Yet another MBA post...inspired by a heated discussion with a colleague (it was friendly though). Now, frequently it has been pointed out in my finance classes that firms try to maximise stakeholder value. This usually means shareholder value, which means stock price!
And the thing that people say is this: if you can manage it, and its not too risky, use debt to raise capital rather than equity.
What does that above statement mean? Stripped of the jargon simply put, it means, "take a loan to expand rather than raising money from shareholders."
Now comes the point...Why is it better to take a loan...after all, you have to pay interest on it.
Let me explain it in this way. Lets say I have a potato farm, which has 10 investors. I make profits of 10 lakhs per year. This means that my shareholders get 1 lakh each. Now, lets say I want to expand, and buy my neighbours farm for 10 lakhs more, which will earn me another 5 lakhs a year. I could do this in 2 ways. Firstly, I can invite 10 new investors to invest 1 lakh each, or I can go to a bank, and at an interest of 10% pa, I could take the loan of 10 lakhs. Let us follow these two scenarios.
In the first scenario, my new profit would be simple. 10 lakhs from my original farm + 5 lakhs from my new farm. Total =15 lakhs. All good. But this 15 lakhs now has to be distributed to 20 people, which means that each shareholder gets only 0.75 lakhs each.
In the second scenario, my profit would be 10 lakhs from my original farm + 5 lakhs from my new farm - 1 lakh in interest payments=14 lakhs. So my profit is lower, but I share this money with only 10 investors, which means that they get 1.4 lakhs rather than 1 lakh they got last year. Of course, my total profits fell, but I don't really care about that...after all, my aim is to get my shareholders rich, and I have achieved that!
Of course, there is a downside, else every company would only borrow money....if there was a drought, and I made only Rs. 50,000, I would still have some money to distribute if I had not borrowed money, and if I had borrowed that 10 Lakhs, I would have been bankrupt, because of the interest costs. So, borrowing money is risky.
Companies which use borrowed money to expand are called Leveraged companies. And conventional wisdom states that if your risks are low (ie: There is not much likelihood of a drought), you should go ahead and borrow money. This would be true especially if your growth return on capital employed (or your profit divided by money invested) is higher than the interest rate prevailing.
The IT industry ought to be a place where leveraging should work then...after all, while bank rates are hardly 12-14%, an industry that grows at 35% should go for loans to grab as much profits as it can to expand. But Infosys has said for a very long time that they do not plan to expand with debt, and they only grow internally rather than taking loans. In fact, they have no debt at all, which seems that they don't reward their shareholders as much as they could.
But here is where I believe that the IT industry is essentially different from manufacturing or agriculture. For my farm which gives me paltry returns, I needed to invest a sizeable amount of money. Typically, a manufacturing plant would invest hundreds of crores, and after a couple of years, profits would be made. But in an IT firm, the investment required is minimal. They really do not need to take loans, because this can be funded out of profits which do not require new shareholders or payment of interest. Here of course, the disadvantage will be lower dividends paid to the shareholders, but this is really the cheapest option, because the shareholders would only get the bank deposit rate from their dividend income, while the company would be growing much faster.
This is the reason for the famous no dividends being issued by Microsoft...they could plow it back into the company and earn far more by growing. And this is why very few IT companies rely on debt and leverage to increase shareholder value. It is no longer very cost effective
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2 comments:
I would like to understand why investments in IT firms are minimal ????? There is enough investment on Infrastructure & people isnt it ?
Investment on Infrastructure is actually close to negligable. Since the office space is leased, there is little fixed cost due to capital being locked up in real estate.
Secondly, employee cost is not sunk cost...At least conventionally, you will hire employees only when you know that you can bill said employees hours to some poor sucker in the US...or Latvia...or wherever! So, as such investments are not in the scale of building a railway, where the gestation period could be about 5 years before you see your first revenues come in!
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