is earnings before interest and taxes, or EBIT. This assumes that you have to reinvest an amount in capital expenditures to maintain your current competitive position that is roughly equivalent to the current amount of depreciation and amortization, which are non-cash charges to your profits. It also assumes that you add back to earnings any monies paid to the owners in compensation, perks or otherwise that are in excess of what you would pay a nonowner to perform the same duties with the same proficiency.
To quantify the return on capital your company produces, a back-of-the-envelope approach is achieved by dividing EBIT by the amount of equity in your company plus interest-bearing debt. If your return on capital is below your cost of capital, then continuing to own stock in your company is not a prudent investment unless you take some action to either increase the cash flow the company produces or to lower your cost of capital. I have valued and sold dozens of companies that routinely failed to produce adequate returns on capital, so it is not unusual, just unfortunate. In truth, very few business owners have ever performed this analysis; therefore, they don’t realize whether ownership in their business is a good investment or not.
The key to increasing profitability depends on your company’s specific situation and is beyond the scope of this article. But an equally valid, yet often overlooked way to increase the shareholders’ return, is to lower your cost of capital through the prudent use of leverage. If your cost of debt is seven percent and your cost of equity is 25 percent, a company with no debt must achieve a return on capital of 25 percent. Similarly, a company with an equal amount of debt and equity capital must earn a return of only 16 percent (50 percent of capital at seven percent plus 50 percent at 25 percent) for it to be producing a market return to the owners.
Using this logic with no caveats leads to excessive leverage when pursuing the goal of driving up the returns to shareholders, which is what we experienced during the leveraged buyout bubble of the late 1980s. What happens in reality is that as you increase the leverage of your company, you increase the risk of defaulting on your loans and reduce your financial flexibility, both of which drive up your cost of equity because your stock becomes a riskier investment. So the use of debt only makes sense when the benefit derived from lowering your cost of capital exceeds the incremental risk of the associated leverage.
Each company has an optimal capital structure that is unique to that company. This occurs when low-cost debt is used to capitalize your business up to the point where the company can comfortably repay its borrowings without compromising its strategy.
Business owners who have never computed their own cost of capital or evaluated their optimal capital structure are “leaving money on the table” by not capitalizing their business in a manner to achieve the highest return on investment. One excuse I hear often is that if the owner sold his or her business, he or she would put the money in T-bills at a return of three percent or four percent, so their hurdle rate for a return on equity is minimal. This is highly flawed logic, though, because it compares apples and oranges. An investment in T-bills is quite a bit safer and more liquid than an investment in a non-marketable private company’s stock. Just because you have had many consecutive years of growth does not mean your company will grow forever or that owning its stock is without risk.
If you own a business that consistently produces a return on capital in excess of 25 percent, you have the luxury of ignoring this issue altogether. You can operate with no debt simply as a matter of principal and still rest assured that you are achieving a fair return on your investment, which is how I run my business.
I like knowing I owe nothing, even if it is not the most financially rational position to take. However, you can get away with this attitude only as long as you are not accountable to any other shareholders. Otherwise, you need to run a few numbers to see if you are fulfilling your fiduciary responsibilities.