Ask Doug & Polly: How much debt?

ANSWER: People refer to debt as leverage because with a given amount of earnings, debt will increase the return on equity, or ROE. Here’s why. There are only two ways to capitalize a business: debt and equity.

Let’s say that a business needs $1 million of capital to get going and that the capital is raised by selling a 50% equity stake in the business (to keep the math simple). The founder maintains a 50% ownership interest in the company, while investors put up $1 million in exchange for a 50% ownership interest in the company. Therefore, the equity in the company would be valued at $2 million ($1 million / 50%). If the company makes $200,000 in the first year, the investors would get a 10% ROE ($200,000 of profit / $2 million of equity).

On the other hand, suppose the company had capitalized itself by selling $1 million of debt. The founder’s equity should still be worth the same $1 million that it was worth in the example above. The company still has the same $2 million of capital (equity valued at $1 million plus $1 million of debt). However, if in the first year, the company earns the same $200,000 of profit, the ROE is now 20% ($200,000 of profit / $1 million of equity). Therefore, debt leverages the ROE. If the total capitalization stays the same (in this case $2 million), for a given amount of profit (in this case $200,000), the more debt the company has, the less equity it needs and the higher ROE will be.

However, more debt isn’t all good news. Debt requires repayment with interest. This increases the company’s costs and, therefore, reduces profit. Further, increased costs mean that the company will be less likely to be able to pay all of its financial obligations.

In general, if the debt isn’t repaid in a timely manner, the debt holders can force the company into bankruptcy. That is, the debt holders can force the company to liquidate its assets to repay the debt (or, at least, as much of the debt as the company has assets to cover). Companies without debt don’t face this risk. There are no required debt payments. No threat of bankruptcy if the payments aren’t made. Therefore, debt increases the company’s risk.

The question of whether a company should have debt is an interesting one and, as you might imagine, one that doesn’t have a simple, one-size-fits-all answer. We could launch into a theoretical discussion about maximizing the risk adjusted rate of return. However, rather than doing that, let’s simply say that some debt may be a good thing if:

• It means that equity investors have to put less money into the business (or leave less money in the business). Therefore, the equity investors have more capital they can invest in other things.
• The equity investors can find other ways to invest their capital that will yield a return that is greater than the cost of the debt.
• The increased risk to the business is manageable and doesn’t more than offset the increased ROE.

The above guidelines, while helpful, certainly don’t allow the precise calculation of how much debt is appropriate. Although we could give you a series of formulas that would allow the calculation of an optimal amount of debt, it would involve estimates and assumptions that would render the result imprecise at best. We think it is better to say that companies should return capital to shareholders (or allow shareholders to keep their capital) by taking on debt as long as the company can cover the debt payments even in the event of a significant downturn in business.

How much debt to take on is not an exact science and requires sound judgment, but that is the nature of business. No matter how much math one does, good judgment is always required.