cost of equity, cost of debt, and implications thereof

Research
1

I’ve recently learned that the cost of equity is always higher than the cost of debt when calculating the weighted average cost of capital. This makes sense to me, intuitively. But it also implies that it’s better for a company to have a lot of debt than a lot of equity. Now since equity equals a company’s total assets minus its total liabilities, and since most of those liabilities are debt (in the debt-to-equity ratio, ALL of them are debt), it would be cheaper for a publicly owned company to have its liabilities be almost as high as its assets than to have no debt at all. Which makes no sense, of course.

Could someone help me untangle the logic here?

Thanks!

  • Yuval
2

There is a stretched deduction from the general principle: you are saying that maximizing the cost of equity equals to maximizing equity value. This is not necessarily true, especially in the real world where there is risk of default. If you increase the cost of equity by levering up (assuming generally higher asset returns than debt cost), the equity expected return could not change (or even go down) because of an higher possibility of default. Even if it does go up, higher tail risk to external shocks could leave the equity value unchanged or even lower.

But your thinking is not completely off track. In fact there are strong incentives for managers to increase debt load in order to return cash to shareholder during good times (especially with low real interest rates and credit spreads), such as it has been happening in the last 5 years.

3

Those who are seriously interested in this topic may want to Google “Modigliani Miller.” I recall from my B-school days that this team of researchers led the way in capital structure research.

Their conclusions, as I recall, were that capital structure did not matter.

The expected cost of equity is and must be higher since equity holders assume more risk and need to be compensated for that. (Realized returns don;the always meet expectations, but that’s a whole different matter – and reinforces the need for an un-front expected risk premium).

So from the company point of view, debt capital is always cheaper (before the fact) than equity. And in recent decades, it has become more so given the plunge in interest rates. So we have seen a lot of companies shift balance sheets toward debt.

But there is no free lunch. Debt is a mixed bag from the company POV. On the good side, it’s cheaper and debt holders don’t share in the growth of profitability – equity holders get to keep it all. But there’s a monstrous downside – debt capital requires fixed obligations re: cash outflow and the consequences for non-compliance can be severe.

Back in the '80s when I was covering companies, I asked a large media-company CFO why they weren’t leveraging up as their peers were. He answered that investment bankers regularly came in with projections showing how well it could work. All the company needed was to keep cash flow growth around 3% per year, a far lower rate of growth than they’d been averaging. His answer, as he threw them out of the office, was that the analysis was bullsh**. Even if they average 8%, you have to consider how the average was happening. It wasn’t like 7%, 9%, 7.5%, 8.5%, etc. Motion pictures was a big part of the business and it could just as easily be 10%, 12%, 6%, 11% -40%, +80% . . . but they’d never actually get to +80% because at -40%, or possibly even -5%, they’d wind up in Chapter 11. He was absolutely right, as I later saw when I got into junk bonds.

In fact, there was an article in a local NYC Business publication about how a lot of what we see as the retail apocalypse is not really amazon’s fault. A lot of stores are closing and chains going under because they can;the service the hefty debt burdens they took on, either on their own or as a result of private equity buyouts, during the boom years.

I don’t remember the Modigliani Miller math, but their research showed that risk and return tradeoffs operated such that no capital structure was inherntly better or worse than any other.

4

Thanks, Marc and Riccardo. I’ve now read the Wikipedia entry on the Modigliano-Miller theorem, and it does seem to make sense. And I really appreciate Marc’s anecdotal observations.

This seems to imply that we shouldn’t really use the current ratio to evaluate publicly owned companies unless there’s a real danger of default.

5

Yuval and Marc,
Great points. Based just on recall doesn’t Greenblatt make the same excellent points that both of you do in the Magic Formula? Isn’t that part of the rationale for EV?

Sorry if this is not pertinent to your discussion or if my recollection is not accurate. And I am sure there is more to the use of EV than this.

-Jim

6

You definitely can use cpital structure in your evaluation of companies and in your modeling. While no capital structure is inherently good or bad, differences do place companies and their shareholders in different places along the return-risk continuum, and you definitely should take into account which position works for you — and its fair game tc change your mind as conditions change (some sets of conditions are friendlier to risk takers than others).

IOW, cap structure isn’t a matter of good/bad, right/wrong. It’s a matter of personal and strategic choice (and as the world has shown us, there are penalties for makin choices unsuitable to the nature of what one is trying to do).

7

Yuval, I actually have a small bit of money in strategy on SP500 universe w/ negative equity as a selection component. It’s a crazy simple screen on SP500 xFinancials/RealEstate - 2 criteria, one is negative equity, the other is a measure of ability to repay that debt. If I recall, the concept works better in SP500 than other parts of the market - perhaps because the SP500 companies might have more steady predictable businesses. It’s entirely possible low interest rates might be driving factor for results. I don’t know.

