IDEAL FINANCIAL STRUCTURE AND MANAGEMENT

ZERO DEBT- ZERO DIVIDEND

The popular view in financial management is that for different firms in different
industries the ideal financial structure would be different. It is my considered view that
irrespective of industry or firm there is one ideal financial structure which is long term
zero debt.
Firstly we should specify that the choice for any company is either owned funds or
borrowed funds. Owned funds may be equity or retained earnings and for a company
beyond the startup phase both of these components would be present. Let’s take an
example to illustrate how borrowed funds are sub optimal
A company has profit before interest and tax of Rs 100 Crores
In case A, it has no borrowed funds so interest is 0
Profit before tax would be Rs 100 Crores
Profit after tax(assuming 30% tax rate) Rs 70 Crores

In case B, the company has borrowed funds

With interest say Rs 10 Crores
Profit before tax would be Rs 90 Crores
Profit after tax at 30% Rs 63 Crores
Thus we see that case A i.e no debt results in higher pre tax as well as post tax profit

While the above is a simple illustration that zero debt is always better than debt, let’s deal
with the conventional submissions in favour of debt
1. Role of Retained Earnings: The cost of debt both before and after tax is always
lower than the cost of Equity. While this is entirely true, we should accept that the
alternative to debt is not just equity or in the case of a growing company with
expansion imperatives, additional equity. Surely we have to consider retained
earnings. Every company is expected to make profits and in the case of an
efficiently growing company the expectation would naturally be for progressively
increasing profits. If these profits after tax are ploughed back i.e. retained, they
would constitute an increasing share of the firm’s owned funds. This would take
care of the company’s need for additional assets to support its growth plans and
would negate any prospect for borrowed funds.
2. Financing Expansion: While a firm can take care of its current levels of
operations with existing funding, when significant expansion is on the cards and
substantially increased funds are required, then borrowed funds are the only
viable choice, because the alternative would be to raise more equity, which would
take more time and cost more. To this argument we submit that any firm’s
expansion prospects do not suddenly appear on the horizon. There will always be
time for a firm to plan its next phase of expansion which most often would be in a
time frame of not less than 3-5 years. If the firm makes profits as planned and
retains all of the disposable profits i.e. after tax profits, there will be adequate
additional funding for expansion. If expansion is carried out in a suitably phased
manner, the retained earnings should be more than adequate to support it.
Zero Dividends: It is a popular myth supported by industry on the one hand and
poorly informed and poorly educated investors that dividends are a necessary part of
return on share holder investment. If an analysis is done as to the growth in the value
of a company’s stock, it can clearly be shown that a company that does not pay
dividend will definitely produce higher long term Return on Investment for its
shareholders than a company that pays dividends. The case of Bharti Airtel in India
and Warren Buffet’s company in the U.S. bears out this logic. It should be obvious
that when a company withholds dividends, the retained earnings increase to that
extent. This increases the net worth of the company and correspondingly increases the
worth of the company in the eyes of would be investors. If one looks at the financial
status of Bharti
Bharti has equity of Rs 900 Crores,
The company’s net worth as of 2008 was Rs 30,000 Crores.
Retained earnings are therefore Rs. 29,100 Crores.
Market price of Rs 10 share in 2008 Rs 960 per share
P/E ratio in 2008 46(highest of any Indian firm)

One final but inadequate justification for dividends is that it firstly reduces the
uncertainty of returns and is a source of short term income to shareholders. To this
argument we must submit that the difference between an equity holder as contrasted
with a person who invests in debt and debt related securities, is that the equity
investor has a higher risk and higher return profile. Part of the higher risk is the
willingness to wait longer to get the return on his/her investment

A Universal Recommendation for Financial Structure: Every company can and

should have debt during its initial stages. We say with good planning a firm should
start with the minimum amount of equity and the min, amount of debt to fund its
initial phase of market operation. As the firm earns profit as it can only be expected
to, it should plough back all of the disposable profits after tax, and with this, should
retire the existing debt as soon as possible. Once the initial debt is retired, the firm
should rely on progressively increasing retained earnings to fund its growth and
expansion imperatives. If a firm finds that it is not able to earn enough to support this
course of action, it should introspect on why it’s functioning is not permitting this
universally suitable and justifiable course of action and make efforts to improve the
profitability of its operations till it is able to rely on retained earnings to finance its
expansion plans.

Need for Educating the Various Stakeholder Groups involved:

Industry: While the above logic and suggested course of action is undisputably
optimal for all companies in every industry, there is currently a lot of thinking and
preaching within industry and academia that debt is not only not undesirable, but
eminently desirable with the only caveat that the amount of permissible debt varies
with the state of an industry(growth or mature phase industries).
Banking and Financial Sector: There are vested interests at work as well with the
banking and financial services industry relying for ever increasing borrowing from
their industry counterparts and the counterparts also ever ready to borrow larger sums
for their operations and commercial functioning. The submission to this is, that there
are huge requirements for lending from the infrastructure and under privileged
sectors. Let the lendable funds be reserved for this salutary purpose and let industry
proceed to operate more intelligently, more efficiently and ultimately reward its
investors with superior long term returns on their investment.

Equity Investors: For the common share holder a certain amount of education and
explaining would be necessary since it has to be accepted that many of them have
been blinkered by the conventional thinking and current industry practices. But let us
accept that investors are intelligent and reasonable people and would certainly be
convinced by reasonable explanation and argumentation which this paper has
hopefully been effective in. In the end the acceptance and progressive implementation
of this funding paradigm can bring rich rewards to all the stakeholder groups
including the larger societal group to which industry has undeniable obligations.