Debt is Sexy

As an avid reader and follower of the global economic slowdown (I prefer to use this as it looks more polished than recession) one can’t help but sit back and reflect on something which our grandparents used to say very often “Stay away...far far away from debt”. In the Indian society, debt was considered a taboo.

Like the RBI being the lender of the last resort for the Banks, debt was the lender of the last resort for people. When no other means of finance were available people used to approach, the local money lender or the PSU banks. Still debt was a very bad thing to carry on your resume – It had massive ramifications. A dad with debt burden could not get his daughter married off; a house in debt was always something children were asked to stay away from (lest they pick up some bad habits). The underlying point is that debt was considered as one of the greatest evils.

However in the last few years, things seem to have changed – atleast in the large metro cities of India. A lot of it has to do with the rapid economic growth that India was making – resulting is higher salaries at a very young age. Something that took our parents 20 years to buy – we wished to get it in 2 years time! So out of college the coffee table discussions centered around not how to buy a flat in the new swanky DLF construction (that comes with it a large gym and a swimming pool) but how to finance it. The decision to buy was a foregone conclusion; it’s just about deciding how to finance it. The answer was simple. Debt! The economy was booming, interest rates were sufficiently low and paying of the EMIs was just a formality.

Personal debt (taken to finance purchase of assets like land, apartments or luxuries like a car) bears a striking similarity to corporate debt in the way it functions. The next few points explain this.

Debt helps you save Tax
Debt is a magical wand. It helps a firm save tax. Yes, it provides the much needed interest tax shield. So if a firm raises a debt of D, there is a direct tax relief of Tc * D and thus ends up paying lower tax than it normally would have.

The sample principal applies to retail debt, say a home loan. The interest on the loan amount taken and also a certain % of the principal amount can be reduced from the taxable income and thus taking debt helps an individual save a significant amount of tax. So instead of paying a whopping amount to the Government of India as tax, it was much better to approach the nearby swanky MNC bank who offer home loans –
In quick time. (Service Quality!)
Provide excellent support in all the pre-processing work
Implications: Take more debt, buy your dream home and ya pay less tax.

Apart from this debt helps the corporations in the following ways:-

Debt helps bring down your WACC
Debt is sexy. Corporate Finance tells us that a good Finance Manager would always look at bringing down the Weighted Average Cost of Capital (WACC) and the more funds he is able to raise using debt, the lower is the WACC. (Cost of Debt < Cost of Preference Shares < Cost of Equity).
Implications: Companies looked at raising a large chunk of their funds via the debt route. It certainly helps when debt was available not only in India but in countries like Japan where interest rates are nearly 0%. Raise more debt, bring down your WACC.

Debt helps increase the EPS
Another tool to measure the performance of a company is the Earnings per Share which is calculated as Profit after Tax / Total No of Shares.
Implications: If a firm needs to raise Rs 100 and issues equity for it, what it is doing is increasing the denominator and hence bringing down the EPS. Companies could instead raise that amount using the debt route. Again debt helps in boosting your EPS.

Thus we see that debt is sexy, so long as the cost of debt is low; i.e we are living in a low interest rate regime. But unfortunately interest rates are not always low, it follows a business cycle. A slowdown as we are seeing now result in extremely low and attractive interest rates. However if the economy picks up in a years time and we are big to high growth phase (which generally lasts for 4 to 4 years) it won’t take much time for the central banks to raise the interest rates. After all they are also responsible for preventing the overheating of the economy. Thus, a few percentage points increase (above the threshold) in lending rates by the banks can have direct implications on the bottom line of corporations; similarly an increase in your home loan rate could pinch you big time and has the ability to send our entire financial planning for a toss.

Does that mean we should completely shy away from debt? I feel the answer is no. The best way forward is to use the combination of the wisdom of our elders and the knowledge of how debt works to make sound financial decisions. The advantages that come along with debt can be exploited by choosing the right size of debt and timing it correctly. We know that business cycles of boom and bust are a reality. The debt amount should be chosen in such that it can be repaid in one business cycle. So you might not have to wait for 20 years to buy that house of yours and maybe it might not be possible in 2 years, but right planning can help you time it somewhere in between these two. The key once again is ability to repay in one business cycle! Go…get your home.