IDEAL FINANCIAL STRUCTURE AND MANAGEMENT ZERO DEBT- ZERO DIVIDEND

The popular view in financial management is that for different firms in different industries the ideal financial structure would be different. It is my considered view that irrespective of industry or firm there is one ideal financial structure which is long term zero debt. Firstly we should specify that the choice for any company is either owned funds or borrowed funds. Owned funds may be equity or retained earnings and for a company beyond the startup phase both of these components would be present. Let’s take an example to illustrate how borrowed funds are sub optimalA company has profit before interest and tax of Rs 100 CroresIn case A, it has no borrowed funds so interest is 0Profit before tax would be Rs 100 CroresProfit after tax(assuming 30% tax rate) Rs 70 Crores

In case B, the company has borrowed fundsWith interest say Rs 10 CroresProfit before tax would be Rs 90 CroresProfit after tax at 30% Rs 63 CroresThus we see that case A i.e no debt results in higher pre tax as well as post tax profit

While the above is a simple illustration that zero debt is always better than debt, let’s deal with the conventional submissions in favour of debt

1. Role of Retained Earnings: The cost of debt both before and after tax is always lower than the cost of Equity. While this is entirely true, we should accept that the alternative to debt is not just equity or in the case of a growing company with expansion imperatives, additional equity. Surely we have to consider retained earnings. Every company is expected to make profits and in the case of an efficiently growing company the expectation would naturally be for progressively increasing profits. If these profits after tax are ploughed back i.e. retained, they would constitute an increasing share of the firm’s owned funds. This would take care of the company’s need for additional assets to support its growth plans and would negate any prospect for borrowed funds.

2. Financing Expansion: While a firm can take care of its current levels of operations with existing funding, when significant expansion is on the cards and substantially increased funds are required, then borrowed funds are the only viable choice, because the alternative would be to raise more equity, which would take more time and cost more. To this argument we submit that any firm’s expansion prospects do not suddenly appear on the horizon. There will always be time for a firm to plan its next phase of expansion which most often would be in a time frame of not less than 3-5 years. If the firm makes profits as planned and retains all of the disposable profits i.e. after tax profits, there will be adequate additional funding for expansion. If expansion is carried out in a suitably phased manner, the retained earnings should be more than adequate to support it.

Zero Dividends: It is a popular myth supported by industry on the one hand and poorly informed and poorly educated investors that dividends are a necessary part of return on share holder investment. If an analysis is done as to the growth in the value of a company’s stock, it can clearly be shown that a company that does not pay dividend will definitely produce higher long term Return on Investment for its shareholders than a company that pays dividends. The case of Bharti Airtel in India and Warren Buffet’s company in the U.S. bears out this logic. It should be obvious that when a company withholds dividends, the retained earnings increase to that extent. This increases the net worth of the company and correspondingly increases the worth of the company in the eyes of would be investors. If one looks at the financial status of Bharti Bharti has equity of Rs 900 Crores,The company’s net worth as of 2008 was Rs 30,000 Crores. Retained earnings are therefore Rs. 29,100 Crores. Market price of Rs 10 share in 2008 Rs 960 per shareP/E ratio in 2008 46(highest of any Indian firm)

One final but inadequate justification for dividends is that it firstly reduces the uncertainty of returns and is a source of short term income to shareholders. To this argument we must submit that the difference between an equity holder as contrasted with a person who invests in debt and debt related securities, is that the equity investor has a higher risk and higher return profile. Part of the higher risk is the willingness to wait longer to get the return on his/her investment

A Universal Recommendation for Financial Structure: Every company can and should have debt during its initial stages. We say with good planning a firm should start with the minimum amount of equity and the min, amount of debt to fund its initial phase of market operation. As the firm earns profit as it can only be expected to, it should plough back all of the disposable profits after tax, and with this, should retire the existing debt as soon as possible. Once the initial debt is retired, the firm should rely on progressively increasing retained earnings to fund its growth and expansion imperatives. If a firm finds that it is not able to earn enough to support this course of action, it should introspect on why it’s functioning is not permitting this universally suitable and justifiable course of action and make efforts to improve the profitability of its operations till it is able to rely on retained earnings to finance its expansion plans.

Need for Educating the Various Stakeholder Groups involved:

Industry: While the above logic and suggested course of action is undisputably optimal for all companies in every industry, there is currently a lot of thinking and preaching within industry and academia that debt is not only not undesirable, but eminently desirable with the only caveat that the amount of permissible debt varies with the state of an industry(growth or mature phase industries).

Banking and Financial Sector: There are vested interests at work as well with the banking and financial services industry relying for ever increasing borrowing from their industry counterparts and the counterparts also ever ready to borrow larger sums for their operations and commercial functioning. The submission to this is, that there are huge requirements for lending from the infrastructure and under privileged sectors. Let the lendable funds be reserved for this salutary purpose and let industry proceed to operate more intelligently, more efficiently and ultimately reward its investors with superior long term returns on their investment.

Equity Investors: For the common share holder a certain amount of education and explaining would be necessary since it has to be accepted that many of them have been blinkered by the conventional thinking and current industry practices. But let us accept that investors are intelligent and reasonable people and would certainly be convinced by reasonable explanation and argumentation which this paper has hopefully been effective in. In the end the acceptance and progressive implementation of this funding paradigm can bring rich rewards to all the stakeholder groups including the larger societal group to which industry has undeniable obligations.