Saturday, March 7, 2009

What is debt?

Figuring out how much debt a company has outstanding is not only critical to assessing its default risk but is a central input into much of what we do in corporate finance (cost of capital, cost of equity and valuing equity). It is a topic we have been examining in both the corporate finance and valuation classes this week. 

I use three criteria to classify an item as debt. 
1. It gives rise to contractual (fixed) payments that have be made in both good times and bad.
2. These payments are tax deductible.
3. Failure to make these payments results in loss of control

Using these criteria, it is quite clear that all interest bearing debt (whether short term or long term, bank loans or corporate bonds) should be considered debt. Here are the more controversial items:

a. Accounts payable and supplier credit:  Generally, I would not include these items as debt and here is why. The interest expenses on accounts payable and supplier are not explicitly broken out. Consider how supplier credit works. You buy items from a supplier, and he lets you pay in 10 days or 50 days. If you pay in 10 days, you get a 2% discount, which you lose if you take the entire 50 days. When you use supplier credit to increase your cash flows, you give up the discount, which effectively is the interest you are paying on the credit. However, when you account for the expense, you record the total cost you pay as part of cost of goods sold and do not break out the discount lost as an interest payment. So, here is the trade off. If you want to count accounts payable as debt, you will have to go into your cost of good sold and break out the portion of that cost that is the foregone discount and show it as interest expense. That can be tough to do.

b. Lease commitments: By the same token, lease commitments should be treated as debt because they are (a) contactual commitments (b) tax deductible and (c) failing to pay them can expose you to legal consequences. We can debate whether they are closer to unsecured debt than secured debt, but not whether they are debt. For any retail or restaurant company, the bulk of the debt is in the form of  lease commitments and we should be considering the present value of these commitments as debt. For firms like the Gap, Walmart and Starbucks, 80-90% of the debt takes the form of lease commitments.

c. Under funded pension and health care obligations: We are trained in accounting classes to be conservative when it comes to debt and to count everything we can as debt. That advice serves us badly in valuation. If we start including under funded pension and health care obligations as debt, we will inflate debt ratios and reduce cost of capital. That does not strike me as conservative. I would ignore these as debt for cost of capital purposes, but will consider them as debt, later in the valuation, when I am intent on getting from firm value to equity value.

More posts on this as we go on, but that is it for now.


dorothy786 said...
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Manish Agarwal said...

Nice and Informative
Something which we won't found in books. Specially the pension fund point.

eran said...

Hi Prof.
If it's not too much trouble, it would be nice if you could talk about the beta of debt. Assuming it to be zero doesn't seem consistent to me if we assume a cost of debt that is higher than the risk free rate.
Also, are you ignoring the health care obligations completely when calculating the weighted average cost of capital? Maybe we can consider them the same way we consider the cost of preferred stocks (make a "special" cost and calculate the weighted average)?

On a personal note, I would like to thank you for this great blog. You have a way to make complex things seem simple and I admire you for that.


Michael Comeau said...

Is it common in the real world for companies to offer discounts for paying within ten days? I worked in a Real Estate management company for some time and never saw such a discount. Just wondering if anyone out there has some input on this issue.

gauravmehta said...

Hi Micheal,

This discount does exist but not in the real estate industy except if you are into building properties. Otherwise this is basically in industries like manufacturing, for example you purchase material from a supplier you have an option of paying him in 10 days and get a discount of 2% or take the full credit period of 50 days but get no discount....Basically this is a method of managing working capital.

Anuranjan said...

Dear Prof.
I had a quick question on preferred stock and its treatment as debt. Though Preferred stock may not qualify as debt on three points you mentioned, I believe that while calculating the default chances of a firm,it should be treated as debt. I agree that when we calculate wacc (cost of capital), it's more closer to equity.
It will be great if you can please talk abt beta of debt as Eran requested earlier.

suken said...

Hi Sir,
I thank you for the BLOG that you have started so that people far across in Indian schools can also interact with you.

My point also lies around the fact of ignoring the market related risks while calculating the cost of debt by assuming a Zero Beta for Debt.
Even when we estimate the Debt Rating for the company we look at the intrinsic factors(unsystematic risks)while there are companies who's debt yield move along with the market, indicating the cyclicity while others not.
So is there any way to factor the market risk of Debt through Beta or Rating adjustment.

Thank you.

CG said...

There seems to be some political moves to change the tax exemption of interest payments for companies, to encourage less debt. A zero tax exmption would take us back to the MM theory that the capital structure doesn't matter but I suspect it will hurt the market values of equities substantially, with further knock-on effects on pension laibilities as equities fall.

Any thoughts?

miszkam said...

Regarding treating accounts payable as debt.
In evaluation we usually include them in working capital calculations.
Does that not pose any problems of double-counting?

Neuroactive said...

If there is no debt on the books of the company, how do we calculate WACC. I know the basic formula but how do you adjust for CoE for zero debt.

dharma said...

hi miskam
Accounts payable is a form of short term debt and will be considered under total debt for valuation purposes. So there is no double counting anywhere.

Sheila said...

Hello Prof. On short term debts and current debt, how do we know they are included interest-bearing debt if there are no clear explanations whether they get interest or not.

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