Academicians have long argued that Debt if used to its fullest can be a great source of cheap money and savings for an organizations but also say that most companies are not able to optimally use debt due to several limitations such as availability of cheap debt, lack of credibility or market conditions. Most companies see debt as something that has a fixed service obligation irrespective of cash flows and as such carries high risk.
So is it true that companies are cautious with debt? Historical trends for companies borrowing seem to prove otherwise. Over 97% of the companies listed in BSE have exposure to debt of which over 83% have a Debt Equity ratio of over 2.3:1
But this is not abnormal as long as the company sees the earnings derived from such borrowed capital as worthwhile. Lets see the kind of benefit that a company can derive from debt. Let us say that by investing a Rupee at a 10% return produces a 10paise profit. Now by borrowing an additional rupee at 5% interest, the profit can be boosted to 15paise which is a 50% increase.
Another aspect is the tax benefit due to the deduction on interest paid. For a company with no debt and thus no interest deductions, a one rupee earning might eventually shrink to 67paise due to corporate taxes, but if the company has a significant interest deduction then the earnings would correspond to almost a rupee. This means that the tax shield from interest buffers out the taxes paid in the long run.
So is it true that companies are cautious with debt? Historical trends for companies borrowing seem to prove otherwise. Over 97% of the companies listed in BSE have exposure to debt of which over 83% have a Debt Equity ratio of over 2.3:1
But this is not abnormal as long as the company sees the earnings derived from such borrowed capital as worthwhile. Lets see the kind of benefit that a company can derive from debt. Let us say that by investing a Rupee at a 10% return produces a 10paise profit. Now by borrowing an additional rupee at 5% interest, the profit can be boosted to 15paise which is a 50% increase.
Another aspect is the tax benefit due to the deduction on interest paid. For a company with no debt and thus no interest deductions, a one rupee earning might eventually shrink to 67paise due to corporate taxes, but if the company has a significant interest deduction then the earnings would correspond to almost a rupee. This means that the tax shield from interest buffers out the taxes paid in the long run.
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