In traditional business culture, financial debt is often perceived as a burden or a sign of weakness. Many successful entrepreneurs pride themselves on having "zero debt", believing this to be the safest financial position. However, from the perspective of advanced corporate finance, this view may be incomplete.
The mathematical reality is that a company without financial debt (unlevered) is often not maximising its potential value. Used with strategic precision, financial debt is not merely a funding mechanism, but a value creation tool that can reduce the cost of capital and increase returns for shareholders.
In this blog post, we technically analyse how the optimal capital structure works and why intelligent gearing is key in valuation and M&A processes. An adequate level of debt not only allows a company to expand its operations and improve profitability, but can also optimise its capital structure, generating greater value in a potential sale and improving its prospects in an M&A process.
What is Financial Leverage?
Financial leverage refers to the use of financial debt to finance a company's operations and investments. Its fundamental principle lies in the possibility of increasing investment capacity beyond what would be possible solely with equity. The key to this strategy is that, provided the return on the investment financed by debt is higher than the cost of said debt after taxes, the company's profitability will increase.
For example, if a company obtains financing at an interest rate of 5% and the investment derived from that debt generates a return of 15%, the positive differential of 10% contributes directly to value creation for shareholders. However, the excessive use of debt can increase financial risks, affecting the stability of the company and its attractiveness to potential buyers in an M&A transaction.
The Cost of Capital: Why is your own money more expensive?
To understand how debt creates value, we must first dispel a myth: equity (shareholders' money) is not free. In fact, it is the most expensive resource in the company.
The cost of equity (Ke) represents the return that investors demand for risking their money in the business. Since shareholders are the last to be paid in the event of liquidation, they assume the highest risk and, therefore, demand the highest return.
Conversely, the cost of debt (Kd) tends to be lower because creditors have payment priority and their returns are more predictable.
How can I increase Company Valuation through Financial Leverage?
Increased Profitability and Cash Generation
The intelligent use of leverage can significantly improve a company's profitability. Investing in new projects, strategic acquisitions, or market expansion with high rates of return can drive growth in operating cash generation. Given that the value of a company in M&A processes is largely based on its ability to generate cash flow, a sustained increase in this metric raises its valuation and makes it more attractive to potential buyers.
For instance, if a company decides to expand into new markets or diversify its business lines by acquiring another company, it is crucial to evaluate whether the return on invested capital (ROIC or ROCE) of the operation is higher than the company's weighted average cost of capital (WACC). If the return generated by the new investment exceeds the cost of the capital employed, value creation is positive, benefiting shareholders and increasing the company's attractiveness in the market.
Example: Impact of increasing financial debt on Return on Equity (ROE)
Let us look at the numbers to see how an optimised capital structure improves the return for the company's shareholders, comparing a conservative company (unlevered) with an optimised one.
| Concept | Company A (No Debt) | Company B (With Debt) |
| Total Assets | €10,000,000 | €10,000,000 |
| Equity (Own Funds) | €10,000,000 | €6,000,000 |
| Financial Debt (5%) | €0 | €4,000,000 |
| EBIT (Operating Profit) | €1,000,000 | €1,000,000 |
| Financial Expenses | €0 | (€200,000) |
| Profit Before Tax | €1,000,000 | €800,000 |
| Tax (25%) | (€250,000) | (€200,000) |
| Net Profit | €750,000 | €600,000 |
| Return on Equity (ROE) | 7.5% | 10.0% |
Although Company B has a lower absolute net profit, its shareholders obtain a much higher return (10% versus 7.5%) because they have needed to invest less equity to control the same volume of assets. Furthermore, Company B pays €50,000 less in taxes thanks to the tax shield.
The concept of WACC (Weighted Average Cost of Capital)
The value of a company is determined by discounting its future cash flows at a risk rate called WACC(Weighted Average Cost of Capital). The basic formula is as follows:
Where:
- Ke: Cost of Equity (Shareholders' Funds).
- Kd: Cost of Financial Debt.
- t: Tax rate (Corporation Tax).
