Company debt before a sale. Too little costs you for years, too much costs you at the deal

A business owner usually knows the company’s value to within a million. Asked about debt, he most often answers with one of two sentences. Debt is cheap, so the more the better. Or: debt is a risk, so the less the better. Both answers lead to losses. The only difference between them is when the owner pays for them.

A loan at 8 percent interest costs a company paying 19 percent CIT (corporate income tax) about 6.5 percent, because interest reduces the tax. In the valuation calculation this difference is the main reason debt can raise the value of a company. Debt is also taken on in place of more expensive equity. The owner then does not have to put his own money into investments, or he can take some of it out. On the other side there is a ceiling. A bank usually finances up to about twice annual EBITDA. With subordinated debt, total debt reaches about 4.5 times EBITDA. The optimal level of debt lies between zero and that ceiling, in a different place for each company.

An owner who avoids debt pays for years before the sale, because he hands the tax authorities a tax shield he did not use. An owner who has loaded the company with more debt than it can carry pays at the sale itself. The buyer then lowers the valuation, and the entire reduction hits the part that is left for the owner after the debt is repaid.

Cheaper debt does not raise value on its own

Debt is cheaper than equity because the lender takes less risk than the owner. He receives interest before any dividend and has security over the assets, so he demands a lower rate of return. That alone, however, does not raise the value of the company. Every additional zloty of debt shifts more risk onto equity, so the owner rightly expects a higher return from it. Cheaper debt and more expensive equity cancel each other out.

Economics describes this with the Modigliani-Miller theorem. In a world without taxes, the value of a company does not depend on whether it is financed with debt or with equity. In reality, the valuation is changed by two factors that this model leaves out. The tax shield creates value, and the costs of financial distress destroy it. The optimal level of debt comes from weighing these two factors against each other.

The tax shield

Interest is a cost, so it reduces the tax base. A company with debt pays less tax than an identical company without debt, and the difference stays in the business. In practice the state subsidizes the interest.

This shows up in the weighted average cost of capital, or WACC. Future cash flows are divided by this rate to convert them into the company’s value today. The lower the rate, the higher the valuation. In the version with tax, the formula looks like this:

WACC = E/V × Ke + D/V × Kd × (1 − T)

The first part of the formula is the share of equity (E/V) multiplied by its cost (Ke). The second is the share of debt (D/V) multiplied by the interest rate on the loan (Kd) and by (1 − T), where T is the CIT rate.

The whole tax shield sits in the expression (1 − T). It is what lowers the cost of debt from 8 percent to 6.48 percent after tax (8 × 0.81), rounded to the 6.5 percent from the start of this article. The larger the share of debt, the more this expression lowers WACC. A lower WACC gives a higher valuation of the same cash flows. Without tax, the expression (1 − T) equals 1 and debt loses its advantage. The source of value is therefore the tax shield, and WACC is the route by which this value reaches the valuation.

In Poland the tax shield has a limit. Interest and other borrowing costs, less interest received, reduce tax only up to the higher of two amounts: PLN 3 million a year or 30 percent of tax EBITDA. Anything above this limit no longer reduces tax. At an 8 percent interest rate, PLN 3 million corresponds to debt of around PLN 37.5 million, so most mid-sized companies financed with ordinary bank loans stay within this threshold. The tax shield also works only when the company has taxable income.

The costs of financial distress

If the tax shield were the only factor, the best company would be one financed entirely with debt. That does not happen, because the costs of financial distress grow together with the debt. They appear long before there is any threat of bankruptcy. The first effect concerns day-to-day operations. Suppliers shorten payment terms because they worry about the company’s solvency. The best employees look for a more stable employer. The bank raises its margin and introduces covenants that limit the management board’s freedom. The second effect concerns growth. All free cash goes to servicing the debt, so the company has nothing to invest with when the market requires it.

The market sets this limit fairly precisely. Bank debt, that is, senior debt, usually reaches about twice EBITDA for the last twelve months. Up to this level, current cash flows service the installments and interest with the margin of safety the bank requires. When, after further loans or a fall in results, net debt approaches 3–3.5 times EBITDA, the bank usually refuses the next one, as I wrote at the beginning of June. Higher debt already requires more expensive financing. Mezzanine, that is, debt subordinated to the bank loan, usually raises total debt to a level of around 4.5 times EBITDA. A company can carry more of this kind of debt because it is repaid differently. The principal comes back in one payment at the end, and in the meantime the company pays only part of the interest. The rest is added to the debt. The current burden on cash flows is therefore lower than the amount of debt alone would suggest. Mezzanine, on the other hand, is more expensive, and the whole principal has to be repaid on a single date. I wrote about it two weeks ago.

