Often times, the question arises as to why big companies with huge revenues and reserves still hold and incur debt. In simpler terms, why should your business still look to attract debt when it has enough retained earnings to finance present and future projects?
From a layman perspective, it is easy to understand how these questions arise, especially in third world countries like Nigeria, where the general perception of debt is grossly bad. However, an understanding of the financial technicalities of debt offers greater insight and helps one to view debt beyond the lens of liability and up to its potential to unlock the growth prospects of a business entity.
We must note that once a company is registered, it becomes a corporate citizen of its own, separate and distinct from its owners. Furthermore, the monies provided by its owners to finance its operations classify as equity, while those provided by creditors who seek interest payments classify as debt. Both are referred to as capital. Therefore, three parties are identified; (a) The company (b) The equity holders and (c) The debt holders. Hence, the capital structure of a company refers to its mix of equity and debt financing.
The distinction of the three parties identified above impliesthat for the provision of capital to the company, the company owes both the equity and debt holders a return from its operations. This return is what is referred to as the Weighted Average Cost of Capital (WACC). It is truly a cost to the company because the company is paying out returns to equity and debt holders. Returns paid out is cost to the company. I will return to the significance of the WACC anon. But this WACC, represented by a percentage, factors in the return due to the equity holders (i.e. the cost of equity, Ke, to the company) and the return due to the debt holders (i.e. the cost of debt, Kd to the company) and is calculated as follows:
╔═══════════════════════════════════════════════════════════╗
║ WACC = (Ke * Equity Amount) + (Kd * Debt Amount) ║
║ ────────────────────────────────────── ║
║ Equity Amount + Debt Amount ║
╚════════════════════════════════════════════════════════════╝
We generally agree that the major factor that determines your rate of return as an investor is risk. The higher the risk, the higher the return demanded. For instance, why is the rate of return demanded from a small bank higher than that demanded from a big bank? Clearly, it is because the risk associated with the small bank is way higher than that associated with the big bank. The fact remains that between the equity holder and the debt holder, the equity holder faces the greater risk. Why? This is because once the company is done with its operations at the end of the year, the debt holders are settled with their returns (interest) first and foremost, before equity holders are settled theirs (dividends) with the residual of whatever profits are left. Moreover, interests are paid to debt holders regardless of whether profits were made during the year or not, whereas, dividends may not be paid to equity holders depending on company performance for the year. The company has an obligation to settle interests payments due to debt holders regardless of whether performance was good for the year or not. If push comes to shove, it may have to even borrow to settle these interests. Therefore, the equity holder is more or less an ‘afterthought’, or a ‘residual consideration’ for the company. Hence, since the equity holder faces greater risk, the rate of return is higher i.e. the cost of equity to the company is higher than that of debt. The implication is that if the debt holder demands say, 8% as returns, the equity holder is left with no choice than to demand a rate higher than 8% to account for the greater risk that he or she faces. It is in this way that we say that debt is cheaper.
Read Also:
Let us return to the concept of the WACC. It represents what the company must carve out from its investments returns to settle its equity and debt holders. Therefore, if the company undertakes a profitable venture, it takes care of those two parties before retaining whatever remains for itself. So, if the calculated WACC of your company is say, 10%, it means that the company should not embark on any project that has a return on investment of less than 10%. This is because it would not be able to settle the two other associated parties, much less retain anything for itself. So the lower the WACC of the company is, the better for everybody. This is because as the WACC goes lower, the implication is that the company can accept a broader spectrum of projects than with a higher WACC. For instance, a company with a WACC of 15% can only embark on projects giving a return that is higher than 15%. All investments that will bring a return of less than 15% is totally classified as ‘not viable’. Thus, this 15% is more or less, a hurdle, a higher hurdle for the company to cross than a lower WACC of 10%. The lower the WACC, the more projects it can accept as viable. Simply put, the lower the WACC, the better!
The concern for business managers should then be about how they can reduce the WAAC of the company. It is at this point that the power of debt is demonstrated. Refer to the box above and consider the following scenarios below.
Company ABC Ltd starts business has a capital need of N100 to finance necessary assets for its operations. The owners of ABC Ltd only have N80 and borrows N20 from debt providers. Debt holders are demanding 8% annually in interest while equity holders will demand something higher, say 10%, annually in dividends. The WACC in this instance would be computed as:
╔════════════════════════════════════════════════════════════════╗
║ WACC = [(10% * 80) + (8% * 20)] / (80 + 20)
║ = (8 + 1.6) / 100
║ = 9.6%
╚════════════════════════════════════════════════════════════════╝
Imagine that the equity holders only choose to fund with N70. Then debt would be N30. WACC would thus be computed as:
╔════════════════════════════════════════════════════════════════╗
║ WACC = [(10% * 70) + (8% * 30)] / (70 + 30)
║ = (7 + 2.4) / 100
║ = 9.4%
╚════════════════════════════════════════════════════════════════
Consider a third scenario where the equity holders only choose to fund with N60. Then debt would be N40. WACC would thus be computed as:
╔════════════════════════════════════════════════════════════════╗
║ WACC = [(10% * 60) + (8% * 40)] / (60 + 40)
║ = (6 + 3.2) / 100
║ = 9.2%
╚════════════════════════════════════════════════════════════════╝
From the above, the more debt is infused into the capital mix of the company, the lower the WACC goes. Of course, the question will still arise as to whether we should just go on and on with infusion of debt until the company or entity is completely financed with debt. Certainly not. The point at which debt infusion should stop is a topic for another discussion. However, the principles and discuss laid out here is what should guide decision making in business. The people owe themselves the responsibility of making data driven and technically correct decisions about their businesses. It appears that the science to decision making in almost every aspect of our national life is often neglected, and this is the case even at the highest level of governance. From steering the ship of state, to managing an enterprise at any level at all, we must develop a culture where decision making is governed by the science that surrounds every relevant subject, rather than relying on subjective reasoning and sentimental waves. After all, that is what education is meant for!
