Zombies & Creative Destruction

Andrew Smithers
London, 13th July 2020

Low interest rates have allowed companies to survive which would otherwise have become bankrupt. This truth has fathered a popular fallacy* which claims that it has a damaging impact on productivity, because these weak survivors, termed zombies, do not invest and as their numbers rise this depresses the level of total investment. Statistics showing that the importance of these zombies has risen while business investment has fallen are assumed to be evidence which support the claim. This is, however, a fallacy arising from confusion over three issues: those between companies and their underlying businesses, between cause and correlation, and between the benefits of creative destruction under conditions of full employment and the damage arising from closing businesses in recessions.

Companies become bankrupt if their profits are insufficient to pay interest on their debts. If, however, the income from their sales is sufficient to cover the costs of the labour, materials and services necessary for their output, the bankruptcy of the company will not result in the business being shut down, as it will continue to operate after financial reconstruction. If profits are insufficient to cover the cost of depreciation then the value of the assets can be written down, equity swapped for debt, and the charge for depreciation reduced. The business will then continue provided that the capital value of its profits is greater than the breakup value of its assets. After reconstruction, companies may be entirely financed by equity, which creditors receive in exchange for the debts owed to them, or they may continue to be partly financed with debt. This will depend partly on the most advantageous arrangement for limiting the amount of tax payable. Most companies will have tax allowances based on the historic cost of their equipment, rather than its new written down value, and may also have tax losses that can be carried forward. The tax advantages of debt will then be small and leverage after reconstruction will usually be low.

*See for example the leading article Reasons to fear the march of the zombie companies in the Financial Times of 25th June, 2020.

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Zombies & Creative Destruction [July 2020]