- E: Market value of Equity.
- D: Market value of Financial Debt.
The strategic key: By introducing debt into the capital structure, we substitute expensive capital (shares) for cheap capital (debt). This reduces the WACC. And in business valuation, a lower WACC mathematically implies a higher Enterprise Value.
The Tax Shield
The great competitive advantage of debt over equity is its tax deductibility. Interest paid on debt is a deductible expense for Corporation Tax purposes, whereas dividends paid to shareholders are not.
This phenomenon is known as the Tax Shield. In practice, it means that the real cost of debt for the company is much lower than the nominal interest rate charged by the bank.
Real Cost of Debt: Real Kd = Interest Rate x (1 - t)
If your company pays an average interest rate on financial debt of 5% and the Corporation Tax rate is 25%, the real cost of that financing is only 3.75%. The State is, effectively, subsidising part of your growth.
Impact on the Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) represents the average cost of the company's financial resources, considering both debt financing and equity financing.
In most cases, the cost of debt is lower than the cost of equity because shareholders assume a higher level of risk compared to financial creditors. Additionally, debt has a tax advantage, as financial interest is usually deductible in corporation tax, thus reducing the real cost of financing.
For this reason, increasing the weight of debt within the capital structure can reduce the average cost of financing the company, widening the differential between the investment return rate and the WACC, which translates into greater value creation for shareholders.
The Limits: The "U" Curve and Financial Risk
If debt is so beneficial, why not finance the company 99% with debt? Here, risk management comes into play.
The relationship between debt and value is not linear. It follows a "U" shaped curve.
- Optimisation Phase: Initially, adding debt reduces the WACC and increases the company's valuation.
- Optimal Point: The ideal capital structure is reached where the cost of capital is minimal, and therefore, at this point, the company's valuation is maximised.
- Value Destruction Phase: If a certain level of indebtedness is exceeded, the risk of default (financial distress) shoots up. Banks raise interest rates and, crucially, shareholders demand a much higher return for the perceived risk, causing the WACC to spike again.
At Maraz Corporate Finance, we provide financial advisory services to companies and help identify that "sweet spot" where company value is maximised without compromising solvency.
Strategic Implications in M&A and Family Business
1. Valuation prior to a potential sale
Financial leverage plays a crucial role in M&A processes, both from the buyer's and the seller's perspective. In the case of a company looking to sell, a capital structure well-optimised through the appropriate use of debt can make its financial profile more attractive to potential acquirers.
From the buyer's perspective, the use of debt in acquiring a company, through a Leveraged Buyout (LBO), allows for maximizing the return on investment. In these types of operations, the buyer uses debt to finance a significant part of the purchase price, taking advantage of the acquired company's cash flow to repay the debt over time. If executed correctly, an LBO can generate high returns for investors and optimise the profitability of the equity committed to the deal.
Furthermore, in strategic mergers and acquisitions, the use of well-managed debt allows for financing operational synergies and business expansions without resorting to a dilution of the current shareholders' stake. This is especially relevant in sectors where market consolidation is key to achieving economies of scale and sustainable competitive advantages.
2. Control in the Family Business
For the family business, control is sacred. Paradoxically, debt can be an ally of control. Financing growth with bank or alternative debt allows the business to expand without diluting ownership, unlike bringing in new equity partners who will demand decision-making power. Maintaining a healthy debt structure protects the Socioemotional Wealth of the owning family.
Conclusion
Financial debt is neither good nor bad per se. It is an instrument that amplifies results. An optimal capital structure is one that balances tax benefits and the reduction of the cost of capital with a prudent and sustainable level of risk.
At Maraz Corporate Finance, we analyse your company and propose the best financial strategy. Whether through our Business Valuation or Financing Advisory services, we help you design the financial structure your company needs to maximise its real value.
Are you considering a corporate transaction or do you need to restructure your financing? Contact our team for a preliminary analysis of your capital structure.
Javier de Rojas Roca de Togores
Partner – Maraz Corporate Finance
