Tuesday, June 22, 2010

Leverage - A double edged sword

Leverage – all of us know what it means. It means a kind of influence or a pull. In finance, leverage refers to the debt a company takes in order to make its financing decisions. Taking debt may help the firms to get a tax shield. This would reduce the tax burden of the company and increase the Return on Equity. When leveraged, there is an advantage of enhancing shareholders’ wealth.

At the times of a recession, lower debt levels save the company. In prosperous times, the debt free companies can grow even more without the need for constant debt servicing. Therefore, all shrewd companies borrow in boom, make profits, set aside a part of their profits and repay the loans within 5 -6 years.

While making a financial decision, a firm needs to decide over aspects like how much capital will be required, how much debt has to be raised, what the nature of borrowings is and what would be the future projection of the cash flows. The nature of debt could be short term or long term, through debentures or Financial Institutions, within country or through FCCBs, from public or from banks.

Some of the companies like software companies like Infosys, Oracle are debt free companies; depending only on equity for their operations. Since such companies are cash rich, they do not have to raise funds from the market.  The advantage of being a ‘zero debt’ company is that; only the owners’ money is in the business. The firm does not have any obligation to pay off to any outsiders. Zero or low leverage keeps the company’s interest costs down and gives the flexibility of investing its cash back into the business for expansion or development of new products and services.  But the disadvantage for such companies would be that they would be termed as passive on expansion; therefore would be left out on growth rates when the environment turns bullish.

But there are companies like Tata Motors which heavily depend on debt for their operations. They launch the SPVs (Special Purpose Vehicles) which mainly aid a merger/acquisition/expansion decision. The SPV is nothing but a legal entity under the parent company; formed for the sole purpose of fulfilling specific and temporary goals. An SPV is created to cut off the firm from financial risk.
For example: In the $2.3 billion Tata – JLR deal, Tata Motors launched an SPV where Tata Sons and Tata Motors pumped in some equity and the remaining was raised as debt from the public. This benefited the company to acquire JLR. But how much successful was the deal is a matter of question.

The Tatas did a similar thing in the Tata-Corus deal as well. They acquired Corus for $12.1 billion. This acquisition was routed through Tata Steel, UK (an SPV). The group’s holding company, Tata Sons pumped in $4.1 billion as equity into the SPV. The balance $8 billion was raised by junk bonds and senior term loans. This definitely helped them to expand their operations in Europe. The debts are being paid off from the profits made out of the deal.
In case of the Tata Group, a similar mechanism was used for the Tetley buy in 2000.

So in short, debt is not all that bad; provided it is monitored and serviced periodically. Or else the companies may enter into something called a debt trap. This trap is no different from a normal trap. Here the company already has a huge debt and takes loan again to cover the 1st debt. Such continuous practice of taking loan to service a loan is termed as a debt trap. This makes the company financially inept; which is not a good sign for the growth of the company. Hence debt can be either a boon or a bane; depending upon the way the companies handles it. 


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