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

Understanding Finance

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.

Understanding Finance

Helping clients understand what we do is key to building relationships. To explain some of the industry jargon that creeps into our world, we’ve pulled together a section of our site to help.

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