Why investors should exercise restraint on debt

IT IS obvious that all else being equal, people and companies that are indebted are more likely to run into trouble than those that are not. It is the presence of debt that creates the possibility of default, foreclosure and bankruptcy.

Does that mean debt is a bad thing and should be avoided? Absolutely not. Rather, it is a matter of whether the amount of debt is appropriate relative to the size of the overall enterprise and the potential for fluctuations in the enterprise’s profitability and asset value.

The reason for taking on debt, using what investors call “leverage”, is simple: to increase so-called capital efficiency. Debt capital is usually cheap relative to the expected returns that motivate equity investments and thus relative to the imputed cost of equity capital.