Valuation guru Aswath Damodaran in his latest blog said the Adani Group collectively carries about three times as much debt as it should, "confirming that the group is over levered." Damodaran, however, said this is 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 government, sloppy bankers and green bondholders.
"In my assessment, Adani Enterprise Ltd carries too much debt, with actual debt of Rs 413,443 million more than double its optimal debt of Rs 185,309 million, and reducing its debt load will not just lower its risk of failure, but also lower its cost of capital," Damodaran said in his latest Musings on Markets.
Adani Enterprises Ltd 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.
Damodaran is a Professor of Finance at the Stern School of Business at NYU. He teaches corporate finance and valuation, primarily to MBAs. In his Blog, Damodaran points out good and bad reasons for borrowing and also talked about the right financing mix.
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, he said.
Damodaran said the contractual claim that comes with debt can create truncation risk, because failing to make interest or principal payments can result in bankruptcy, and effective loss of equity.
He noted that borrowing money at a lower rate, by itself, cannot alter overall cost of funding, since that cost is determined by the risk of assets. The benefits of borrowing at a lower rate will always be offset by a higher cost for equity investors, leaving the cost of funding unchanged, unless a finger is put on the scale, giving one source special benefits.
“In much of the world, governments have written tax codes that do exactly this, by making interest payments on debt tax-deductible, while requiring that cash flows to equity be made out of after-tax cash flows. That tax benefit of debt will increase with the marginal tax rate, making it much more beneficial to borrow in countries with high tax rates (Germany, Japan, US) over those with lower tax rates (Ireland, much of Eastern Europe)," Damodaran said.
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Damodaran said there are many bad reasons for borrowing, and "some companies seem intent on using these bad reasons."
He said the 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.
Damodaran said the second 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.
Damodaran said 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.
He said debt payments are serviced with operating cash flows, and the more operating cash flows that firms generate, as a percent of their market value, the more that they can afford to borrow.
"In my post on the Adani Group, I 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)," he said.
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