Jun
18
Why do large companies need to borrow so money so frequently?
Filed Under Other - Business & Finance
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I understand some struggle and need to borrow but it seems even successful companies borrow money. Why? Shouldn’t they keep enough of their profits in cash so they can use it instead of borrowing? Somebody explain this please.
I understand some struggle and need to borrow but it seems even successful companies borrow money. Why? Shouldn’t they keep enough of their profits in cash so they can use it instead of borrowing? Somebody explain this please.
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2 Responses to “Why do large companies need to borrow so money so frequently?”
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It can get very complicated so the easy answer is the cost of borrowed money is tax deductible so it is cheaper to burrow. This is especially true for very large or very profitable companies. There is also a need for fluctuating amounts of money when they make capitol improvements.
excellent question actually. here is my best attempt for simple examples. its called leverage gone wild.
large successful companies didn’t / don’t necessarily need to borrow (with the exception of a bank or finance or auto company, which is a different business model).
an equity investor (ie common stock etc) wants/ needs a return of say 15, or 30% (for example, depending on the point in the business cycle) for their risk. this is considered the “cost of equity capital” so companies would need to invest in only high returning projects / businesses of at least that.
but then a bank (or a fund, etc) comes along and says they’ll lend you another X times working capital or cash flow or book equity etc for half that price, then you can invest in more projects / businesses that aren’t quite as high in return. because this is a lower “cost of capital” for the debt as opposed to equity.
so how much debt should a company take on, if any? it was / is always been the “64 million dollar question” – and now the concept will be re-thought no doubt. many were paid on their ability to aggressively sell these ideas to companies.
conservative managers would have said no debt is best, more aggressive ones would say the more the better, a lower cost of capital meant more projects and higher return on equity, faster profit growth, a better stock multiple, and ultimately better stock options returns personally for them. also, since bond or loan holders are debt, they can’t vote and leverage the return of the equity holders, who through the board of directors may have ok’d a borrowing strategy for these reasons.
once you decide to borrow, how long should your maturities be? in a normal economy with an upward sloping yield curve, longer term means higher cost. some would go conservative and issue long bonds (5-30 years), others who could get a great credit rating would be aggressive and decide they would do as much 30 or 90 day commercial paper and push the envelope and be i a constant state of refinancing.
since memories are short and none of the corporate managers have really ever seen this type of credit crunch (younger considered better usually), they never would have dreamt a moderate amount of debt would be a problem in terms of refinancing. some (GE comes to mind) deserved every bit they had coming. they loaded up early at the salad bar.
other examples could be cyclical companies, meaning their cash flow goes way up and down with the economy and over-estimated their trough income when borrowing in good times. again not necessary just aggressive.
a third example could be a leveraged buyout where someone was able to buy a company by borrowing a huge amount (70% range) of the purchase price in debt, now are having problems with profits. the ultimate aggressive example, an ownership change probably wouldn’t have happened without debt.
but generally, its not that big an issue, – its the big 3 automakers and others that have used *heavy financing* for selling its products or decided to get into the lending business (i.e GE). in this case, these are really capitalized like banks that have little equity.
when you have car companies and industrial manufacturers making / buying residential mortgage loans, something isn’t right. and this is what happens. leverage gone wild and equity investors who went along for the ride.
the boom was so long and so wide everyone became way over-confident, esp. after 9-11 and the economy was resilient, investors, borrowers and lenders were cocky.