Hacker News Reader

> Obviously, a private company with hundreds of millions in stable recurring revenue shouldn't operate debt-free -- debt can be a useful tool, even if only as a rainy-day tool for situations such as the recent pandemic.

Why obviously? Seems to me when a crisis hits the last thing you want to have is debt you need to pay back. For example, should Apple, with their huge mountain of cash, have debt? Do they need debt?

I guess one can also ask the same about countries. Do they really have to maintain some level of debt in order to have a healthy economy? Why not just have a big bunch of cash put aside for a rainy day? How is this "obvious"?

I think we are conflating "available credit" and "utilized credit". (Or, rather, I didn't clarify that myself.)

Available credit is something like, "Company X has $100M in annual revenue and a $5M line of credit, which is not presently utilized." Arguably, such a company is better positioned than the same company X without the $5M credit facility. The cost of the annual fee to maintain the credit facility will be miniscule compared to the security provided by having $5M instantly available in a rainy day scenario. This is the way by which I mean some corporate debt (specifically: available revolving credit) is "obviously" a good idea.

You're right that term loans involve more trade-offs: interest, maturity, etc. But those are still trade-offs, not always downsides. Assuming even a modest annual-interest-rate-beating growth rate in the business with a high probability that such growth materializes, the debt can make the business easier to manage and actually increase the probability of sustainable growth. That's the other way in which I believe that debt can be an obvious benefit.

But obviously if you take too large a term loan, it can be disastrous, thus my question about debt ratios. For example, for company X above, it's obvious to me that a $100M term loan would probably be dangerous. But, a $10M term loan vs $5M? Not sure. That's why I am curious about ratios.

Also, re: your question about Apple:

> For example, should Apple, with their huge mountain of cash, have debt? Do they need debt?

Obviously not. Debt is for companies that have already utilized most of their cash, right? Or have future cash flows that they want to access now before the cash actually materializes. Apple, by contrast, should probably become an investor or lender, since it doesn't know what else to do with its excess cash. It certainly serves no purpose being hoarded on their balance sheet.

You can create debt in jurisdiction A collateralised with assets (even cash!) in jurisdiction B... potentially without any tax implications. I expect Apple can borrow money basically for free, so there's probably a bunch of financial-engineering type reasons that debt would be useful to them.

> Seems to me when a crisis hits the last thing you want to have is debt you need to pay back.

I think that when a crisis hits the first thing you want is cash, and that means the last thing you want is to have just spent all your cash paying off debt.

Imagine that you need to buy $100,000 of inventory to sell, and you have $100,000 to spend. If you spend all your cash on inventory, then you have zero dollars on hand. When your account comes back and tells you that you need to pay another $10,000 in taxes — now you need to borrow, and it's a lot more difficult to borrow with nothing in the bank than with $100,000. When one of your customers trips and falls on the just-washed bathroom floor, you need money to compensate him. Not having cash is pretty awful: necessary cash outflows can be spiky, and income can be spiky, but the spikes do not necessarily need to align. This can lead to a cash flow crisis, and eventually to a restructuring bankruptcy.

OTOH, if you had borrowed the money to buy that inventory, then yes you would have had to pay $110,000 or $105,000 or whatever, but you would also have had the freedom that cash gives you. Borrowing would have smoothed out a major expense, and permitted you to pay it off in smaller chunks, making a cash flow crisis less likely (although of course still possible).

Consider right now, with the whole COVID-19 situation. It could very well make sense to borrow at a good interest rate: the difference between the interest rate on debt and one's investment return rate is essentially the cost of insurance to have cash on hand. Note that sometimes this can even be negative: it is possible even now to get 0% interest-rate credit cards with terms of over a year: you can invest the cash and pay it off in twelve months.

Debt used to create value or accelerate value creating processes is good debt. Debt used for stock buybacks, paying off interest on existing debts, executive bonuses, etc. is bad debt. It is pretty straightforward, we just seem to have lost our connection between the stock market valuation and the actual value of companies. We were content watching companies increase in value when they were actually stagnating and drowning in debt.

Think about a company as an entity that invests in projects with the goal of maximizing the time-adjusted return. The company must fund those projects with either debt or equity, and each funding source has a cost. The optimal debt load is one such that the projects undertaken by the company are funded at the lowest cost.

This is a nice theoretical answer, but I am looking for something a little more practical. Also, assume that a company has already acquired all its "expensive capital" via venture markets and sale of private shares. Given the current metrics of the business, how should it decide how much "cheap capital" to acquire via the debt markets?

It’s perhaps a high level answer but it’s not theoretical, if you are interested in diving deep I would highly recommend Professor Damodaran’s corporate finance course, he is the gold standard and it’s available for free on YouTube. Without repeating the entire course I’ll try and expand. The critical business metric is free cash flow, all operational data leads to that. We can project the firms free cash flows out over a period of years. Now the question is: how much should we spend to get this stream of cash? It’s not simply less than the sum of the cash flows, because the ones that come later are worth less than the ones that come sooner. To account for this, we “discount” those cash flows at a specific rate, the weighted average cost of capital. This number is where we bring in the mix of debt and equity in the firm and contains the cost of equity financing and the cost of debt financing, which mostly has to do with what interest rate the firm can borrow at. There is an optimal quantity of debt that minimizes this discount factor, thus maximizing the value of the future cash flows, it’s convex. If we can spend less than those summed discounted cash flows, funded with that optimal mix of debt and equity, we are NPV positive. This means we are generating real economic profits with our business activities.

Super helpful. Thank you for this thoughtful answer and I'll check out the YouTube recommendation. Cheers!

I just want to thank you again for that YouTube recommendation for Prof. Damodaran’s course. It is exactly what I am looking for. In particular, the middle part of his course (“the financing decision”) is specifically about how to think about debt vs equity mix.

https://twitter.com/amontalenti/status/1282735518061600768

Enjoy! I hope you find corporate finance as cool as I do. He’ll cover this but keep in mind there are a few differences with a firm such as yours who’s investors are less diversified.

Why would a company take on expensive capital if cheaper capital is readily available?

If the cheaper capital is cheaper because it’s more restrictive.

There's a fair amount of thought behind what the ideal debt ratio should be for a company, but basically the goal is to minimize the cost of capital while maximizing market value.^[1]

[1]: https://www.investopedia.com/terms/o/optimal-capital-structu...

Thank you for this. I did not know the term "Optimal Capital Structure" but it seems like a good jumping-off point for researching the topic.