Coming up with a fundamental value for a business is one of the most important skills a successful investor needs to have. Typically, most businesses get financing through a combination of borrowing and offering stock or other equity positions. In an unlevered firm, however, there is no debt, and so the entire value of the business is reserved for shareholders. This has obvious advantages, but there are also trade-offs that can make companies that do have debt more attractive to stock investors.
The pros and cons of leverage
A company that has no debt has the benefit of not having to work to pay back its lenders and bond investors. Without the need to pay interest on outstanding debt or come up with principal repayments when the debt matures, a company can focus on deploying all of its cash flow toward either reinvestment in the business or returning capital to shareholders.
However, having no debt also limits a company’s growth to whatever amount of capital it can raise through offerings of equity. When the cost of equity financing that’s implied by the valuation of shares is more expensive than the cost of borrowing, then relying solely on equity doesn’t give investors the best possible return.
For example, say a company has 1,000 shares outstanding priced at $100 per share. With invested capital of $100,000, the company is able to make a profit of 10% annually, which works out $10,000 per year, or $10 per share. It wants to double its operations and can extend that 10% up to $200,000 in invested capital.
If it issues new stock, then it will have 2,000 shares outstanding at $100 per share and produce profits of $20,000, or the same $10 per share. That gives existing shareholders no incentive to raise capital through a stock offering.
By contrast, say the company can borrow $100,000 at 5%. If it does so, it will have to make an interest payment of $5,000 annually. But if the business produces gross profits of $20,000, that will leave $15,000 after making the interest payment for shareholders. That works out to $15 per share, which should result in the value of the stock rising by roughly 50%.
The true value of unlevered firms
Perhaps the biggest advantage of unlevered firms is that they have the capacity to take on new debt when opportunities arise. By contrast, companies that already have a lot of outstanding debt typically have to pass up growth opportunities if they can’t raise the necessary capital by other means. That makes an unlevered firm much more attractive to growth investors.
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