By: Stephen Haggard

Growing up in an Ozarks farm family, debt was a dirty word. One paid off one’s debts as soon as possible. Then, when I went off to college, I met the children of urban professionals whose families had sizable debts, yet these people seemed otherwise healthy and normal. How was that possible?

It turns out both groups of people were approaching debt rationally, given their situations. Consider two workers — a farmer and a government bureaucrat. For simplicity’s sake, let us assume that both workers make, on average, $60,000 per year. The government worker makes $5,000 every month and has little uncertainty about her income. The farmer, on the other hand, only generates cash flow when he sells something. Some sources of farm income are relatively steady, like milk and eggs, but the major cash flows, like the harvesting of a crop or the selling of a season’s worth of calves at auction, are quite lumpy. Furthermore, though the farmer’s income averages $60,000 per year, weather and fluctuating market prices mean that some years are far better and some years are far worse. Who can afford to have a higher level of debt? The worker with the smoother, more certain cash flows. The farmer’s chances of not having enough cash inflow in a given month to cover his debt payments, which are the same every month, are much greater due to the volatility of his cash inflows.

Businesses are similar. Some businesses, like electric utilities, have steady cash inflows and can afford a higher level of debt than a biotechnology firm, which receives cash only when it sells a patent for a new discovery. Consider the uniformity of your own business’s cash inflows carefully when deciding on the appropriate amount of debt for your firm.

Why is debt even desirable, given the possibility of financial distress it brings? First, debt allows business owners to magnify the returns they receive for the same equity investment. Imagine an inventor with $100,000 in cash and an idea that will change the world. The inventor can purchase a small workshop with her $100,000 and produce $1 million worth of product every year, or she can borrow $400,000 and purchase a small $500,000 factory which will allow her to make $5 million of product every year. Before consideration of interest charges, it is easy to see her profit will be at least five times greater in the second scenario, greatly increasing the return she receives on her $100,000 equity investment. It is highly unlikely that interest charges will be high enough to wipe out this gain in profit. Besides, moving on to benefit number two, the interest paid on debt is tax deductible. Each dollar of interest paid really costs only 65 cents because it reduces taxes by 35 cents, assuming a 35 percent tax rate.

A native of southwest Missouri, K. Stephen Haggard is a professor of finance and a BancorpSouth Endowed Research Professor at Missouri State University. His teaching and research interests include corporate finance and asset pricing.

This article appeared in the October 21, 2017 edition of the News-Leader and can be accessed online here