The Impact of Financial Leverage on Corporate Results and Valuation

Financial leverage refers to the use of borrowed funds (debt) to finance a company's operations rather than relying solely on its own financial resources. By taking out loans or issuing debt securities, a company increases its financial leverage, which can have both positive and negative effects on its financial performance.

One of the primary benefits of financial leverage is the ability to amplify shareholder returns, i.e., to boost operational profits. This occurs because, by using debt to finance part of its operations, a company can achieve a return on investment higher than the cost of the debt. An important point to highlight, especially in a world with taxes, is that leverage becomes relevant since using third-party capital brings a tax benefit. The financial cost (interest) can be deductible from the taxable income.

However, financial leverage also carries risks. Firstly, excessive use of debt can significantly increase a company's risk. When a company borrows funds, the interest payments and debt amortization become an additional layer of fixed costs. If the company is unable to generate enough cash flow to cover these payments, it may face financial difficulties or even bankruptcy. Practically speaking, the degree of financial leverage, in terms of profit sensitivity, follows the same logic presented in the previous article when we discussed operational leverage.

Moreover, financial leverage can impact the valuation of a company. This is because the cost of debt is a critical component in determining the discount rate used to evaluate the company's future cash flows. The higher the cost of debt, the higher the discount rate, and consequently, the lower the company's valuation. Generally, this discount rate, in addition to reflecting the opportunity cost of money over time, also implicitly prices in the probability of default (insolvency) and asset recovery in the event of the company's bankruptcy.

For example, if a company has a weighted average cost of capital (WACC) of 10% and a growth rate of future cash flows of 5%, the company's valuation would be calculated as the future cash flows divided by (10% - 5%), which equals 5%. However, if the company increases its financial leverage and its cost of debt rises to 12%, the discount rate would increase to 7%, which would reduce the company's valuation.

It is essential to emphasize that financial leverage is not inherently good or bad. It depends on the specific context of each company and its ability to manage the risks associated with using debt. Some companies may significantly benefit from financial leverage, while others may be adversely affected by it.

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