In this current economic climate of bailouts and bankruptcies, "debt" has become a four-letter word, but Investment Manager Bill Girard argues that borrowing money still might be your smartest choice.

There is a common myth—held to be a truism by some—that says “wealthy entrepreneurs avoid borrowing.” The thinking goes something like this: Wealthy people have lots of their own money and so they don't like to expose themselves to banker's demands by borrowing something that they already have plenty of.

Nothing could be further from the truth. Wealthy people have often grown rich because they have learned the value of leverage. They use small amounts of their own equity and collateral to borrow other people's money to finance successful enterprises. Their return on investment improves significantly because they are earning returns with other people's money. Let's look at an example.

Assume that a business will cost $500,000 to start up. For simplification let's say that this amount includes all of the equipment and other capital costs. It also includes all the working capital required to cover operating expenses for a period of time until the new business is able to generate enough money internally to cover all expenses and generate a respectable profit to the entrepreneur.

Let's assume an entrepreneur has plenty of her own cash and is able to underwrite the full startup cost without borrowing. Here is the decision she could make that does not involve borrowing.

Investment & Return Without Borrowed Funds

Start up Capital Required
Funds Borrowed
Entrepreneur's Capital Investedttt
EBITDA (assumed to be 12% of startup cost)
Interest Expenset
Earnings after Interesttttt
Rate of Return on Invested Funds

$ 500,000
$ 0
$ 500,000
t$ 60,000
tttt$ 0
$ 60,000
12%

In this example she invests $500,000 and earns $60,000 (EBITDA) which means “earnings before interest, taxes, depreciation and amortization.” We are assuming that this is equal to 12 percent of the startup cost. If she covers all the costs without borrowing then her rate of return on her invested capital is 12 percent.

But look at what happens to her rate of return if she chooses to borrow a portion of the startup cost. In the example below she borrows $350,000 of the total capital required and pays an interest rate of seven percent.

Investment & Return With Borrowed Funds

 

 

Start up Capital Required
Funds Borrowed
Entrepreneur's Capital Investedttt
EBITDA (assumed to be 12% of startup cost)
Interest Expenset
Earnings after Interesttttt
Rate of Return on Invested Funds

 $ 500,000
 $ 350,000
$ 150,000
t$ 60,000
tttttttt$ 24,500
$ 35,000
24%

We can see with this simple example that she has increased her rate of return on the money she has invested from 12 to almost 24 percent. The only difference is that she has now borrowed a portion of the startup capital.

Her earnings after interest are certainly higher if she doesn't borrower. However, to achieve this she needs to invest more than three times as much of her own money. Using borrowed funds almost doubles the return on her capital.

My analysis oversimplifies the complex decision making that an entrepreneur undertakes when deciding to borrow money.. However, given the discussion around the current credit crisis it's important to remember the important role played by credit in wealth creation.