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Principles of Finance Videos 166 videos

Principles of Finance: Unit 1, Company Formation, Structure, Inception
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Principles of Finance: Unit 4, Appropriate Debt Levels 5 Views


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Description:

What are appropriate debt ratios? Are those just debt ratios that don't wear jean shorts to the opera?

Language:
English Language

Transcript

00:00

principles of finance a la shmoop. appropriate debt ratios. so let's start

00:07

out this little story asking why a company would take on debt in the first [man makes presentation with white board]

00:11

place? now let's say a company could buy a

00:13

competitor who is struggling to survive for twenty million bucks and put that

00:17

competitor's product onto the company sales and distribution platform and in

00:22

the first year of owning that target take a company that was fairly breakeven

00:27

and in year one have profits of eight million bucks. after you know firing

00:31

everyone from the competitor company and that was just acquired. in year two the

00:34

company that makes twelve million dollars in profit basically earning back

00:38

all of the money it borrowed to buy that competitor. was that a good deal? well

00:43

absolutely. and companies take on debt all the time to make what is called

00:47

strategic accretive acquisitions just like this. they borrow money to do the

00:52

acquisition because well they probably didn't have the cash to begin with, and

00:56

they didn't want to use their own stock because they didn't want to suffer

01:00

dilution in the process. the debt capital allowed the company to expand and grow

01:04

faster than it would have had it remained unleveraged. so that begs the

01:09

question, how much debt can a company borrow? like what's the appropriate level [cash pictured]

01:14

and how do you even think about that question? well let's start with some

01:17

frames that paint out companies who can and maybe should borrow a lot of money,

01:21

and those who should not. all right well the truth is that economic cyclic ality

01:25

determines borrowing rationale. you've probably heard of the cycle or at least

01:30

the economic cycle or at least cyclic ality. none of those ?crickets? okay all

01:35

right and let's go back. well most of the world's economies operate in regular

01:38

mini boom and bust cycles. the stock market typically leads this cycle or

01:43

said the other way around the economy lags the stock market. why? well because

01:47

stock market prognosticators investors and other gadflies spent all day staring

01:52

at data and talking with other gadflies about what they all see in their crystal

01:57

balls. well they're the Canaries in the mine shaft these gadflies they try to

02:01

look into the future because they get massively paid if they are accurate in

02:05

their predictions by putting their or their investors money

02:09

where their mouths are. and they look for patterns. well roughly every seven or [crystal ball says "invest now"]

02:13

eight years we tend to have a boom and a bust cycle from 1981-82 to the late 80s

02:18

we had a big bull market and bull economy and then the junk bond scandal

02:22

kind of killed things or about two years market recover and then from late 1992

02:25

until late 99 early 2000 we the greatest bull market in history, thank you very

02:30

much Yahoo and all those people, then things blew up for about two years and

02:34

the market bottomed late 2002 and the county and oh three and recovered it in

02:38

two oh seven oh eight, when it blew up again big time in the mortgage crisis

02:42

which bottom then mid oh nine and fund the markets been on a tear after that

02:46

for a decade. better check your calendar. yeah so any blip on the radar from a

02:51

bomb going off in the middle east to a sign of fraud to a sign of structural

02:55

weakness like the student loan crisis, we're all nervous about these days will

02:59

send a mini panic to the people who invest in the stock market they pull

03:03

their money the market Falls until it reaches a level where growth investors

03:06

have all left all the optimists are gone and the value investors have now stepped [growth investor defined]

03:11

in because the fundamental risk reward ratio now looks favorable for a dollar

03:15

invested today paying more than a dollar in the next no year change.

03:19

so back to company debt levels if you are a highly cyclical company can you

03:25

afford a lot of debt ? no absolutely not. if your only business is selling washing

03:32

machines you're gonna have very few people upgrading in bad economies.

03:36

they'll just repair their old ones and make them last two more years instead. in

03:41

those bad years it's likely you go from operating profits of 20 percent to

03:45

operating losses of like 10 percent meaning of revenues. something like that

03:49

anyway if you then stacked a bunch of debt on top of that well you'd risk

03:53

bankruptcy in the bad times and be well pretty much dead. click on our IP. so that

03:59

was washing machines. highly cyclical business cannot afford a lot of debt. but [massive washing machine pictured]

04:04

what about cable television? well most people in America would rather starve or

04:08

at least live on ramen noodles, than have their Game of Thrones and Internet

04:12

connectivity turned off right? so in boom times the cable industry you know

04:16

doesn't grow much faster than it does in bad times.

04:19

doesn't whither. and the cable industry is a non cyclical business and is appropriate

04:24

for a lot of debt. and historically yeah the cable industry has taken on massive

04:28

amounts of debt. so note the myriad strategic options that having access to

04:32

debt capital affords companies. lots of great reasons to have the option of a

04:37

bunch of debt when the great opportunities arise. all right well if

04:40

the company has lots capital at its disposal it can build better product and

04:44

more efficient factories, tastier treats, quicker better delivery to customers, it

04:48

can also buy competitors cut costs, and raise prices. or saving any of those

04:53

strategic options it can take out debt, to just buy back its own stock. that way

04:57

when you want to scream at the idiot who's running the company the one [woman glares at self in mirror]

05:00

responsible for selling you the friggin shares, that you just bought back, well

05:05

you know then all you need to do is find a mirror. so all debt is not bad. all

05:09

right well what's an appropriate debt level? yeah well there are really two

05:13

drivers of appropriateness so when it comes to debt levels and both are framed

05:17

in the revenue and margin structure of the company, all right backing up. the

05:21

general idea is that you have a lot of revenue and high margins say a billion

05:26

dollars in cash profits each year, well then can you afford a billion dollars of

05:30

debt? almost certainly. can you afford 10 billion of debt?

05:33

well almost certainly not. [10 billion in debt crossed out]

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