A Case for High Debt
Debt tends to have a negative connotation in most people’s mind. In personal finance it represents assets that will need to be given away later in life. But corporations have an unlimited life span. This, and other factors, gives management the option to make debt a permanent part of the company’s capital structure. In a regulated, mature industry such as a public utility, this can have many wealth-enhancing benefits for the stockholders.
The fundamental law that applies to all financial analysis is the law of arbitrage. An action should be taken if it yields the highest possible return for the risk involved. If an investment is paying more than its risk would suggest, a profit can be made by borrowing money to buy the investment. In companies like Edison, where the industry is stable and regulated, it is often better for the company to acquire large amounts of debt. The overall cost of capital for the company will go down, and the shareholders will earn a greater return on the equity portion of the company.
Alan J. Fohrer, CFO of Edison International, said in the case, “If we didn’t have taxes it would be different, but the tax deduction is very important.” Taxes figure into the cost of capital because they are paid with pretax dollars. For example, $10 paid as a stock dividend actually reduces the assets of the company by $10. However, $10 paid as interest, assuming a 20% tax rate, results in a tax benefit of $2 by reducing the taxable income. The actual cost of the debt interest is $8. This benefit encourages companies to take on as much debt as possible (Gertier, 287).
A steady source of cash flow is critical to maintaining a good credit rating. Edison’s cash flows are extremely safe for two reasons. First, the company supplies a service for which the demand is very inelastic. It takes an incredible leap in electricity costs for people to reduce their electricity consumption at all. F