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When Is Debt Good?

Posted January 15, 2011 by FinanceDog Staff

Using debt to finance a business may seem counterintuitive, but in fact, it can be an efficient and cost effective way to fund a business. Tax breaks and the relatively cheaper cost of debt are two reasons why a company should use debt to finance at least part of its business.

Many companies tend to carry more debt than equity, but Google is different. Today, Google has no debt. But is that good or bad?
Just recently I (Joe) was facilitating a session with employees from a small business that had been acquired by a larger public company. The small business did not have any debt prior to the merger. During the balance sheet discussion, the previous owner of the small business asked, "Why do we have debt in this new company? I hate debt."
Most of us don't care for debt. We hear about the crushing effect of consumer debt on our economy. So why is debt for a business a good thing?
There are two reasons why a company should use debt to finance a large portion of its business.
First, the government encourages businesses to use debt by allowing them to deduct the interest on the debt from corporate income taxes. With the corporate tax rate at 35% (one of the highest in the world) that deduction is quite enticing. It is not uncommon for a company's cost of debt to be below five percent after considering the tax break associated with interest.
Second, debt is a much cheaper form of financing than equity. It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return. Debt is much less risky for the investor because the firm is legally obligated to pay it. In addition, shareholders (those that provided the equity funding) are the first to lose their investments when a firm goes bankrupt. Finally, much of the return on equity is tied up in stock appreciation, which requires a company to grow revenue, profit and cash flow. An investor typically wants at least a 10% return due to these risks, while debt can usually be found at a lower rate.
These facts make debt a bargain.
It would not be rational for a public company to be funded only by equity. It's too inefficient. Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money.
So why not finance a business entirely with debt? Because all debt, or even 90% debt, would be too risky to those providing the financing. A business needs to balance the use of debt and equity to keep the average cost of capital at its minimum. We call that the weighed average cost of capital or WACC.

Back to Google. It's a nearly $22 billion company with no debt, which is inefficient. The problem for Google is that their cash flow and profit are so strong that they can finance the business with retained earnings. But I predict that as Google matures and growth slows, debt will become an important source of funding.

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