Foreword
We’ve discuss the capital stack of a company before — basically how the company funds its initial creation and ongoing concerns. But why are there so many classes of funding? Why not just fund the entire company with equity? Or with debt?
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Perfect business
Let’s say we have found a magical business — it scales perfectly from $0 to infinity amount of money we invest in the business, and for every $1 invested, it will return 10c every single year. So, if we invest $100 into the business today, it’ll return $10 at the end of 1 year, another $10 at the end of the 2nd year, and so on.
A naïve view would say that this business returns 10%. But can we do better?
Terminologies
Before we go further, let’s get some terminologies out of the way:
| Term | Definition |
|---|---|
| Returns on invested capital (ROIC) | A measure of the efficiency of a business, it is defined by NOPAT divided by invested capital: NOPAT / Invested capital |
| Cash returns on invested capital (CROIC) | A measure of the efficiency of a business, it is defined by free cash flow divided by invested capital: Free cash flow / Invested capital |
| Cash returns on capital invested (CROCI) | Not to be confused with CROIC, CROCI is another measure of the efficiency of a business and is more commonly used for enterprise purposes (i.e. when a company is trying to buy another company). It is defined by EBITDA divided by total equity: EBITDA / Equity |
| Invested capital | The total amount of capital invested into a business, generally defined as total equity + total debt: Equity + Debt |
| Net operating profit after tax (NOPAT) | A measure of how profitable a business is, it is defined by net operating profit – taxes: Net operating profits – taxes |
| Net operating profit | A measure of how profitable a business is, it is defined by free cash flow – depreciation – amortization: Free cash flow – depreciation – amortization (1) |
| Free cash flow | Another measure of how profitable a business is, it is defined by: Total sales – COGS – Operating expenses – Capex |
| Costs of goods sold (COGS) | The cost of making each unit of product sold by the business |
| Operating expenses | All costs related to a company’s primary business, other than COGS, such as sales and general administrative costs, etc. |
For the purposes of this discussion, we’ll focus on ROIC.
ROIC
In our little toy example, the ROIC of the business is simply 10% — for every $1 invested, we get 10c back per year.
Does this mean that the owner of the company, i.e. the shareholders must settle for a 10% return on their money? Is there anything they can do to improve those returns?
Financial alchemy
Let’s say we want to invest $10,000 in the company, giving us a return of $1,000 per year.
We could put up that $10,000 ourselves and settle for a return of 10% a year, or we could borrow $5,000 at 5% interest rates, and only put up $5,000 of our own money:
| Debt funding | Equity funding | Invested capital | Total return | Return to debt holders | Return to equity holders | % Return on equity |
|---|---|---|---|---|---|---|
| $0 | $10,000 | $10,000 | $1,000 | $0 | $1,000 | $1,000 / $10,000 = 10% |
| $5,000 | $5,000 | $10,000 | $1,000 | $5,000 x 5%= $250 | $750 | $750 / $5,000 = 15% |
By funding half the business with debt at 5% interest rate, we’ve created an additional 5% of return for our equity holder!
In fact, if you think about it, as long as the interest rate paid for debt is below the ROIC, it always makes sense, in this example, to fund the business with debt — Since the debt holders demand a return less than the ROIC, the difference (ROIC – interest rate) effectively accrues to the equity holder.
ROIC vs CROIC
In our little toy example of a perfect business, ROIC = CROIC, as there are no taxes and the business is perfectly scalable with no drag (i.e. no depreciation nor amortization). In the real world, this is generally not true, and the difference between ROIC and CROIC is important!
ROIC measures how profitable a company is overall, while CROIC measures how good a company is at generating cash. Because debt interest payments are tax deductible, and because depreciation and amortization are tax deductible too, a company has some leeway to manipulate its funding sources (invested capital) to try and reduce its total taxes paid. For example, the more a company funds itself with debt, the higher ROIC it will generally be able to report, all else equal, as we’ve seen from above.
Furthermore, some businesses do not pay corporate taxes — REITs are a famous example, and instead, their shareholders pay taxes for profits directly on their own tax returns.
Finally, some businesses have depreciation and amortization costs that are far higher than what it actually costs the businesses — REITs again are a famous example, with proper maintenance, buildings tend to depreciate less than the accounting depreciation suggests.
For these reasons, generally speaking, most businesses should be valued on their ROIC, while real estate heavy businesses are generally better evaluated on their CROIC.
ROIC vs risk
In our perfect business example, because there is no risk, it is always preferable for the equity shareholders to fund the company with debt as long as the interest rate is below the ROIC. That is not always true in the real world — often, businesses tend to get less efficient after they reach a certain size, so infinite growth is impossible (edit: prior version had a typo saying infinite growth was possible — it’s not). Also, companies tend to get more risky as they take on more debt, as debt payments are mandatory, while equity dividends can generally be skipped without much financial repercussions — if a company falls on hard times, it can conserve cash by reducing or even skipping dividends, but it generally cannot reduce nor skip debt payments without an event of default.
Debt buyers understand that the more debt a business takes on, the more risky the debt becomes as there is less of an equity cushion if something goes wrong. As such, they’ll demand higher interest rates as the debt to equity ratio goes up.
Which is to say, the more debt a company takes on, the more levered it is, the more risky it tends to be. Though if everything works out, the more profitable for the equity shareholders it will be as well.
Footnotes
- This isn’t exactly correct — certain non-cash expenditures such as stock based compensation, changes in inventory levels, etc. are taking out as well. For the purposes of this discussion, this is close enough.
Janky Thoughts 