19 July 2018

The consolations of debt

As a general starting point, more debt makes a company more valuable to its owners.

by John Royden

Head of Research

For example: you invested £100,000 into a start-up widget manufacturer with shares or equity and it made a pre-tax profit of £10,000. After tax of £2,000, the company ends up with £8,000 and it pays you an £8,000 dividend. If it repeats this performance every year then you get £8,000 per annum forever.

But you could have started the company with 1p of share capital and lent it £100,000 with interest at 10%. Before interest the company would have made the same £10,000 but it would have paid you £10,000 of interest leaving a pre-tax profit of £nil. So the company would not pay any tax.

If the company made £10,000 every year, then it would pay you £10,000 every year by way of interest. So do you want an income of £10,000 per annum from debt finance, or £8,000 from equity finance? Clearly the debt financed business is more valuable to you.

Debt increases the value of a company because the company pays less tax. This is called the tax shield of debt, but there is more to debt than tax.

Too much debt can hurt a business in some cases. You might not choose to buy a washing machine or a car from an over-leveraged manufacturer because there would be a risk that the company would go bust and you might not get any spare parts. On the other hand, if a toll road business was 99% financed by debt, then that very high leverage would not have the slightest effect on your decision to buy the product or drive on the toll road.

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