Infinite Debt

Felix Salmon points us to this Harvard Business School writeup:

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…

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.

People pay six figures for this from an academic institution. People talk a lot about the front-office finance people not understanding the complicated Black-Scholes problems, but I sometimes think the most dangerous finance idea people have an elementary school understanding of is the old 1950s workhorse The Modigliani-Miller theorem. (If you think of it as a “no arbitrage” argument, it is the first piece of financial engineering. Certainly the first “quant” finance argument.) Here’s the freshman level equation you plug values into:

What they are saying in the excerpt is just that equation. You could learn what they just described to you by reading the Wikipedia page (feel free to donate them the $100K you were going to give HBS). In practice, you have a consensus of Financial Economists walking around thinking that businesses aren’t leveraged highly enough, because in a perfect market there is no difference between equity and stocks, and we are imperfect in so much as there are tax-benefits. This trickles down to students.

Now of course, if you really dig into the spreads, risk-neutral valuations, and business-cycle risk premiums in cutting edge research, you can find arguments like The Risk-Adjusted Cost of Financial Distress (pdf – fantastic paper, if you find that interesting): ” In particular, [our results] suggest that marginal risk-adjusted distress costs can be of the same magnitude as the marginal tax benefits of debt” – ie leverage has its costs that are just as bad as the benefits are good, but that involves a lot of math, statistics, learning a full literature and even then you’ll have an academic fight over everything. Instead we can just give MBA students an equation to memorize, spit back on a test and leave them with the impression that they should be levering up in all cases.

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7 Responses to Infinite Debt

  1. Taunter says:

    That’s funny. I would argue that public companies, broadly speaking, are under-levered; Google is only the extreme end of the spectrum. After all, what is a management buyout but replacing some chunk of the public equity with debt, in the name of “the public would not tolerate the level of debt that we, the managers, wish to incur”?

    It is particularly relevant in companies where individuals hold large, concentrated positions. Unless his company has government-sponsored immunity from adverse consequences of its debt (yes, you, Goldman Sachs), a concentrated shareholder has different interests from the market; a safe $1bn is a lot more valuable than a $1.5bn at risk of any strange economic event. Sergey and Larry have no reason to try to goose the economics of the core business; their exit will either come over an extremely long period of time (Bill Gates) or through a corporate transaction (Steve Case). Someone who holds shares within a diversified portfolio probably looks at the problem differently.

  2. chrismealy says:

    Keep this up and you’ll hurt Megan McArdle’s feelings.

  3. Not the Mike You're Looking For says:

    M-M abstracts away from a lot of considerations–bankruptcy costs, asymmetric information, market inefficiencies. When I first read it, my reaction was, “OK, so if you eliminate all of the attributes that make debt different from equity, then there is no difference between raising funds throughn debt or equity. Brilliant.” Later on I realized the theory’s value in making financial problems more tractable, but that’s not an issue for practitioners.

    It does show the pitfalls of academic training. Students memorize the formula, but they never learn how to use it. They certainly don’t have any appreciation of what is left out of the formula, and the HBR example is a wonderful example of this.

    One important omission is that debt comes with many more restrictions than equity. Moral hazard is important enough that lenders are generally going to ask for various covenants. Equity, on the other hand, allows Sergey and Larry to say that they’ll do whatever the f*** they want (more or less; there are limitations, of course). That’s valuable to them but does not compute in the HBS curriculum.

    It’s arguably worse than not learning the formula at all. If you’re ignorant, at least you know you’re ignorant, but this kind of knowledge gives students false confidence that they know what they’re doing.

  4. pebird says:

    Someone better tell Microsoft that should load up on debt – they haven’t been able to figure out how to be successful without it for the last 20+ years.

  5. q says:

    neither standard finance nor economic theory take into account debt and liquidity in any reasonable fashion — and for that reason they are very poor in understanding the crisis at hand.

  6. Chris says:

    What opportunity is Google leaving on the table for which their marginal benefit of grasping it would exceed their marginal cost to finance expanding (through debt) to grasp it? If there *is* such an opportunity, why is expanding through debt preferable to expanding through capital? If there aren’t any good opportunities, why would Google lever up to seize bad opportunities?

    It seems to me that the difference between equity and debt is that if your company’s big new initiative doesn’t pay off this quarter, you can tell your shareholders to be patient (and at worst lose some market cap, maybe not even that if you can make a persuasive case that the project will bear fruit in the future), but your bondholders want their payment regardless and can force you into bankruptcy if you can’t pay up. That’s why levered companies are always looking at short-term returns – *they have to*. They have a monkey on their back that has to be paid every quarter or it cuts their throats. Only equity has the luxury of long-term planning.

    Leverage magnifies your good luck so you can take home a huge bonanza (which the bondholders do not have to be cut in for a share of – they get only their fixed payment). But it also magnifies your bad luck so that you don’t survive it. And you have to beat the bond interest rate just to break even. It would take an insane (perhaps literally) degree of confidence to be *sure* there’s so much money sitting on the table that you can lever to pick it up and not risk destroying yourself in the process. So the people who do lever up are either gamblers or lunatics. Which one do you want to trust with your money?

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