I posted this as a response to a query to this forum, and thought it might be useful to everyone if it got more exposure. The basic idea is that businesses don't only borrow because they have to -- ie don't have the money to meet payroll or finance inventories.
They borrow for the simple mathematical reason that borrowing boosts profits. That's what all the financial press is talking about when they talk about "leverage."
It's the first thing you learn on the first day of "Corporate Finance 101" in Business School or Law School:
http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=114&topic_id=50595&mesg_id=50610It's called leverage.
Let's use a landlord's rental property as an example. Assume that he owns the building outright (paid off mortgage), and paid $100,000 for it. Let's assume that at the end of the year his profit is $10,000.
His equity in the house, therefore is $100,000.
That's a rate of return of 10,000/100,000 = 10%. So his rate of return is ten percent.
Now, let's suppose he can borrow money at 5% in an interest only loan. If he refinances 1/2 the value of the building for $50,000, then he will have to pay interest of 5% on $50,000, which is $2,500.
So now his investment or equity in the property is $50,000. The $2,500 interest has become an expense. The house now earns $10,000 - $2,500 for the landlord, or $7,500.
Notice that his rate of return is now 7,500/50,000 = 15%
He has increase his rate of return just by borrowing. That's because the amount he pays in interest is less than the amount he makes on the building; or in other words, interest is less than the rate of return on the whole business.
Borrowing money is like getting a partner (the bank) who doesn't want as much from the business as you do -- he just wants certainty that he gets paid.
If that same landlord refinanced $80,000, the landlords investment or equity in the building is only $20,000.
His interest cost is 5% of $80,000 or $4,000.
The total return on the business is now $10,000 - $4,000 = $6,000.
The landlord's rate of return on equity is now $6,000/20,000 = 33% !!!
That's the "magic of leverage".
But, you may ask, if the landlord only has $20,000 equity in the building, what happened to the other $80,000? He can keep it in safe cash. Or more likely, he can own 5 times as many buildings, all generating 33% returns instead of 10% returns.
Instead of earning $10,000 on a single $100,000 house, he is now earning $30,000 on five $100,000 houses -- $500,000 worth of houses -- in which his equity or investment is only $100,000.
$30,000/$100,000 = 33% rate of return. Most people would rather earn $30,000 than $10,000.
The problem is that this increases risk. If in any year, the amount earned on the house slips below his interest costs (eg if all the tenants move out or can't pay rent), then he goes bankrupt -- something that would not have happened if he had never refinanced.
This is what's happening across the economy right now.
So corporate finance is all about figuring out how much debt to take on compared to equity, to boost the rate of return without taking on too much risk.
Even mega profitable companies take out loans. Not because they need the money, but to boost profits. In that way banks are silent partners in most businesses. They usually quietly earn lower rates of return in exchange for the certainty of getting paid.
This is entirely separate from unexpected expenses, needing to make payroll, financing short term inventory expansion or so on.
This is a permanent structural, mathematical reason that businesses always stay in debt -- to boost profits.