Financial Leverage & WACC: How Small, Overleveraged Businesses Can Inflate the Value of the Firm with an Abnormally Low Weighted Average Cost of Capital

Leverage is a powerful tool for a company’s management to potentially maximize shareholder return and boost financial performance.  When cash is not readily available to invest in positive net present value projects, a firm may use leverage to achieve its objective of investing in positive net present value projects which should serve to increase long-term shareholder value.  In addition, the use of leverage in the capital structure serves to lower the company’s weighted average cost of capital, which may expand the realm of projects in which the firm may invest (presuming the mandate is that the company invests in projects whose internal rate of return exceeds the cost of capital or hurdle rate).

However, leverage is a double-edged sword.  As the amount of leverage in the capital structure of a company increases, the financial risk of the firm also increases.  As leverage requires repayment (whereas there is no guaranteed return on equity or obligation to provide dividends), a firm must have adequate cash flow and coverage to service its debt obligations.  The use of leverage in the capital structure also presents some challenges for the business appraiser who may be attempting to determine the value of the company and if wealth has been created or destroyed as a result of management’s decisions.  Highly levered firms may have an artificially depressed weighted average cost of capita that boosts the value of the company but which may not adequately reflect the risk profile of the firm’s leverage.

Financial Leverage Article

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