Joe Barbieri
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Joe Barbieri in Joe the Investor,

Can Excessive Debt Financing Take Down Large Corporations?

The flood of cheap money via lower interest rates has allowed everyone access to cheap debt. For corporations, this means that the cost benefit analysis of carrying debt versus the return on investment is skewed towards investments with lower returns. Lower returns may imply poorer quality since a good investment would command a higher return. This phenomenon has allowed corporate takeovers to balloon over the last 5 years. Since many takeovers are financed with debt, the takeovers are easier to orchestrate since they are cheaper to fund.

What are the risks to this kind of behaviour? The lower return on investment required to pay back the debt is one factor that has already been mentioned. Should a business decision be based on a lower return on investment, this means a company can be less prudent about what sort of investment it makes. In the case of a takeover, this translates into what sort of company it is buying. What if interest rates rise? Won’t these corporations be responsible for a much larger interest payment to finance takeovers of companies? Higher interest rates could also mean that companies being taken over may become less profitable on average due to higher interest expenses. This represents a double whammy that can make takeovers financed with low interest debt look foolish in hindsight. If many big companies are doing this, it may be setting up a crisis in corporate solvency. How likely this “crisis outcome” is depends on how many companies have enough resources to whether an interest rate hike or a change in financing requirements. A company that is sitting on a lot of cash will be able to buy much more when companies are cheaper in value; a type of deflationary scenario in the corporate world. A third risk factor is that large corporate takeovers may also set up a huge concentration of wealth in a few companies.

There has been talk about bubbles in real estate, the stock market and the bond market. There may very well be a bubble in takeovers which may reverse very quickly since interest rates can be changed in an instant and financing can dry up overnight. Since these takeover deals take months and years to play out, this can be a disaster if the takeovers are not timed right or have inadequate financing to see the deals through to completion. The talk of higher interest rates at the Federal Reserve means these risk factors may become a reality within the next year.