SA paper and packaging company Mpact recently reported highly satisfactory results, a rarity for an SA industrial company. It appears to have good growth prospects linked to SA’s favourable agricultural export outlook.
Caxton argues that Mpact has raised too much debt for its comfort, and may have in mind using its own cash pile to fund capital expenditure after a merger. It is a generally valid point; Mpact might be better advised to fund its growth by raising more equity capital and less extra debt. The temptation offered by interest rates below the prospective internal rates of return on capex is to raise debt to improve the return on shareholder equity. When internal rates of return have exceeded the costs of finance, hindsight tells us more debt would and should have been the preferred source of capital. In an uncertain world such favourable outcomes cannot be guaranteed.
Debt is not necessarily cheaper than equity because it is more risky and the firm may have to pay up for the financial risk it has taken on, usually when it is least convenient to do so.
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