When is a it good to invest is highly leveraged companies?
Hey I got asked this in an interview and got tripped up. Can someone explain to me how by investing in a company with a decent amount of leverage can actually deliver juiced up returns to shareholders? Like if that company is able to actually able to generate solid cash flow and pay back debt, how does that juice the returns if you own stock?
I maybe way off the mark but will take a shot - If the shareholder has a high conviction that the return generated by deploying the capital generates a much higher return than the cost of debt then he/she knows the higher leverage would be value enhancing.
Let's say you have a company with EV of 100 that is financed with 20 debt and 80 equity. If EV increases to 120, all 20 accrues to the equity. Therefore, equity goes up +25% vs. +20% for a company with no debt.
Hm, but what about a highly levered company that then is able to generate a lot of cash flow and pays off it's debt. How do the equity holders benefit?
If the company in my example above generates 20 in FCF and uses it to pay down 20 in debt, then equity will go from 80 to 100, an increase of +25% vs. +20% for a company with no debt that generates 20 in FCF.
Cost of debt is cheaper than cost of equity. So as long as the company is certain it can pay off the debt and is not overlevered it should prefer to raise capital through debt rather than equity. You can think of this from a DCF perspective, this will lower the wacc increasing the value of the company.
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