What has a lower cost; debt or equity? If you ask this question to any student of finance, the immediate answer will be that debt has lower cost as it offers a tax shield on interest. On the other hand, equity dividends are a post tax appropriation and hence there is no tax shield available. That is technically correct and we need to understand this concept of post tax and pre tax appropriation before embarking on the cost of debt and the bankruptcy risk.
Particulars (Company X)Fiscal Year 2017-18Fiscal Year 2018-19Net SalesRs.25,00,000Rs.30,00,000Cost of SalesRs.18,00.000Rs.22,00,000Gross ProfitRs.7,00,000Rs.8,00,000Operating ExpensesRs.3,00,000Rs.3,50,000Operating ProfitRs.4,00,000Rs.4,50,000Interest ExpensesRs.1,00,000Rs.1,20,000Pre Tax ProfitRs.3,00,000Rs.3,30,000Tax payable at 30%Rs.90,000Rs.99,000Profit after TaxRs.2,10,000Rs.2,31,000 Dividends paidRs.1,10,000Rs.1,20,000
In the above 2-year income statement of Company X, there are 2 variables that you need to track; the interest expenses and the Dividends. The interest cost of Rs.1 lakh is allowable as an expense in your income statement and therefore you pay tax on profits after reducing the interest. When you deduct interest of Rs.1 lakh, you reduce the tax outflow by 30% of that amount so this 30% (or Rs.30,000) becomes a tax-shield for the company as it reduces the amount of tax payable. From the company’s point of view the actual interest cost in post-tax terms is Rs.70,000 for fiscal year 2017-18 and Rs.84,000 for fiscal year 2018-19. It is this tax shield that makes debt attractive to companies.
On the other hand, the dividend is a post-tax appropriation. That means it costs the same in pre-tax and post tax terms. It is this tax treatment that leads a lot of companies to splurge on debt assuming that its cost is much lower. However, the perceived tax benefits on debt come with a major bankruptcy risk. Having seen how to calculate the cost of debt from financial statements, let us also understand how to measure bankruptcy risk. The above cost of debt calculation is quite basic and we will now look at the bankruptcy risk.
What is bankruptcy risk and how debt affects the balance sheet.
While it is true that tax shields are available for debt and not for equity it needs to be remembered that cost of debt is a commitment while cost of dividends is not a commitment. There is no obligation on the part of the company to pay dividends whereas payment of interest on debt and repayment of principal are obligatory commitments. That is what makes all the difference. Let us look at 3 separate circumstances where the cost of debt forces up the risk of bankruptcy.
1. Where the business cash flows are cyclical or gestational
This is very true of companies in the steel sector and the telecom sector. Let us take steel first. Steel stocks may be great in good times but they tend to really underperform in bad times. When the metal down-cycle starts the steel companies see a sharp fall in steel prices and therefore a major hit on sales and profits. As a result the operating profits of the company are just not sufficient to cover the cost of debt and the interest coverage keeps going down pushing the company closer to bankruptcy. Let us look at telecom as an example of gestation. The business requires long years of investments in hardware and spectrum and it takes a long time to recover costs. What happened in the aftermath of Reliance Jio when other telecom companies were forced to cut prices? It has pushed a lot of telecom players close to the risk of bankruptcy as the huge cost of debt is now becoming prohibitive. If one looks at the NPAs of the banks, most are a result of their inability to generate enough operating cash flows to cover interest costs.
2. Where the cost of debt is too high
This is true during high growth and high interest rate regimes. Also, mid-cap companies may have borrowed at higher rates as they may not have had access to cheap funding. The problems may not have surfaced in buoyant times but in a downturn these problems of high cost of debt comes home to roost. That is why it is also critical for companies to look at options to reduce their cost of debt by borrowing at lower rates and repaying their high cost of debt. This is a strategy that many companies have employed successfully.
3. Where the cost of debt spurts due to currency risk
This is a problem that is specific to companies that have borrowed in foreign currency (dollars and Euros). If the dollar and Euro become stronger, it means that foreign currency borrowers will have to repay more in dollar terms. Indian companies have mountains of debt in dollar borrowing and this could become a real problem if the US Fed hikes rates consistently this year and hence the dollar index starts moving up. In fact, such currency exposures can push companies faster towards bankruptcy if the currency risk is not properly hedged.
It is a myth that companies reduce the cost of capital by adding more of debt. This is called the agency risk in debt. The perspective of the company management is at cross purposes with the perspective of the shareholders and the stock markets. From an equity valuation point of view, markets always give a higher valuation to companies that are able to grow with limited debt and little bankruptcy risk. That, probably, settles the argument!
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