Do As I Do, Not As I Say
A work post. Terribly dry and boring, but then I am a terribly dry and boring person. Try to stay awake if you can please…
There’s been a heck of a lot of talk recently about governments and consumers getting into a mighty big mess because they’ve sold their countries’ souls to the Devil and borrowed to fuel a mighty spending binge. Our average entrepreneur Joe Shmoe has mortgaged his house up to the hilt in order to fund the photography business of his dreams, and now that the Great Recession is here, he’s hanging on by the skin of his teeth.
But wait just a dar-gone minute, Mr Shmoe before you throw in the towel, dissolve your company and hand your keys back to the bank. Soon, very soon, you will surely reap the rewards of your follies. That $40K studio refurbishment with fluffy blond assistant, hot-tub and 50 inch plasma screen that you borrowed and guaranteed against your home was actually a mighty fine idea. No matter that your company is on the brink, your fluffy blond assistant has deserted you because you haven’t paid her for two months and the water company has cut off the water supply to your hot tub. Hang in there Joe! You were right to splurge on credit cards so you could fund expansion of your fabulous photo business. Oh yes you were. Now please do take a moment out from hiding from the bailiffs and let me explain why.
I love these back shots - this one's above my bed
Many moons ago when I was a very green junior accountant, one of the very first things we were taught was that debt is cheaper than equity. It’s amazing what rubbish they teach accountants nowadays isn’t it? Small wonder that the world is in such a mess. Anyhoo the truth is that debt finance is actually safer from a lender’s point of view. Debt is cheaper for two reasons. Firstly, because debtors have a prior claim if the company goes into liquidation, then that debt is actually safer and hence debt investors demand a lower rate of return than equity investors. For your company, this translates into an interest rate that is lower than the expected total shareholder return on equity.
Second, interest paid is tax deductible (unlike equity dividends) and a lower tax bill effectively creates cash for the company. Not only does interest have to be paid before dividends, but also arrangement costs are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs, they are also tax deductible.
Are you lost? O.K. Well, let’s consider an example (Caution! Basic accounting theory may result in boredom-induced-coma – do not attempt without a glass of chardonnay – it all makes more sense after alcohol, I promise):
Consider if you run a small photography company and you need that $40,000 loan to bail you out, keep you fed and pay the rent for your shiny new studio. Now let’s assume in our wildest fantasies that your bank would actually agree to help you, then what are your options? Well, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbour for $40,000. Then suppose your business earns $20,000 profits during the next year (pushing it, I know, for a photography company, but bear with me.) If you had taken out the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit. Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbour.) Thus, your personal profit would only be $15,000 (75% x $20,000). So from this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity.
Voila! Debt is cheaper than equity (mostly.)
But what if you have been very wise, saved steadily all your life and you now have a spare wad of dosh and you don’t think it’s the wisest option to stuff it under the mattress? What do you do with your life savings in order to keep your nest-egg ultra-safe and support you in your old age?
Well, whatever you do, don’t give it to the banks 'cos they’re all going bust (plus they give a terrible ROI nowdays) and if you entrust it to your professional investors then (unless you use Stephen's) most of them will charge you stupid rates of commission and probably use it to buy into a “multi-level debt instrument” which is gobbledegook for them squandering your dosh on any high-risk endeavour they fancy, and BTW there’s no guarantee that you’ll get your money back (I used to audit some of these investment companies – believe me, many of them just wanna have fun gambling with other people’s money –it’s great work if you can get it. ) Of course you could give your money to a nice sensible pension scheme instead but that’s just another way of giving it to exactly the same reckless financial advisers to blow howsoever the mood takes them.
