Debt and Equity

The Financial Structure of the firm is the relationship between Debt and Equity. The relationship is called "Leverage" because stockholders are matching their equity with debt to create a bigger company.

The Debt versus Equity relationship is so fundamental that three popular definitions for leverage are in common use:

• Debt/Equity
• Debt/Assets
• Assets/Equity

Of these we prefer Assets/Equity because it gets at the relationship from an owner's perspective. (Debt/Assets is favored by lenders, and Debt/Equity by Management.) Owners are creating Assets (the Company) by matching their Equity with Debt in some proportion.

A Leverage of 3.0 says, "For every $3 of Assets there is $1 of Equity."

Leverage	Assets	Debt	Equity
1.0	$1	$0	$1
2.0	$2	$1	$1
3.0	$3	$2	$1
4.0	$4	$3	$1

When students run the simulation, they often strive to eliminate the Debt and bring Leverage down. They pay off any Current Debt and retire all bonds. Sometimes they set Accounts Payables policy to zero (paying vendors immediately), which eliminates all forms of debt and brings leverage to 1.0.

In short, they manage the company as they manage their personal finances. This thinking is incorrect, especially in the early years of your tenure. It occurs so frequently in the simulation that we should take a moment to compare personal finances with corporate finances.

Consider the example. Without the Debt, the Assets would only be half as big. Instead of a company with $100 million in Assets, you would have a company with $50 million. Looking at the Leverage table, a competitor with identical equity and a Leverage of 2.0 would have twice your assets at their disposal. With a Leverage of 3.0, they would have three times your Assets.

In your personal finances, debt buys non-income producing assets. Interest payments consume your income instead of you. In a business, debt buys income producing assets. If you can borrow money at 10% and make 20%, you should borrow all you can get.

The relevant questions are:

• Can we find investments that generate a higher return than the cost of the funding?
• What is the risk that our investments will not produce the expected returns, perhaps even causing us to default on our debt and go bankrupt? The higher the Leverage, the higher the risk.

The amount that you can borrow is limited by debt holders. They know that things can go wrong. For example, you buy capacity, but your competitors introduce new products, and your new capacity sits idle. Debt holders control their risk by charging higher interest rates as Leverage increases, and by setting limits on the amount you can borrow.

Near the end of the simulation, companies can usually fund plant improvements entirely from profits, and teams are tempted to pay down debt. For example, the company has a $30 million profit and only needs $15 million for plant improvements to keep up with industry growth. (Further, it has $10 million depreciation that could pay for the new plant.) The argument goes, "We do not need more debt to grow our company. We have become a cash cow, and it makes no sense to let cash accumulate. Let's use our excess Working Capital to retire debt, eliminate interest payments and improve profits."

To evaluate this argument, one must recognize that the environment has changed. At the beginning of the simulation, investment opportunities abound and you need new capital to fund them, either debt or equity. Seven or eight years later, the investment opportunities are still there, but you can easily handle them from the wealth you are creating.

Of course, this happens in the real world, too. Any cash cow could pay off its debt to improve profits. They maintain their Leverage for reasons worth exploring.

The simulation highlights an intrinsic competition between Management and Owners (stockholders). By definition, Management owns no stock, and Owners do not manage. Of course, in the real world individuals can do both, but the roles are fundamentally different. Owners accumulate capital and put it at risk. In modern times "owners" include pension funds, mutual funds, venture capitalists, etc. as well as private investors. Managers take the capital and create additional wealth. In principle the new wealth belongs to the owners. In practice, managers want the wealth, too.