Salesforce issues $25 billion in debt to buy back stock. Should we be concerned?

Salesforce announced this week that it executed the first steps in its debt-fueled $25 billion accelerated stock buyback plan. That’s half of the bigger $50 billion repurchase authorization approved in February.

Raising debt to repurchase stock is a move that deserves scrutiny.

After all, equity comes with neither the financial obligations nor the consequences of issuing debt. If a company misses a stock dividend payment, it doesn’t look good, and the stock will get hit. However, there are no legal consequences or claims to be filed. If a company defaults on debt, it will face legal issues and claims from bondholders.

We know why Salesforce wants to repurchase stock — management believes that last month’s brutal sell-off on AI disruption fears has made the share price attractive — because, as CEO Marc Benioff said in Monday’s press release: “We are so confident in the future of Salesforce.” (Salesforce insiders are also buying. Board member and Williams-Sonoma CEO Laura Alber purchased about $500,000 worth of Salesforce stock on Thursday, and David Kirk, also a director and former chief scientist at Nvidia, picked up roughly $500,000 worth of Salesforce stock on Wednesday.)

So, why is Salesforce issuing debt to buy back stock? Part of it may be that Benioff and company want to conserve cash. But mainly, it comes down to the cost of equity versus the cost of debt. CNBC Investing Club Reporter Paulina Likos and I actually touched on this concept briefly in a recent video about discounted cash flow valuation modeling. While the video was more focused on terminal value, we did cover the concept of a discounted rate, or the required rate of return an investor demands for investing in a given security. We noted that individual investors can and should use whatever rate they deem appropriate for the risk they are considering.

For companies on Wall Street, however, the discount rate is often their own “weighted average cost of capital,” or WACC. The WACC is the weighted average of the cost of debt and equity required to fund the company.

Breaking it down:

• V = Total value is equity plus debt
• E = Market value of equity (E/V is the weight of equity in the capital structure)
• D = Market value of debt (D/V is the weight of debt in the capital structure)
• Ce = Cost of equity
• Cd = Cost of debt
• T = Corporate tax rate

Don’t worry too much about how to calculate this. The real purpose is to look at what goes into the equation to better understand how corporations think about achieving the most efficient capital structure, meaning the lowest possible WACC. The lower the discount rate — WACC in this case — the higher the present value of future earnings and cash flows. The takeaway: Any increase in the weight of the lesser-priced asset — equity or debt — can reduce WACC. That is, until the point at which investors start to be concerned with the leverage on the balance sheet and begin to express that concern by demanding a higher return on equity, driving the stock lower, and the company’s cost of equity higher.

So, what’s lower for Salesforce: cost of equity or cost of debt? Figuring the debt part is easy enough because Salesforce told us what yield they are paying on the bonds. That’s what the following slide shows.

Referring back to the earlier WACC equation, the cost of debt is multiplied by one minus the tax rate to reflect that companies get a tax deduction on debt interest payments. So, the actual cost of debt is lower than what is represented on the slide. Don’t worry about how much lower, just know that based on the WACC calculation, the true cost of debt is the yield seen above multiplied by a number less than 1. So, at the highest level, on the notes that mature in 2066, Salesforce has a pre-tax cost of about 6.7% and post tax cost on the debt somewhere below that — maybe closer to about 5.3%, assuming a 22% corporate tax rate.

Now that we know what the most expensive portion of this debt raise will cost Salesforce, let’s figure out what its cost of equity is. To do this, the capital asset pricing model (CAPM) is used. Here is the calculation:

Breaking it down:

• Rf = Risk-free rate — an often used proxy is the 10-year Treasury yield
• β = Beta — a measure of systemic risk, is a stock’s volatility versus the index
• Rm = Expected market return (Rm – Rf is a calculation of market risk premium)

There is an equation for figuring out beta; however, most data providers already have it. We pulled the beta input for Salesforce from FactSet, rather than calculate ourselves. So, with Salesforce’s three-year beta of 1.21, the 10-year Treasury yield of 4.24% (as of this writing), and 8% as an expected market return, which is conservative, Salesforce’s cost of equity is around 9.27%. Since the cost of equity is much higher than the cost of debt, swapping out equity for debt lowers Salesforce’s weighted average cost of capital.

It’s understandable to question Salesforce’s debt-fueled stock buyback because it brings on new financial obligations at a time when the stock is saying the long-term prospects are in trouble due to AI. However, from the perspective of management, which clearly is not concerned about the long-term fundamentals, it’s a smart move to enhance the company’s capital structure by lowering the overall cost of capital. A lower WACC not only helps to increase present value by lowering the discount rate in Wall Street’s financial models, but it can also open up more investment opportunities because the hurdle to generate a positive return is lower.

The move may be rational, but whether it’s smart, only time will tell. Salesforce is trading out balance sheet optionality for a lower share count, which boosts earnings per share. But the strategy also results in a lowered credit rating by S&P Global due to increased leverage on the balance sheet. That means future debt will come at a higher cost.

It all hinges on whether Salesforce can service the debt, and that likely comes down to who is right on the AI debate. If Salesforce actually does get replaced by Claude-like replacements (we don’t think that will be the case but it’s clearly what the market fears), then the debt will get harder to service, investors will grow even more concerned now that the balance sheet has been levered up, and the stock likely declines — resulting in all of this being not only a total waste of money but a financial anchor as well. On the other hand, should management be proven correct and Salesforce does grow through this and actually benefits from AI, then this move will strengthen the company’s capital structure.

While the credit rating ding remains troubling, it can be reversed if all works out, as management will be able to pay back the debt, deleverage the balance sheet, and improve overall financial credibility. The move would also increase the reward should the bulls be proven correct by ensuring that shareholders all own a bit more of the company than they did previously, thanks to the retirement of the shares that this debt will repurchase.

(Jim Cramer’s Charitable Trust is long CRM. See here for a full list of the stocks.)

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