So what options do you have left? Well, you could always be saintly and pay off your debts, but then you would be a numpty because the way our governments are going to get out of this ghastly mess they’re in is to borrow and mortgage our countries to the hilt and then “print money to service the debt and use inflation to run it down.” So why not be like the government and spend, spend, spend? After all, what’s the worse that could happen? You go bankrupt. However in the UK the new bankruptcy rules mean that you get to keep “essential items” like that plasma t.v. and hot tub that you borrowed for so recklessly on your credit card last year, plus your debt will also written off after a year and you can then go carry on with life as normal.
Think I’m kidding? Sorry, but no. This is exactly what a friend of ours did. Boggling but true. He didn’t get to keep his fluffy blond assistant though – she still left him. Mind you I don’t think he cares that much – after all he can watch “Who wants to be a millionaire?” on a very cool 50 inch plasma from the comfort of his hot-tub.
It’s a strange world isn’t it?
Now…where’s the phone number of that hot-tub company again?
All images are of Roswell Ivory
There’s been a heck of a lot of talk recently about governments and consumers getting into a mighty big mess because they’ve sold their countries’ souls to the Devil and borrowed to fuel a mighty spending binge. Our average entrepreneur Joe Shmoe has mortgaged his house up to the hilt in order to fund the photography business of his dreams, and now that the Great Recession is here, he’s hanging on by the skin of his teeth.
But wait just a dar-gone minute, Mr Shmoe before you throw in the towel, dissolve your company and hand your keys back to the bank. Soon, very soon, you will surely reap the rewards of your follies. That $40K studio refurbishment with fluffy blond assistant, hot-tub and 50 inch plasma screen that you borrowed and guaranteed against your home was actually a mighty fine idea. No matter that your company is on the brink, your fluffy blond assistant has deserted you because you haven’t paid her for two months and the water company has cut off the water supply to your hot tub. Hang in there Joe! You were right to splurge on credit cards so you could fund expansion of your fabulous photo business. Oh yes you were. Now please do take a moment out from hiding from the bailiffs and let me explain why.
I love these back shots - this one's above my bed
Many moons ago when I was a very green junior accountant, one of the very first things we were taught was that debt is cheaper than equity. It’s amazing what rubbish they teach accountants nowadays isn’t it? Small wonder that the world is in such a mess. Anyhoo the truth is that debt finance is actually safer from a lender’s point of view. Debt is cheaper for two reasons. Firstly, because debtors have a prior claim if the company goes into liquidation, then that debt is actually safer and hence debt investors demand a lower rate of return than equity investors. For your company, this translates into an interest rate that is lower than the expected total shareholder return on equity.
Second, interest paid is tax deductible (unlike equity dividends) and a lower tax bill effectively creates cash for the company. Not only does interest have to be paid before dividends, but also arrangement costs are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs, they are also tax deductible.
Are you lost? O.K. Well, let’s consider an example (Caution! Basic accounting theory may result in boredom-induced-coma – do not attempt without a glass of chardonnay – it all makes more sense after alcohol, I promise):
Consider if you run a small photography company and you need that $40,000 loan to bail you out, keep you fed and pay the rent for your shiny new studio. Now let’s assume in our wildest fantasies that your bank would actually agree to help you, then what are your options? Well, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbour for $40,000. Then suppose your business earns $20,000 profits during the next year (pushing it, I know, for a photography company, but bear with me.) If you had taken out the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit. Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbour.) Thus, your personal profit would only be $15,000 (75% x $20,000). So from this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity.
Voila! Debt is cheaper than equity (mostly.)
But what if you have been very wise, saved steadily all your life and you now have a spare wad of dosh and you don’t think it’s the wisest option to stuff it under the mattress? What do you do with your life savings in order to keep your nest-egg ultra-safe and support you in your old age?
Well, whatever you do, don’t give it to the banks 'cos they’re all going bust (plus they give a terrible ROI nowdays) and if you entrust it to your professional investors then (unless you use Stephen's) most of them will charge you stupid rates of commission and probably use it to buy into a “multi-level debt instrument” which is gobbledegook for them squandering your dosh on any high-risk endeavour they fancy, and BTW there’s no guarantee that you’ll get your money back (I used to audit some of these investment companies – believe me, many of them just wanna have fun gambling with other people’s money –it’s great work if you can get it. ) Of course you could give your money to a nice sensible pension scheme instead but that’s just another way of giving it to exactly the same reckless financial advisers to blow howsoever the mood takes them.
