Debt Funding-Double edged sword
Debt is not a four letter word when the going is good for the Corporates and can be the worst of the four letter words when the going gets bad for Companies
Let us just have a peek in to the kind of impact Debt has on Coporate net earnings.Most obvious advantges of debt are that one needs to pay a fixed interest irrespective of how much one earns deploying the funds. This can work to the detriment of the Corporates when the actual return on overall capital deployed is lower than the fixed interest commitment. The other advantage is that Interest in debt is tax deductible. This has a major presumption that the Company is making profits and can in fact take advantage of interest deduction
The commitment to pay interest is fixed and has nothing to do with the kind of productive use the money has been put to. Most obvious advantage will be when you use the capital to earn high returns and have to pay for use a much lower interest.
Let us illustrate with a simple example with different sets of assumptions on the overall earnings and tax
Assume that we have deployed Rs 200 , 50 % of which , that is Rs 100 being own ( equity ) and the balance Rs 100 borrowed. On the borrowed, let us assume interest commitment of Rs 10 PA. Let us also assume that we have a total earning on the total capital deployed at 15%, that is we have earnings of Rs 30 PA.Take out the interest of Rs 10, leaves us Rs 20 on which let us assume tax at the rate 30% is payable.This leaves Rs 20 minus Rs 6 being tax , that is Rs 14 in the hands of the equity holders. This effectively gives a Post tax return of 14% , that is Rs 14/Rs 100 ( being equity)
In the same example , the higher the leverage, that is , higher portion of debt would increase the earnings of the Equity holders.
Let us assume that the Company is making a return of 8% on capital deployed. Earnings before interest would be Rs 200* 8%= Rs 16. Interest of Rs 10 to be paid. This leaves a net post interest profit of Rs 6. On this tax of Rs 1.8 to be paid leaving Post tax and interest return of Rs 4.2. This effectively is a 4.2 % return on the Equity holder’s funds. Not a favourable situation for the equity holders . They get 4.2% notwithstanding the fact that the funds were deployed to earn 8 %. Impact of gearing ( higher debt).
Return on equity in a situation where the interest commitment is higher than the earnings on the funds depoloyed will get worse with higher gearing ( thet is use of higher debt Vis a Vis Equity)
Good Companies prefer to have a low gearing as a matter of conservative financing policy.One can see the trend across all well managed and regular profit making companies.
