Impact of the debt leverage on the ability of the business to create value

In the long term, the value of business and thus also the prices of shares are driven by the development of company fundamentals, the outcome of which is an improving ability to generate free cash flow or, in other words, capital return. We believe the best capital return indicator for measuring the value creation potential of the business is return on invested capital, because for example, return on equity can be influenced by, e.g., debt leverage. This should, however, not have a direct link to essential investment decisions related to sustainable value creation. We will now examine how leverage is often not directly linked to investment decisions that are essential for sustainable value creation through examples.

Return on capital and free cash flow are crucial

Let’s assume that the company generates 10 units of money as free cash flow per year and that the value of the company in question is 100 units of money (10/10%, where 10% is the required return). The company decides to withdraw a loan of 20 units of money from a bank and to pay that amount to the owners. Let’s assume that the company has previous retained earnings, which enables it to distribute dividends, even though it pays money taken out as debt to its owners. The allocated euro does not know whether it is invested back in the business, in a new venture, repurchasing of shares, repayment of debt or dividends. After this transaction chain, the company's ability to generate free cash flow has not changed, it is still 10 units of money per year.

But when a company uses debt financing to finance its business, i.e. a bank, it will spend 80 units of money of its business value (100 units of money) on shareholders and 20 units of money on the bank. Financing decisions are not investment decisions and financing decisions do not automatically generate value. Financing decisions have no impact on business value unless the allocation of new capital creates value (RONIC > WACC) and thus improves the ability to generate cash flow.

The debt in itself does not create value but increases leverage, whether it is a company or a real estate. Lending is a financing decision, not an investment decision, and thus leverage should not be directly linked to investment decisions relevant to sustainable value creation.  Let’s use investing in real estate as an example. An investor buys an apartment for 100 units of money and finances half of the price or 50 units of money with debt, the value of the apartment does not change. The investor has simply used the bank as their partner in financing the apartment and the bank is unlikely to commit itself to this arrangement with bad terms.

Debt leverage has advantages and disadvantages

Financing business with debt has certain advantages, such as deductibility of interest expenses, which means that the company has to pay less taxes (ceteris paribus) and thus free cash flow may be higher. However, with debt financing, business financing may result in caution in the company management related to investment willingness, business management and decision-making, as debt investors come first in the pecking order which means the company must meet the obligations of debtors. Like in the examples, financing decisions should not have a direct link to essential investment decisions related to sustainable value creation. When examining financing decisions, it is crucial whether the decision affects the ability of the business to generate capital and thus free cash flow. In addition, the examination should consider the impact of the tax deductibility of interests mentioned earlier and how financing decisions will be reflected in management’s future decisions affecting the business.