So what options do you have left? Well, you could always be saintly and pay off your debts, but then you would be a numpty because the way our governments are going to get out of this ghastly mess they’re in is to borrow and mortgage our countries to the hilt and then “print money to service the debt and use inflation to run it down.” So why not be like the government and spend, spend, spend? After all, what’s the worse that could happen? You go bankrupt. However in the UK the new bankruptcy rules mean that you get to keep “essential items” like that plasma t.v. and hot tub that you borrowed for so recklessly on your credit card last year, plus your debt will also written off after a year and you can then go carry on with life as normal.
Think I’m kidding? Sorry, but no. This is exactly what a friend of ours did. Boggling but true. He didn’t get to keep his fluffy blond assistant though – she still left him. Mind you I don’t think he cares that much – after all he can watch “Who wants to be a millionaire?” on a very cool 50 inch plasma from the comfort of his hot-tub.
It’s a strange world isn’t it?
Now…where’s the phone number of that hot-tub company again?
All images are of Roswell Ivory
Labels: economics, money, Roswell Ivory
posted by Lin at 11:26 AM
9 Comments:
Beautiful back shot.
I've begun to (once again) embrace the barter system.
You wile account think of everything don’t you!! But it only proves that to save money you need money. Or put another way bank don’t lend money to people who need it only to people who don’t. I love your back photo too.
I agree with both of you of course.
I think what surprises me is that they still teach this stuff to youngsters nowadays. It's this culture of "debt is cheaper than equity" or "spend what isn't yours" which has resulted in the current mess. Worse, people are getting away with it, as my bankruptcy example illustrates.
I was always brought up to believe that you shouldn't spend it if you don't have it, with the sole exception of your mortgage (which in turn should be strictly within your means.)
Will - we too have embraced bartering - without it we'd have sunk without trace long ago.
Love the first shot also, so does my wife.
Basically have lived by the "cash only" philosophy all our lives - except for the mortgages, and paid those off as soon as we could - no borrowing from equity. [Actually I charge everything I can to a cash-back card and pay it off at the end of the month, got a nice chunk back last year]
LOL.
I for one am 100% debt-free -- but that is more a function of my age than any particularly strong budgetary philosophy.
If I had a business to build, of course, ....
I have an M.B.A. in Finance from New York University so I at least understood a little of what you wrote. (The degree was supposed to get me a shiny new job but it's all it's gotten me is a $19,000 hole in my bank account. I'm still stuck with the same old job.)
I've only borrowed money for three things: my undergraduate college degree (the loan was paid off long ago); my apartment (still paying that off); and my medium format Pentax system (I paid it off over the course of a year and the interest was a few hundred dollars; it really didn't cost me anything, though, as if I'd waited a year to save up the money, the cost of the gear had gone up by a few hundred - so it would have cost the same in the end).
Your example may make sense for businesses. Some - or most, perhaps all - businesses need to borrow money to invest in equipment, staffing, etc. If they've done wise business planning, those investments will pay off.
The problem is when people borrow for non-essential things without seriously thinking of ever paying it back; or the banks loan the money without ever wondering seriously if they'll get paid back.
Of course, if those non-essentials won't get taken away when people go bust, why worry about paying it back at all???
Does this mean I can go out on a shopping spree today? Please clarify quickly before I do something rash!
Like Stephen and George, I have been paying with cash for a long time.
Happy Easter to you, too, Lin, and to everyone out there in bloggie world!
wow ... "Are you lost?" not in this case. We are on the same page. You must be a faster typer, that would taken me over a hour. I speak better than I type I assure you.
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