Rhody Trader

Joe Weisenthal claims in his Clusterstock entry that Harvard Business School is Teaching Dangerous Nonsense About Leverage. It’s basically a little add-on commentary to a post by my corporate compadre Felix Salmon on his Reuters blog. Felix, and Joe by extension, are going after the Harvard folks for this statement:

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…

While I think there are plenty of reasons for bashing Harvard (I used to coach for Brown, so they are fair game as far as I’m concerned ), it’s definitely harsh to go at them for this, which basically just comes from well known financial theory. Certainly, it’s not confined to that Cambridge campus. My former professor, Dr. Gordon Dash, offered up the following in response:

That is traditional thinking at its best about lowever the avg cost of capital. Of course, what is not mentioned is HOW these folks estimate the cost of equity — well it is by the use of the old CAPM and its reliance on the linear relationship between risk and return. It might just be that the firm is so saddled with high-priced equity that it would not make sense to take on any other form of capital expansion without first reducing the risk adjusted cost of equity.

As much as the old methods of financial analysis have come under sharp criticism, there is definitely the question of cost of capital which needs addressing, and that’s something Felix and Joe have ignored. They’ve just harped on the “debt is bad” theme. I understand it given what we’ve gone through, but it risks swinging things in the whole opposite direction, which isn’t any better.

The bottom line is that each company should be making decision about their capital structure that make sense for their particular situation, maximizing the return of their shareholder’s investment, but with a reasonable risk profile.

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