Article of the Day Link: GE is refinancing.

Despite forecasted cash stockpiles of \$100 billion, General Electric is refinancing (ie. reborrowing) \$5 billion worth of debt. That is, GE is electing to borrow when it has more than enough money coming in to pay for whatever it needs.

Why?

Because the current rate they can borrow at is around 2.85%. And according to their CEO, their current returns on capital sit at around 12%. Now what does that mean…

Let’s say that I have a friend who can buy me an iPhone 5 in America for \$600, send it to me, and I can then sell it on the black market in my home country for \$800. I make a profit of \$200, which works out to a 33% return on my capital (\$200/\$600).

\$800 (Selling Price) – \$600 (Cost Price) = \$200 (Profit)

\$200 (Profit) ÷ \$600 (Capital) = 33% (Return)

Now, let’s say that instead of sending \$600 of my savings to Mr America, I borrow \$300 at 3% interest and only use \$300 of my own money.

\$300 (Capital) + \$300 (Borrowing) = \$600 (Cost Price)

I still make a \$200 profit less, say, \$9 in interest. So my overall profit is \$191. But my initial capital was only \$300, because I borrowed some money. This makes my return on capital 64% (\$191/\$300).

\$800 (Selling Price) – \$600 (Cost Price) – \$9 (interest) = \$191 (Profit)

\$191 (Profit) ÷ \$300 (Capital) = 64% (Return)

Or, if you look at it another way – I make 33% on my capital of \$300. And I make another 30% on the bank’s money, because I made 33% profit at a 3% cost of borrowing. Totalling ±63%.

\$100 (Profit) ÷ \$300 (Capital) = 33% (Return)

[\$100 (Profit) – \$9 (Interest)] ÷ \$300 (Borrowing) = 30% (Return)

Now what if, instead of borrowing \$300, I borrowed \$600? After repaying the bank, I’d probably sit with about \$180 in profit. For doing nothing more than taking on the risk of not being able to pay back…

And in the case of GE? Well if they can borrow at 2.85%, and generate returns with the borrowed money of 12%, it means that they can pocket the difference/margin of 9.15%.

It’s the great allure of debt. The rich don’t get richer with their money. They get richer with yours.

Until it all spirals out of control. But that just makes it more exciting, because when it does spiral out of control, everything gets recessionary, and the Fed steps in to lower interest rates to the point where companies go back to wanting that margin.

Borrow borrow borrow.