If this is the actual long anticipated reversal in interest rates, what does that mean for you and me and what is a good capital structure for future enterprises? (I believe that even personal finances should be thought out and well-structured. While individuals don’t have the tax situations that company’s have, they have plenty of capital allocation choices that are very similar to what a public enterprise would engage in.) The best place to start that thought is to explore what worked really well in the past. Let’s assume a hypothetical simplified business that makes widgets- Widgets R Us Inc. They require a small amount of cash on hand for day-to-day activities, maintain an accounts receivable and payable and take inventories of widget parts and turn them into full widgets which are then sold on the open market for a profit. We’ll assume some generic facts about the business and show two hypothetical simplified capital structures to illustrate the value of leverage in an inflationary environment and falling interest rates. Take a look at the simplified balance sheet and income statements below:
The terms at the top just govern the basic business structure and environment for Widgets R Us. The Revenue/Assets % is the annual revenue yield expected from total assets in this business and employing a standard distribution of assets for this business (i.e. the right amount of cash, A/R, PP&E, etc. to efficiently turn raw goods into a finished product). The COGS/Revenue is the total expense needed for the operation with the Gross margin simply being 1 – COGS/Revenue. The starting interest expense is the average interest ratio on all of the debt (i.e. Notes Payable and Long Term Debt) the company currently has on the balance sheet. The tax rate is the standard unmodified corporate income rate. We’ve assumed a five year compound inflation rate of 25% which breaks down to an annual inflation rate of 4.564%. Lastly, we assume since interest rates have been falling the company has the chance reissue its debt at a new and lower rate. For our example the 5 year expected interest rate is 8%, while the current one is 10%.
Next follows a very simple balance sheet and income statement. We start with both short term assets (cash, accounts receivable, and inventories) and long term assets (PP&E and Goodwill). Next is the short term liabilities (Notes Payable and Accounts Payable) and Long Term Debt. Finally, assets-liabilities=shareholder’s equity. Notes: Accounts Receivable is money owed to the company from outside sources, Accounts Payable is money the company owes to outside sources, and Goodwill is the excess fair market value over existing asset value).
After that comes a simplified income statement. We earn 40% of the total assets as an annual revenue (i.e. $6,100 is 40% of $15,250). We pay 75% of that as COGS and then pay interest expense leaving us with income before taxes. We then have to pay income taxes leaving us with net income.
The example breaks down the business into two hypothetical capital structures. The first example is with a low leverage ratio. Indeed the total debt $2,250.00 and the shareholders equity is $10,500 as compared to a total asset base of $15,250. The equity in this operation is nearly 2/3rds of the value in the business and very little of this operation is leveraged. In the second case the business is carrying $10,000 in long term debt and $1,000 in short term debt (and plans on maintaining this amount through the next five years). Now equity is a paltry $1,750 or a little over 1/10th of the total asset base of $15,250.
Columns three and four show the business in year five for both example 1 and example 2. IT IS IMPORTANT TO NOTE THAT THERE IS NO ASSUMED ORGANIC GROWTH FOR EITHER EXAMPLE. The businesses still need the required distribution of assets to operate and the only thing that has change is that inflation as increased both the price that goods can be sold at and the resulting price for the assets needed for this operation. We aren’t making the business bigger or changing products or anything else. We are just assuming that prices for everything went up! (The revenue earned increased by 25% from $6,100 to $7,025, the value of the assets needed to do that amount of revenue went up by 25% – Inventories went up 25% from $2,500 to $3,125, PP&E went up 25% from $5,000 to $6,250, etc.)
Once again we aren’t making the business bigger or changing products or anything else. Inflation has boosted our output prices and our required input prices. Nothing else. While most of the assets have gone up in value, some things have stayed the same. Goodwill hasn’t changed, since we really didn’t do any acquisitions, divestitures, etc. Our debt amounts haven’t changed. The low leverage business still carries a total debt burden of $2,250 and the high leverage business still carries a debt burden of $11,000 of combined notes payable and long term debt.
One other thing has changed. In five years we had the opportunity to refinance the debt at a lower rate due to falling rates. The interest we pay on the debt has gone from 10% to 8%; this affects our interest expense line item in the income statement. So what are the five year results for owners of this business solely due to disparate capital structures and an environment we’ve had for the last 30 years? Well there are two numbers that changed dramatically for the two businesses. The first is the amount of shareholders equity. The low leverage business (example 1) grew their shareholders equity from $10,500 to $12,187.52 for a 16% increase in value, but the high leverage business grew their shareholders equity from $1,750 to $3,437.52 for a 96.4% increase! Those shareholders made bank. In addition to the growth in equity, the net income changed due to inflation, but also due to the decrease in interest expense. We see the low leverage business growing their net income by only 21%, while the highly leveraged business grew their income by 106%!
That’s a pretty big difference in 5 years for earnings and equity. And all it took was a serious amount of leverage. It’s also important to note that the low leverage business didn’t keep up with the rate of inflation in either equity growth or earnings growth. If the low leverage business was actually publicly owned (and possibly even if it was privately owned), the owners would be having a very serious talk with the management team asking them why they were getting paid for sub-par growth. In fact, there probably would have been a distinct pressure to change the situation (by leveraging the capital structure) or by replacing the management team. The second way of righting the business is exactly how Bain Capital makes it money! If you understand that example, you can be as rich as Mitt Romney!
All joking aside, it’s important to see where inflation and reductions in interest rates affect a company’s prospects. Inflation primarily affects the balance sheet. If an enterprise can count on a steady and positive rate of inflation, it can assume a higher leverage ratio and wait for inflation to help juice the shareholder’s returns by counting on the increase in nominal prices for inputs and outputs. On the opposite side, a reduction in the borrowing costs for capital primarily affect the income statement, if the firm doesn’t take advantage of the lowered rates to raise the amount of leverage. In a realistic enterprise, they would definitely increase the amount debt on the balance sheet to maintain the present value of the tax shield asset (pre-tax interest expense reduction in taxable earnings). In our example the constraint was to not allow a change in liabilities; this was done to highlight the effects that have been in place for the last 30 years.
And the last 30 years, in general, have been incredibly good for businesses. The constant reduction in interest rates and the continuous positive rates for inflation have allowed companies to assume higher rates of leverage to increase their rates of return. This is the primary tactic for private equity enterprises. Buy a company with large amounts of debt that are then added to the company’s balance sheet and wait for the operational turn-around (plus inflation and reduction in interest rates) to juice up the equity and earnings so that you can quickly sell. But if the environment changes what happens to Widgets R Us Inc? In the follow up articles we’ll see what happens to the two different businesses when interest rates rise. After that we’ll conclude with some actual advice.