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.