Accessing Risk Independent of Capital Source

Few things focus the mind of a prospective borrower more than that of the unconditional personal guaranty.  And while there is no denying the gravity of committing oneself (and ones family) to such an obligation, it is important to remain clinical when assessing the riskiness of deploying capital.

 

Since business owner’s wealth is typically tied substantially to his or her equity in their company, in most cases and from a financial point of view, it should not matter if an investment is made using equity or debt.  Let us explain.  In all cases the return on capital deployed for a project is the same whether or not the capital is debt capital or equity capital.  And this holds true even in the downside scenario where a partial or even total loss is realized.  If there is a gain on the investment, wealth is created and if there is a loss, wealth is destroyed.

 

This fundamental (pardon the pun) truth is an important back drop for properly assessing investment risks.  Because while it is true that access to debt generally expands capital availability and it is also true that debt pay back takes priority over equity returns, in a rational world an investor should not make or forgo investment decisions based on the type of capital used – the weighted average cost of that capital yes – but never the individual type of capital.

 

The theory says a firm should pursue all projects that offer a risk adjusted return greater than the firms cost of capital.  And theory meets practice in this realm all of the time – even if informally nearly every business owner instinctively understands the potential return profile of a new opportunity – and also the risks.  The new opportunity can be as simple as taking on an additional customer or expanding exposure to a customer materially, all the way through installing a new piece of machinery or equipment.

 

But in all cases the risks and return potential associated with those opportunities exist whether or not they are pursued and are the exact same if pursued regardless if financed with debt or equity.

 

We can guess that this assessment may not be sitting well instinctively with all readers at this point.  So we offer a distinction that will hopefully resonate as follows – while it is the case the risk adjusted return profile is always the same for any given project regardless of capital source – the returns to equity (the chief concern of a business owner) – be they positive or negative do in fact change based on capital type.

 

Simply stated the use of leverage amplifies the returns to equity – either in the positive direction if the investment is a good one – or in the negative direction if the investment does not work out as anticipated.  As we heard Donald Trump say once in an interview (paraphrased) “Using debt in good times or for good investments is terrific – you make a ton of money.  But if times turn bad or if the investment is a bad, you get crushed.”

 

While we can’t say we agree with all Donald Trump has to say, on this one we could not be more supportive.

 

Which leads us to our advice – which we follow in spades in our own company – which is to simply focus all of our energy trying to figure if the investment will be a good one and how to mitigate its risks.  Assuming we like the project, we make the investment – regardless of the source of capital to do so.  If we don’t like it – we just won’t invest.

 

The costs and availability of debt and/or equity do matter very much in determining the weighted average cost of capital.  While it is obvious that less is better when it comes to costs, we’ll take a closer look in a future article at some of the trade offs related to new projects when the costs of incremental capital is higher.