Financial Intelligence at Harvard Business School

By Felix Salmon
July 16, 2009

Harvard Business School has a blog called Financial Intelligence, where you can find this:

It would not be rational for a public company to be funded only by equity. It’s too inefficient. Debt is a lower cost source of funds and allows a higher return to the equity investors by leveraging their money…

Back to Google. It’s a nearly $22 billion company with no debt, which is inefficient. The problem for Google is that their cash flow and profit are so strong that they can finance the business with retained earnings. But I predict that as Google matures and growth slows, debt will become an important source of funding.

Yes, this is the kind of insight that 942 MBA students are paying $76,600 per year for. The “problem” for Google is that it’s making too much money! Debt is good because it provides leverage for equity investors! And of course, “as Google matures and growth slows”, it will never be content with simply making billions of dollars a year, but will instead seek “funding” in the debt markets in order to, er, invest in something. Or something. That’s all left very vague.

The weird thing is that if Google was ever silly enough to believe this claptrap, it wouldn’t wait until its business had “matured” to raise debt — instead, it would raise debt right now, and spend the proceeds on buying back its stock. That would put an end to its “inefficient” capital structure right there. Thankfully, Google is sensible enough not to want to spend vast amounts of money on needless interest income — especially when it’s paying no dividend. And I doubt it’ll raise any debt at all for the foreseeable future, either now or after its growth has slowed. It simply doesn’t need to.

(HT: Zubin)


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You know what boards of directors say about shareholders; “If they can’t take a joke, f___ ‘em”. Google has worked out that shareholders are bigger suckers than bankers and so lets the equity carry the risk. Maybe Harvard’s worried about the possibility of Google-think becoming a trend and cutting the banking profession out of the equation altogether, thus it aims its pro-establishment PR campaign at the next generation of great’n'good; best to get your indoctrination set up early.

I’m beginning the enjoy “Harvard MBA Watch” more than the previous Ben Stein series. Power to your elbow Salmon.

Posted by otto | Report as abusive

Felix: Any insight on why MSFT might have issued debt in the past?

Posted by SDS | Report as abusive

Are you going to actually give us an argument for why it wouldn’t be in the interests of Google’s shareholders for the company to issue debt and buy back stock? Or are you going to allow words like “claptrap” and “silly” to stand in place of an actual argument?

Posted by right | Report as abusive

Also, hopefully this is obvious to your readers, but Harvard Business Publishing is not the same thing as Harvard Business School. You don’t pay for the kind of insight you are quoting; that kind is freely available on a blog.

Posted by right | Report as abusive

I’m glad Sergey & Larry went to Stanford and not Harvard. I doubt either google employees or its shareholders would complain.

I can’t imagine with all the poor performances of leveraged buyouts that they could really publish this. Take Freescale. it is teetering because of its onerous debt load, and its investors are taking 50% haircuts on debt.

The problem is that some startup will hire a HBS MBA to run its finance dept and it will be derailed before it can get rolling because of too much debt.

Posted by winstongator | Report as abusive

Internal financing is inefficient because it doesn’t take advantage of the business acumen of the financial sector.

And profits are bad because you have to pay taxes on profits.

This is basic stuff…

Posted by Max | Report as abusive

Emit debt to raise leverage is standard reasoning in business economics and is certainly not limited to Harvard Business School. I think it’s wrong, myself, but then I don’t think much of macro, either.

Posted by a | Report as abusive

Max, you *are* joking about “the business acumen of the financial sector”, right?

Posted by Felix Salmon | Report as abusive

yes he was Felix. also about the profits.

Posted by jswede | Report as abusive

Felix, my friend.. why the animosity towards HBS??

As the lead voice for the Reuters commentary group, im sure HBS will have a spot for you for next year.. seat number 943 perhaps?

Posted by daniel | Report as abusive

Felix – in order to understand why debt is useful to a cash-flow machine like Google, you must understand “Cost of Equity” and the Modigliani-Miller theorem (which was worthy of the Nobel Prize).

If the tax-effected cost of debt is less than the true cost of equity, then it does make sense to stockholders for their company to issue debt. Miller_theorem

“The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, …the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt. It does not matter what the firm’s dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the “capital structure irrelevance principle.”

“While it is difficult to determine the exact extent to which the Modigliani-Miller theorem has impacted the capital markets, the argument can be made that it has been used to promote and expand the use of leverage.”

“When misinterpreted in practice, the theorem can be used to justify near limitless financial leverage while not properly accounting for the increased risk that excessive leverage ratios bring. In particular the theory does not account for the bankruptcy risk associated with debt as compared to equity stakes. “

I’m Felix Salmon. I don’t really know what I’m talking about but I’ll pretend like I do. I don’t understand things like Cost of Equity and how internal financing acts acts to stunt growth. I’m just going to criticize high flyin’ fancypants MBAs because that makes Harvard “them” and caricatures of “them” are a great way to rile feathers without having to back up my opinions with knowledge.

Posted by Jay | Report as abusive

Have you ever taken a finance class Mr. Salmon? If you have, maybe you should be denigrating the school you attended instead…

Posted by Crys | Report as abusive

If MBA’s are to blame for everything like you say they are, then can we say Reuters (thus, based on your logic… YOU) to blame for CNBC?

Mike does a good job of shooting down the M-Mists: 7/infinite-debt/

Posted by Felix Salmon | Report as abusive

Look, there are good reasons for google to fund itself with retained earnings. Mostly, it has to do with most of their resources going into speculative projects and a probably overvalued stock. But this analysis is right in the long run, if not particularly inspired. As companies mature they should issue more and more debt. Mature companies have stable cash flows. Stable cash flows should be matched with debt because debt has a tax advantage. Don’t issue debt against unstable cash flows because bankruptcy is costly. There’s really nothing to notice here.

financial Intelligence makes fruit of all season.

Posted by Johny | Report as abusive

I can’t imagine the fate of investors if Google’s growth slows down in the future. andyou/