Topic 40
Leverage: The Real Deal
Using a reasonable amount of debt to finance an acquisition will enable the buyer to increase the offer value to the seller and realize the buyer's target return on equity, CL.
LEVERAGE INCREASES DEAL VALUATIONS
- Debt (leverage or gearing, as it is sometimes called outside the United States) is a good thing in doing acquisitions.
- Debt enables buyers to offer higher prices to sellers due to the fact that less costly debt is used in place of more costly equity capital in financing the deal.
- Here's the real deal and the theoretical basis for the use of debt: The government acts as a third partner in financing the deal (equity partner, lender partner, government [tax] partner).
- The government allows a corporate tax deduction for the interest payment to the debt holders (versus no deduction on dividend payments to equity holders).
- With debt in the capital structure, less cash taxes are paid on the same level of operating profit (profit before interest and taxes) versus no debt, because of tax- deductible interest. Therefore, total cash flow available to all investors (debt and equity holders) in the form of dividends and interest is higher by the amount of the income taxes not paid arising from the use of leverage.
- Annual free cash flow before interest expense increases in an amount equal to the taxes not paid—cash taxes are lower, resulting from the interest shield.
- The enterprise value (V) of the target company is higher with the use of debt in an ...
