Escolar Documentos
Profissional Documentos
Cultura Documentos
While the above is a simple illustration that zero debt is always better than debt, let’s deal
with the conventional submissions in favour of debt
1. Role of Retained Earnings: The cost of debt both before and after tax is always
lower than the cost of Equity. While this is entirely true, we should accept that the
alternative to debt is not just equity or in the case of a growing company with
expansion imperatives, additional equity. Surely we have to consider retained
earnings. Every company is expected to make profits and in the case of an
efficiently growing company the expectation would naturally be for progressively
increasing profits. If these profits after tax are ploughed back i.e. retained, they
would constitute an increasing share of the firm’s owned funds. This would take
care of the company’s need for additional assets to support its growth plans and
would negate any prospect for borrowed funds.
2. Financing Expansion: While a firm can take care of its current levels of
operations with existing funding, when significant expansion is on the cards and
substantially increased funds are required, then borrowed funds are the only
viable choice, because the alternative would be to raise more equity, which would
take more time and cost more. To this argument we submit that any firm’s
expansion prospects do not suddenly appear on the horizon. There will always be
time for a firm to plan its next phase of expansion which most often would be in a
time frame of not less than 3-5 years. If the firm makes profits as planned and
retains all of the disposable profits i.e. after tax profits, there will be adequate
additional funding for expansion. If expansion is carried out in a suitably phased
manner, the retained earnings should be more than adequate to support it.
Zero Dividends: It is a popular myth supported by industry on the one hand and
poorly informed and poorly educated investors that dividends are a necessary part of
return on share holder investment. If an analysis is done as to the growth in the value
of a company’s stock, it can clearly be shown that a company that does not pay
dividend will definitely produce higher long term Return on Investment for its
shareholders than a company that pays dividends. The case of Bharti Airtel in India
and Warren Buffet’s company in the U.S. bears out this logic. It should be obvious
that when a company withholds dividends, the retained earnings increase to that
extent. This increases the net worth of the company and correspondingly increases the
worth of the company in the eyes of would be investors. If one looks at the financial
status of Bharti
Bharti has equity of Rs 900 Crores,
The company’s net worth as of 2008 was Rs 30,000 Crores.
Retained earnings are therefore Rs. 29,100 Crores.
Market price of Rs 10 share in 2008 Rs 960 per share
P/E ratio in 2008 46(highest of any Indian firm)
One final but inadequate justification for dividends is that it firstly reduces the
uncertainty of returns and is a source of short term income to shareholders. To this
argument we must submit that the difference between an equity holder as contrasted
with a person who invests in debt and debt related securities, is that the equity
investor has a higher risk and higher return profile. Part of the higher risk is the
willingness to wait longer to get the return on his/her investment
Industry: While the above logic and suggested course of action is undisputably
optimal for all companies in every industry, there is currently a lot of thinking and
preaching within industry and academia that debt is not only not undesirable, but
eminently desirable with the only caveat that the amount of permissible debt varies
with the state of an industry(growth or mature phase industries).
Banking and Financial Sector: There are vested interests at work as well with the
banking and financial services industry relying for ever increasing borrowing from
their industry counterparts and the counterparts also ever ready to borrow larger sums
for their operations and commercial functioning. The submission to this is, that there
are huge requirements for lending from the infrastructure and under privileged
sectors. Let the lendable funds be reserved for this salutary purpose and let industry
proceed to operate more intelligently, more efficiently and ultimately reward its
investors with superior long term returns on their investment.
Equity Investors: For the common share holder a certain amount of education and
explaining would be necessary since it has to be accepted that many of them have
been blinkered by the conventional thinking and current industry practices. But let us
accept that investors are intelligent and reasonable people and would certainly be
convinced by reasonable explanation and argumentation which this paper has
hopefully been effective in. In the end the acceptance and progressive implementation
of this funding paradigm can bring rich rewards to all the stakeholder groups
including the larger societal group to which industry has undeniable obligations.