There aren’t a lot of stocks that pass the test so it’s probably not robust statistically. I was trying to think of companies most screens would discard at the outset and worked from there. Here’s the back test. Thought it was pretty interesting result for the big company SP500 universe, and would support case that loading up with debt, at least in certain types of businesses, can return very well for shareholders. The result surprised me.

negative_equity.jpg
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8

I love this idea, Michael. It’s really inspired. Thanks so much for sharing it.

9

Are you applying a Rank and limiting the names or just using rules that screen to the holdings?

I like the idea of eliminating the worst out of an index and there are firms that the sell that idea.

Given it is the S&P500 there is a lot of room for sharing ideas openly without hurting one’s strategy. Not asking you to, just saying.

On S&P500, with just !GICS(Financial, RealEstate) you get a good lift considering you are holding 400ish large cap stocks.
When I added ComEqQ > 0 the results degraded slightly.

10

Yuval, I agree with you but I bite the bullet: I think something’s gone clearly wrong with modern finance when debt is seen as reducing risk.

This is why I always shrug in disgust when people calculate the weighted average cost of capital as being less than the cost of equity. Really, so leverage reduces risk? I guess we should all open margin accounts and start borrowing then…

Note also Whitman et. al. write in “Distressed Investing”:

<<Further, Franco Modigliani and Merton Miller, two eminent economists, received a Nobel Prize for postulating, “Assuming that managements work in the best interests of stockholders, corporate capital- izations are a matter of indifference.” What utter nonsense! This book, we hope, has lessons for value investors who invest only in the common stocks of strongly capitalized companies.>>

So not everyone agrees.

11

Hi Shaun, if the question is for me - the result shown is a simple screen w/ no ranking applied. Everything that passes is included in the example. Universe is SP500xFinancialsxReal Estate. One screen criteria is negative equity on the balance sheet, and the other criteria is a measure of ability to repay. (I won’t give it totally away, but it’s not complicated. For company with that much debt the ability to repay is important part of the screen performance. Negative equity by itself is not a sufficient criteria - at least from what I worked on.)

The screen can be improved some by ranking, but there are so few companies passing that I just showed everything that passes in the example above. At last rebalance there were only maybe 8 or 9 total companies from the SP500 passing - so small list. Early in the backtest hardly any companies were passing. It’s a fairly low turnover approach.

re: eliminating worst out of an index. What index etfs do these kinds of avoidance? Absolutely though. If I was building an index fund of 100s of holdings I’d do that. There are some strong factors to help identify truly terrible portfolios, but it seems to me many of those factors are really best used in a negative way to avoid bad stocks rather than select good ones. It seems the smaller the companies get, the stronger the benefits in avoidance if I’m building large index-like portfolios.

12

Curious as to where you saw suggestions that debt reduces risk. It doesn’t. It increases risk and increases potential return. Changes back and forth between debt-heavy or equity-heavy cap structures alter the nature of the risk-reward tradeoffs.

I think it would be benefical to eliminate the good-bad judgments and focus instead on the nature of the differences. There are cases where overall beenfit (the risk-retrn balance), or “utils” if I dare use the economic philosophy jargon connected with utility theory, for the first time since the Carter administration, can be enhanced by debt and vice versa.

13

Shrug in disgust all you want, but the cost of debt is ALWAYS less than the cost of equity. If it were otherwise, nobody would ever buy stocks and everyone would buy bonds instead.

Or let’s look at it from management’s point of view. Let’s say you start a company and need a million dollars in financing. You could sell some of your company to an outside investor (equity) or you could borrow the million dollars from a bank (debt). Then let’s say you make a million dollars in profit. What do you end up with if you sold a portion of your equity? A net profit of a million dollars times one minus the percent of equity you sold. What do you end up with if you financed via debt? A million dollars times one minus the percent interest, plus a tax credit. Now outside investors expect a return on equity that’s a lot higher than interest rates on debt, or else they’re not interested in investing. So the percent of the profit you’ll pay to your outside investor is, in a perfect world, always going to be a lot bigger than the percent of profit you’ll pay to your debt holder. Not only that, but with an equity sale you lose a great degree of management control, a lot more than if you’d sold bonds. So you have to take that cost into account too. Lastly, you’d be paying a lot more tax with the equity investor, since you get a tax deduction on interest expense, and your investor would have to pay taxes on her dividends and thus would require even a higher rate of return.

Of course, debt is far riskier than equity, but we’re looking at costs, not risk. Equity is far more expensive.