A recent Fortune article by Geoffrey Colvin discusses the relatively low percentage of debt in the capital structure of a large percentage of US public companies (he cites that “25% of the Russell 3000 have no debt or negative debt”). His primary point is that by not having “enough” debt, companies are suffering from a higher WACC (weighted average cost of capital). His rationale for why many companies are choosing to not use as much debt as might otherwise be indicated is that reduced debt leads to reduced volatility in a company’s finances and hence, the stock price. He assumes that CEOs prefer the reduced stress from lower stock price volatility.
In comparison, McKinsey recently published an article, “Making Capital Structure Support Strategy,” suggesting that companies should select a capital structure (debt/equity split) to support the corporate strategy rather than merely to seek tax advantages (because the interest on debt capital is deductible whereas dividend payments on equity capital are not). The McKinsey authors focus more on how a company might select a specific level of debt based on corporate strategy and likely future scenarios, but they nevertheless indicate that companies with extremely low levels of debt can generally increase value by increasing debt to “typical levels.”
As a practical matter, most of the companies with low or zero debt use additional cash as a replacement for a revolving line of credit to fund A/R or smooth out the effects of variation in sales or inventory purchases. So, to “increase” the debt on the balance sheet of such companies to reduce WACC, these companies first need to reduce their cash. (After all, taking on debt with the sole effect of investing that additional capital as cash or cash equivalents would be pretty annoying to most investors.) The goal is not to increase the amount of invested capital in the firm but simply to reduce the WACC. So, for any amount of debt raised, invested capital must be reduced on a corresponding basis.
How can companies reduce their invested capital? Well, for the class of companies we’re discussing here, the most obvious method would be to use up some of their cash. They could make an acquisition, declare a dividend, or implement a stock buyback. An acquisition would not have the effect of reducing invested capital. A dividend, even under current lower tax rates, still has the effect of reducing the value of the wealth transferred to shareholders. A stock buyback is the most efficient scenario for using the company’s excess cash in a manner that reduces invested capital. After the buyback, the company is free to raise debt capital to replace the cash previously held. If all works as planned, the company’s WACC should decrease because the cost of the debt used to replace the cash will be substantially lower than the cost of equity for the cash that was held.
What other factors, beyond those suggested by Colvin, might account for the apparently excessive amounts of cash on company balance sheets? Our economist friends would probably suggest that the firms have a more pessimistic view of the future than outside analysis would seem to suggest. I think that one contributing factor is that some analysts habitually back out the effects of excess cash when calculating ROIC. In effect, they say that since the firm could reduce its invested capital by dividends or stock buybacks, you should analyze the company as if it had divested the excess cash. Of course, this approach is more than just a white lie because the firms really are holding the cash and somebody, somewhere, has to get paid for the cost of that capital. In addition, financial advisors and consultants probably favor more exotic reductions in working capital such as factoring, inventory management systems, and similar techniques because it is much harder to structure a seven-figure fee for an engagement around “declare a dividend.”
Finally, I’ve just seen a reference to another article on this point, and we’ll generate a follow-up post.