Let's Talk About Debt, Baby

Cue Salt-n-Pepa. Ah, there's the beat.

Wait a minute. who's that pasty guy at the mic? My God, I've heard garbage disposers with more range! Is he dancing, or signaling for help? What, did he get dressed in the dark?

You mean you want to talk about debt? Well, that's a substantially less interesting topic that the original song tackles. Ah, but this is a financial website, and I'm sure with but a quick search you can find plenty of places that discuss that other topic on the Internet.

I'm completely serious.

I had some interesting questions from readers as part of my guest stint this month on the Motley Fool Hidden Gems newsletter regarding companies and their use of debt. There is a belief that we shun companies that have debt, favoring ones that have balance sheets completely free of long-term liabilities. This, of course, is untrue. But in describing why this was untrue, I realized that this discussion might benefit from having a wider audience.

First, a tautology: It should be self-evident that companies would want to invest in projects that are profitable, as opposed to ones that are not. But this isn't quite right: Companies aren't seeking just profitability. They're also seeking projects or business lines where their returns exceed the cost of the capital they deploy.

Debt: the cheapest source of capital
There are numerous forms of capital, including options, warrants, and preferred classes of shares. But the three major types, the ones used in the overwhelming majority of cases, are cash, stock, and debt. For each company, financial planners have what they call a target capital structure that keeps their cost of capital as low as possible, all else being equal.

Of course, all else isn't equal. So let's introduce a few more considerations: leverage, risk, and flexibility. When the managers decide how to pay for investments into the company, they'll keep each of these things in mind. All of this comes back to why companies might use debt over issuing new stock, or cash, and their inherent strengths and weaknesses.

The lowest risk, and the lowest-cost route, would be to fund operations with cash flows. This is what Costco (NASDAQ:COST) tends to do, as does Microsoft (NASDAQ:MSFT). Whenever they have a new project or want to open a new location, they simply stroke checks. Most companies do not have this level of flexibility. But even big cash generators like Pfizer (NYSE:PFE) have to opt for alternative methods of funding from time to time: When Pfizer bought both Warner-Lambert and Pharmacia, it had but a fraction of the cash necessary to close the deal -- much of that earmarked for working capital -- and chose equity. Cemex (NYSE:CX), on the other hand, has used debt for many of its acquisitions, including its buyout of Southdown, a transaction that made Cemex one of the largest cement producers in the United States. Did Cemex go the debt route, and Pfizer the equity route, out of necessity? Not necessarily.

Each had the choice to use debt or equity. Pfizer chose equity, and in the process, those who owned Pfizer before both mergers own, by my estimation, no more than half of the total company today. Cemex chose debt. Cemex's election to do so means that it got cheaper capital, but at higher risk. Yep, debt is cheaper than equity, for a few reasons. Equity is a claim on earnings, and those shares are permanent, whereas debt has a right to a fixed payment for a fixed period of time. Equity has no tax advantage, while debt payments are tax-advantaged. Equity certainly feels free (absent dividend payments), but it is not. It actually can be substantially more expensive than debt.

Let's take an example. A company has an enterprise value of $100 million and shares priced at $10 apiece. Let's say that the company has pre-interest earnings of $10 million. (Wouldn't it be great if the numbers were all this easily divisible in the real world?) If the company has 100% equity, and zero debt, it would earn $1 per share. (100 million divided by 10 equals 10 million shares.)

Now, let's say that the company's capital structure was 80% equity and 20% debt, on which it pays 8%. Let's also say that the company's tax rate is 40%. So the total number of shares is now 8 million, and the earnings per share are $1.13. We now have 8 million shares, and earnings are $10 million, minus $960,000, which is the post-tax cost of debt service. You can see where this is going. If the company had 99% debt, all else remaining the same, earnings per share would be $52.48. So why don't companies just go all debt?

Well, for three reasons, the first being that it just doesn't quite work that way. All else is never equal. Keep in mind that while debt is cheaper, it is also riskier. In this way, it's like lots of purchase decisions we make every day. Buy a cheaper battery and you save money, but you risk it not working as long as a good old Duracell. Buy store brand mac and cheese and you risk having it not tasting as good as the stuff from the old standby, Kraft (NYSE:KFT). Debt increases earnings per share. It also increases risk. Companies with higher debt levels are more likely to suffer financial distress during business downturns, because though earnings are variable, those debt payments are fixed. Krispy Kreme (NYSE:KKD), which got some positive financing news today, isn't in trouble as a result of decreasing sales. It's in distress because that decrease pushed it below where it could service its debt.

Secondly, because of that rise in risk, the cost of debt generally starts to rise. If a Cisco (NASDAQ:CSCO) wanted to take on some debt right now, it would be able to get it at rates barely above what the U.S. government pays, because it generates enormous amounts of cash and has no leverage. The airlines, on the other hand, would mostly have to pay enormous rates of interest, because their debt levels are already staggering. So that 8% our mythical company got on its first 20% of debt would start to rise. Interestingly, because risk doesn't just sit on one side or the other of a company's balance sheet, at high levels of debt, newly issued equity becomes more expensive as well.

The final reason is that while companies are certainly in favor of generating large earnings per share, their goal in optimizing their capital structure is to maximize not earnings per share, but price per share. All else being equal, does a company with high levels of debt (and therefore risk) command the same multiples as one that has very little? Obviously not. Shareholders don't particularly like uncompensated risk, and as such, they're unlikely to pay the same price for a company with large levels of debt as one without. But as the exercise above shows, certain levels of debt can be, if anything, beneficial to shareholders.

It's all about moderation.

Most recent contest
The wonderful Calming Kitty CD went in a flash. I asked readers to name the five Division I-A football schools that did not have the word "university" in their names. No sooner had I finished typing (OK, maybe I had gone to lunch) when the answer, "Georgia Tech, Army, Navy, Air Force, and Boston College," hit my inbox. I'll have another trivia question on Wednesday. I've got a good one, but I'm at a loss for a good prize to give.

Bill Mann owns shares of Costco. The Fool has a disclosure policy.