Aswath Damodaran, professor of finance at the Stern School of Business at NYU and valuation guru, said in his latest blog that the Adani Group has three times as much debt as it should, confirming that the group is overleveraged. Damodaran, however, said this is a bad business practice, not a con.
He said there is little, if any, benefit in terms of value added to Adani from using debt, and significant downside risk, unless the debt is being subsidised by someone. That, he said, could be the government, sloppy bankers and green bondholders.
“In my assessment, Adani Enterprises
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He also noted that in their zeal for control, insiders, founders and families sometimes make dysfunctional choices, and one of those is on borrowing. A growing firm needs capital to fund its growth and that capital has to come from equity issuances or new borrowing.
“When control becoming the dominant prerogative for those running the firm, they may choose to borrow money, even if it pushes up the cost of funding and increases truncation risk, rather than issue shares to the the public (and risk dilution their control of the firm),” Damodaran added in latest Musings on Markets.
Since Adani Enterprises is part of a family group, where higher debt at one of the Adani companies may be offset by less debt at another.
He said borrowing money cannot alter the operating risk in a business, which comes from the assets that a company holds, either in-place or as growth investments. But the borrowing will affect the risk to equity investors in that business, by making their residual claim (earnings) more volatile. In addition, the contractual claim that comes with debt can create risk, because failing to make interest or principal payments can result in bankruptcy, and effective loss of equity.
One reason offered by most debt-heavy entities is that using more debt will result in higher returns on equity, since there is less equity at play. That, he said, is technically true for the most part. But since the cost of equity rises proportionately, that benefit is an illusion, he added.
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Another reason offered is that debt is cheaper than equity, to which the response should be that this is true for every business, and the reason lies in the fact that lenders have first claim on the cash flows and equity investors are last in line.
There can be an optimal mix of debt and equity for a business. But the payoff, in terms of value, from moving to that optimal may be so small that it is sometimes better to hold back from borrowing. Damodaran said if the primary benefit of borrowing is a tax benefit, the higher the marginal tax rate, the higher its optimal debt ratio.
In the wrap, he mentioned that both our personal and business lives, there are good reasons for borrowing money and bad ones.
After all, the politicians who lecture businesses about borrowing too much are also the ones who write the tax code that tilts the playing field towards debt, and by bailing out businesses or individuals that get into trouble by borrowing too much, they reduce its dangers. That said, there is little evidence to back up the proposition that a decade of low interest rates has led companies collectively to borrow too much, but there are some that certainly have tested the limits of their borrowing capacity.
For those firms, the coming year will be a test, as that debt gets rolled over or refinanced, and there are pathways back to financial sanity that they can take.