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Is interest more interesting?

  If the company has assumed a significant debt burden, the dollar can be applied to debt service (interest payments). Since interest payments are deductible, the company pays no corporate income tax on the dollar, which flows directly to the bondholder. The bondholder must pay tax on the interest he receives, and ends up with $0.60 after tax. Since interest payments are an expense, funds used to meet them are not part of the company's earnings so all the considerations about earnings expectations apply to interest payments as well. While assuming debt is an efficient way to transfer company revenues to holders of its securities and, as we have seen in the case of Leveraged Buy Outs, are used explicitly to that end to rectify the situation where a company cannot reinvest earnings at debt market yields or better, in general debt only makes sense in cases where one needs the capital borrowed. In a business with little need for capital, taking on debt makes no business sense except as part of a takeover defence or subterfuge to return pre-tax earnings. It is unlikely in the extreme that the securities market would welcome a large junk bond offering from a cash-rich, non-capital-intensive business with no need for the proceeds of the offering. In addition, debt carries with it all the risks of debt leverage, foremost among them the risk of bankruptcy in the event of inability to service the debt. Since this negates the key strong point of a New Technological Corporation, its technological leverage without debt, it would seem a highly unadvisable course.

If the sales dollar is neither spent on the operations of the business nor paid in interest, it becomes a dollar of pre-tax earnings. First in line, of course, is the tax man, who lops off his 40% for the Common Good. The remaining 60 becomes after-tax earnings, reported to the shareholders in the next operating statement. If the company simply retains the income and invests it in money-market instruments, it simply adds to the company's cash pile which is the beneficial property of the shareholders. Earnings from the cash hoard are, as noted above, aggregated with earnings from operations and may, if things don't get too far out of line and nobody notices what is happening, be reflected in the stock price at a P/E befitting a high technology company rather than a Treasury Bill.


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Editor: John Walker