Debt and Equity Financing Aren't the Same

Back when I was in business school, we were taught that in valuing a company, there's effectively no difference between debt and equity financing.

Now, that may seem counterintuitive -- in equity financing, a company offers stock in exchange for capital, while in debt financing, a company borrows from a lender in exchange for capital. You're either diluting your stake in the business or in hock to a creditor. Sounds a lot different, doesn't it?

But ...
A group of Nobel economists, though, put out a theory widely taught in business schools around the country. Quoting Investopedia:

The market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. ... The basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.

That's fine in the academic world, with lofty assumptions like efficient markets and equal access to information. But as it plays out in real life, I can't agree with that theory -- and I'd guess that CEOs who overleveraged their companies (and are now in great trouble) probably side with me.

See, economic activity is cyclical -- not linear -- so if you have too much debt to handle the down phases of the business cycle, you'll get in trouble. If you miss enough interest payments on your debt, you're going to file for bankruptcy protection. If you skip dividends, you anger your shareholders and your stock goes down, but you have more money to put the company on the right path to profitability -- after which you can do things like begin paying dividends again.

Think of the distinction this way: By definition, debt investors are concerned with the return of capital. Equity investors are concerned with the return on capital. That one word makes a mountain of difference.

Corporate financing follies
Let's look at some real-life examples. I recently wrote about why Rio Tinto (NYSE: RTP  ) faces more challenges than its competitor BHP Billiton (NYSE: BHP  ) . Rio Tinto is burdened with debt and so was forced to make a fire-sale deal with Aluminum Corp. of China (NYSE: ACH  ) .

In every industry, the overleveraged companies pay dearly when a crisis strikes. For every overleveraged Lehman, there is a more liquid Goldman Sachs (NYSE: GS  ) . And even in highly leveraged industries, such as real estate, with companies like General Growth Properties -- which recently filed for bankruptcy protection -- you'll find alternatives. Kimco Realty (NYSE: KIM  ) , for one, is still able to raise capital even in this market; and others, such as Simon Property Group (NYSE: SPG  ) , are paying dividends in stock to conserve much-needed cash and avoid more debt.

When there's too much debt in the system
Of course, Wall Street is hardly the only place in America where debt has piled up. We can point to the spectacular corporate, consumer, and government debt binge as the root of today's economic problems. I believe this recession will last longer than usual because of that binge, with any recovery likely to be muted. (To some, it may not feel like a recovery at all.)

On the consumer level, just look at one of the housing boom's great financial innovations: the negative amortization loan. With these loans, the borrower did not have enough income to service the loan, so part of the interest got added to the principal every month. The assumption here was that an ever-growing loan is no problem, because that house would obviously appreciate forever. As we all know now, that assumption didn't turn out so well for anyone.

Position your portfolio
So how can you position your portfolio against an unwinding debt binge?

Very simply, be cautious of companies with onerous debt loads. The easiest way to do this is to check a company's debt-to-equity ratio and compare it with industry peers -- the higher the ratio, the more leveraged the company.

And remember: If a company doesn't stay current on its debt, it usually files for bankruptcy. Companies like MGM Mirage (NYSE: MGM  ) are up against the wall for this very reason. Relying on equity financing is safer, simply because it gives you more alternatives -- as well as a fighting chance to stay solvent.

To anyone who may have heard the nonsense that there is no difference between debt and equity financing, I recommend you stick to the advice of Mark Twain and not let your schooling interfere with your education. Because there's a big difference.

More on debt issues:

At Motley Fool Stock Advisor, Fool co-founders David and Tom Gardner always look closely at company financials when making stock recommendations. See which companies they like with a free 30-day trial.

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2009, at 4:17 PM, jettson12 wrote:

    There you go again...another article, another casino bashing. I'm convinced you guys are short on the casino's.

  • Report this Comment On April 29, 2009, at 4:42 PM, MotleyIsAFool2 wrote:

    Do you guys ever shut up? Look, just come out and say that you're short on MGM or that Vegas cleaned your clock at the tables.

    The bias is glaring.

  • Report this Comment On April 29, 2009, at 4:44 PM, MotleyIsAFool2 wrote:

    jett,

    It's kind of funny, really. This website has so little clout that five negative articles a day won't even move a stock.

  • Report this Comment On April 29, 2009, at 5:40 PM, mipakaco wrote:

    The constant bashing of both MGM (and LVS) is getting kind of tiresome. (Sickening, actually).Day after day, same crap about how awful they are. And day after day, they continue to go up. I've been trading LVS since the $3's and made a bundle by NOT listening to your advice. Like previous posters have said, you guys must be short. Maybe you shouldn't be getting your advice from Cramer.

  • Report this Comment On May 01, 2009, at 10:14 PM, nietschele wrote:

    You guys above are missing the point -- it's not about casino, or real estate or mining bashing -- those are just illustrations.

    Ivan thanks for a well written article pointing out differences we don't always think about.

  • Report this Comment On May 02, 2009, at 7:50 PM, ivanmartchev wrote:

    I am glad that at least one commenting reader got the point.

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