Question

Many factors determine how much debt a firm takes on. Chief among them ought to be the effect of the debt on the value of the firm. Does borrowing create value? If so, for whom? If not, then why do so many executives concern themselves with leverage?

Answer 1

Answer:

Borrowing creates value for the firm. The use of borrowed funds can affect the firm positively or negatively, because of the higher level of risk, therefore it is imperative that the executives concern themselves.

Explanation:

The use of financial leverage can make or break the company as there are many risks involved, one being the repayment of the principal amount with interest, regardless of whether the firm made a profit or not by using those funds. Value is created by the firm if they use financial leverage as funds are used to pay for operations and generate an income, and, if successful – make a profit. “At an ideal level of financial leverage, a company’s return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns. If earnings before interest and taxes are greater than the cost of financial leverage than the increased risk of leverage will be worthwhile.” (Lumen Boundless Finance, 2020)

The liquidity (ability to pay for short term debts) and solvency (ability to pay for all debts) of a company is measured by the company’s use of leverage and its survival after that. This is why shareholders and management must check these ratios often and keep them at a positive position.  

Answer 2

Answer: Yes, borrowing creates value for equity shareholders. This is mainly as a result of tax benefits of interests paid on borrowings

Explanation:

Yes, borrowing does create value for the equity shareholders, this is mainly as a result of tax benefit of interests paid on borrowings.

If leverage causes changes, then it should lead to changes in either the discount rate of the firm(which is weighted-average cost of capital) or changes in the cash flows of the firm.

Leverage causes changes in both discount rate (WACC) and not on the cash flows to the firm. Since, WACC is known as the weighted average of cost of debt and cost of equity and since the cost of debt is usually less than the cost of equity, the WACC decreases with increase in borrowings, when the equity beta does not change. Furthermore, as the cash flows to firm is calculated before the interests paid on borrowings, the increased borrowings wont affect the Value of asset (FCFF) .

Cash flow is discounted at the rate that is consistent with the risk of those cash flow. At the cost of capital for the unlevered firm, pure businesses should be discounted. Financing flow needs to be discounted at the rate of return required by the provider of debts.