Rewriting Shakespeare’s finance rules
Shakespeare wrote “neither a borrower nor a lender be, for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” That advice has changed in more recent times – when you speak to your financial advisor she will tell you the importance of being invested, but also to keep enough cash for a rainy day. Contradicting Shakespeare, the genius though he was, cash is deemed less desirable for the companies in your investment portfolio. Net cash, that is, cash less borrowings, is generally seen by investment analysts as value-destroying for shareholders. What is more, there are good reasons why companies should have net borrowings in order to maximise the value of a company’s stock. Below, we explain why Shakespeare may have been wrong, and why borrowing might not be such a bad thing after all.
As an investor, you have a choice of a range of investments, but, for simplicity, assume you have only cash or stocks. If you invest in cash at the bank, you will earn around 4% with very little risk. If you chose to invest in a company’s equity, you have to accept a lot more risk and you therefore require a return, over time, in excess of cash; say, 8%. This return comes to you as some combination of dividends or increase in the stock price.
From a company’s perspective, in order to achieve that magic 8% figure, its investments must show a pre-tax return on equity in excess of that, ideally over 10% (assuming 20% corporation tax) in order to pay dividends and to reinvest for the future.
Suddenly the 4% return a company earns on cash looks a lot less favourable, and consequently it is deemed to destroy shareholder value. True, cash makes a company safer, but the cost is it dilutes returns. However, this does not explain why having debt can be seen as value enhancing. The answer lies, in part, in the tax system, and how companies fund themselves.
Generally, companies can chose two ways to finance themselves: equity, which we have spoken about; or debt. A large, listed, and stable company can borrow relatively cheaply, paying only 6% on its debt. The tax system allows a company to deduct this from its profits before it pays tax, so the after-tax cost of interest is therefore only 4.8%, assuming 20% corporation tax (calculated by cost of debt * (1 – tax rate)). This after-tax interest cost is very attractive compared to the relatively high cost of equity, so in theory a capital structure made up entirely of debt would be most efficient. Right?
Well, debt can be risky and interest rates are unpredictable, and the more debt you hold the more expensive it becomes to finance. This is why there is no easy formula for how much a company should borrow. Companies in higher risk businesses, that are perhaps cyclical, should probably not borrow or certainly borrow less so that they have sufficient resources to weather the tough times. Even Shakespeare might agree that some prudence is wise; overreaching ambition, after all, has toppled more than one king — and a few overleveraged CEOs. The balance really depends on the company, and the environment it operates in.
On occasions, companies completely misjudge how much they can borrow, leading down the path of distress and possibly bankruptcy. A good example today is Thames Water. A very stable business like water should be able to borrow more than most companies, but a combination of high debt, historical issues, mismanagement, and the changing regulatory environment, has left it in deep distress. The lesson to be learned from Thames Water is that companies should not be too aggressive in their borrowing. Companies need to keep something up their sleeve for unforeseen circumstances, which is why you often see them with some cash on the balance sheet, and paying for borrowing facilities they do not intend to use.
So, while Shakespeare might have had a point in warning against borrowing from your mates, when it comes to companies, the picture is a little different. A well-judged level of debt can, in fact, be the mark of a well-managed business — an efficient use of capital that boosts returns without pushing the company over the edge. The trick, of course, lies in moderation. Too little debt, and a company risks sitting idly on its cash, dulling its edge; too much, and it may find itself in a Thames Water-style tragedy.
In the end, it’s not about avoiding debt entirely, but using it wisely — much like an investor balancing risk and reward. If the Bard were writing Hamlet today, he might have added a footnote to Polonius’s advice: “Neither a borrower nor a lender be — unless the return comfortably beats your cost of capital.”
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