1 September 2014

Debt Motivation

Previously, I have explored the notion that financing companies with debt made them more valuable to the owners because interest payments were tax deductible and so saved the company tax.

by John Royden

Head of Research

which pay less tax are more valuable than companies that pay more tax, all other things being equal.

The empirical evidence suggests that debt does more than just save tax - it actually makes directors work harder. And companies with directors who work harder are worth more than companies with lazy directors, all other things being equal.

Companies with higher levels of debt force directors of such companies to operate their assets as efficiently as they can and to pay out the cash they cannot profitably reinvest, instead of frittering away potential profits in organizational inefficiencies, or making frivolous acquisitions at inflated prices. 

Those of you who owned mining shares might have done better if mining companies had been more highly leveraged, or indebted, so that the boom time cash flows had gone back to investors rather than on overpriced acquisitions. 

Here is another thought.  If you are a director of a company sitting on a pile of cash and things get tough, then you can carry on with your holidays, short working days and long weekends knowing that the cash will continue to fund the business. If your margins shrink you still get to keep your job and the cash pile pays your salary.

If you are a director of a company that needs to pay its debt off in a few months and things get tough, then you work very hard to make sure that the company continues to generate the cash to pay off the debt and fund your salary.

One economist called Theo Vermaelen tried to quantify the beneficial effects of extra debt. He calculated that the shares of companies which announced share repurchases funded with debt rose by an average of 18%. That is way more than is justified by the tax shield of interest payments and can only really be explained by the notion that directors of companies with higher debt levels are more productive and less prone to shareholder value-destroying investment.

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