TO borrow or not to borrow is not the question. The issue is rather whether the use of the borrowed funds will generate adequate returns to repay the loan plus interest amount. This requires that there is a project with a net positive value (NPV) for investment or long term value addition.
Cost of borrowing is an aspect of the bigger issue of cost of capital. Cost of capital is made up of cost of equity and cost of debt. Generally cost of debt refers to the total cost a debtor will pay for borrowing money.
The total cost of debt is equated to the amount borrowed plus the cost of borrowing (interest payment). Cost of borrowing may include the interest payment plus other incidentals such as loan facilitation fees, default risk premium, account maintenance fees, insurance fees and other fanciful ones which are peculiar to the loan offer. Caviar emptor (Buyer beware!)
Borrowing is a necessary function of investment, especially when the return on the investment (ROI) is higher than the cost of the loan. This is at the heart of business finance. It serves the purpose of personal finance, as well as National investment.
Importance of Borrowing
Borrowing is vital to running a company or economy successfully. This is caused by the inadequacy of funding to prosecute all projects and programmes within an early time frame. It is therefore important to learn how to borrow more effectively.
Borrowing is necessary for undertaking investment projects and to facilitate the operation of business activities. It is mostly used to finance the acquisition of fixed assets like heavy duty equipments or landed property. It is sometimes used to fund the replacement of existing loan. This is effective when the new loan is cheaper than the old. It also useful as working capital when financing short term cash flow challenges.
Most businesses take off as a project. They actually start as an idea which is conceptualised to create valuable project. This is where the investment decision begins. It is then tested for feasibility and viability. Once it passes this test, the next requirement is finance.
The core source of finance is either from internally generated funds or borrowings from third parties. It could be short or long term. The key criterion for selecting an appropriate funding source for any project is the cost of that fund. For loans this is equated to the cost of debt capital.
In financial terms, you should borrow money for an investment only if the return on the investment (project) is higher than the interest on the loan. This underscores the maxim that the financial objective of a firm is to maximise the wealth of the shareholders.
In any circumstances and under any jurisdiction, one should only take a loan for which the benefit outweighs the cost in either social or commercial terms. Any other contrary decision would be a slippery road to financial disaster at personal, corporate or national level.
Influence on Interest Rates
The interest rates are influenced by numerous factors relating to the type of loan. The length of time over which a loan is to be repaid, the collateral, credit history, and the lending source could all influence the interest rate charged. There are other external influence like economic conditions such as inflation and exchange rates, and other government policies. There is also the Treasury bill rate which affects the supply and demand of money and hence, the cost of borrowing. The loan maturity period also affects interest rates.
Good Loans, Bad Loans
A loan in any form is not a bad thing. Indeed some loans are desirable in any capital structure. It is rather too much of it which is bad. When you have too much debt it leads to high gearing. Too much debt will give you financial diarrhoea. The cost of debt i.e. interest payment could bleed your financial resources to the point of financial distress of death, whether personal, corporate or national. The adage is to borrow within your means. Many persons and businesses have gone bankrupt for failing to observe this credo. If you must borrow, then borrow effectively or efficiently.
Dos and Don’ts
Never borrow to finance expenses, unless it a temporary measure. A microfinance loan of 6% per month is equal to 72% per annum.
Never borrow short term for long term projects. Don’t also borrow long term to finance short term project. They could all lead to financial mis-match.
Debt is a necessary component for financial activities i.e. projects, but it is best served when the cost (interest rate) is lower than the returns on the investment.
Debt can be very tantalising especially when your back is against the wall. But it could hold you to ransom and slavery when poorly managed. The HIPC programme was a good experience. The continuous challenge faced by countries such as Ireland, Italy, Greece and Iceland are hard lessons. The bitter result is usually economic hardship and inevitable bailout.
The Way Forward
Borrowing is not the only solution to financial challenges. Occasions for funding could be resolved by evaluating various optional solutions. Adopt other financing methods like leasing and hire purchase. For capital intensive projects, public private partnership (PPP) could take the pressure off scarce resource. Better still, project financing (using future cash flow to pay for the cost of the project) methodologies works.
Plan your borrowing carefully to acquire higher yielding asset which has the propensity to pay for itself. Borrow for value addition programmes. One who borrows brews his or her own trouble. Watch what you borrow!