The optimal level of debt is the point at which the tax benefit of an additional zloty of debt equals the additional cost of risk. Below this point, the company has too much expensive equity in its financing. Above it, the cost of risk rises faster than the benefit of the tax shield. Pilots have a name for a similar point, cruising altitude: there the aircraft burns the least fuel and still has power in reserve. At Capital One Advisers we calculate this level for every company that enters a sale process or a capital raising.

Higher interest rates move this point down. Higher interest produces a bigger tax shield. The same cash flows, however, will service less debt. A level that was safe when money was cheap can be too high when money is expensive.

The second condition: what the debt pays for

The level of debt is one condition. The second is independent of it and concerns what the debt finances. Debt amplifies the result of an investment in both directions. A project that earns more than the loan costs raises the current return on equity. The company’s value, however, grows only when the return on the investment exceeds the average cost of all capital, that is, WACC. An investment that brings in less than the loan costs increases the owner’s loss faster than it would without debt.

The two thresholds therefore have to be checked separately. The first concerns the project: whether what the debt finances earns more than the capital costs. The second concerns the balance sheet: whether the total debt has moved the company to where the cost of risk exceeds the benefit of the tax shield. A company can meet one condition and break the other.

Why funds finance buyouts with debt

Private equity funds show in practice that an optimal level of debt exists. Owners often ask why a fund that manages billions finances an acquisition largely with loans. The answer has two layers, and only the first concerns the value of the company.

Debt in a buyout activates the tax shield and lowers the WACC of the company being acquired, as I described above. This benefit exists regardless of who the owner is.

The second layer concerns the fund’s return. The example is deliberately simplified and does not come from any deal. A company worth 100 is bought with 100 of equity, or with 40 of equity and 60 of debt. After four years it is worth 160. Without debt the fund turns 100 into 160, that is, it earns 60 percent. In the version with debt, after repaying the 60 of debt, it is left with 100 from the 40 it put in, that is, it earns 150 percent. The calculation deliberately ignores interest and the tax shield. It also assumes the same growth in the company’s value in both versions. It shows only how debt changes the split of the result and the risk borne by equity.

If more debt always gave a better result, funds would finance acquisitions with loans to the limit. Usually they do not. They set debt at a level the company’s cash flows can service with a margin of safety. Above this level the risk grows that the lenders will take control of the company, and this risk outweighs the benefit of the tax shield.

Where this calculation stops working

The theory does not give one number for a specific company. The costs of financial distress are hard to measure before they appear. A company in a cyclical industry, or one with heavy spending on replacing its assets, can carry less debt than a service business with multi-year contracts. A loan is repaid from the cash left after that spending. Funds get it wrong too, especially when they finance a buyout when money is cheap and repay the debt when it is expensive. An owner who avoids debt often has rational reasons. He keeps full freedom of decision and does not sign the personal guarantees that banks often demand from owners of mid-sized companies, such as a blank promissory note (weksel in blanco). The WACC formula does not measure these benefits.

Who pays for the mistake, and when

An owner who avoids debt pays for years. He hands the tax authorities a tax shield he did not use and keeps his own money in the company, money he could have taken out earlier as a dividend. Selling the company will not give this money back. The buyer values future cash flows on the basis of the financing structure he will put in place himself after the acquisition. The benefit of the new debt goes to him first. How much of it he gives up in the price depends on how many buyers are competing for the company. Having no debt can also cost money indirectly. A company without a credit line keeps more cash in its account for seasonal needs. In a sale, the parties then argue about how much of this cash is needed for operations and how much is surplus. I wrote about this a week ago.

An owner who has loaded the company with more debt than it can carry pays at the sale. The buyer sees covenants close to breach and postponed investments, so he lowers the valuation. The investor presentation talks about enterprise value. The seller, however, receives the price for the shares, which is calculated only after the debt is deducted. The entire reduction in the valuation therefore hits his part.

That is why at Capital One Advisers this calculation is part of preparing for a sale and is done before the first confidentiality agreement. The open question is how much headroom to leave below the ceiling. Some calculate it so that the company can get through the worst year in its history without breaching covenants. Others leave additional room for an investment or acquisition that has to be carried out quickly, without new consent from the bank. The first approach gives more tax shield, the second more freedom in the years before the sale. The choice depends on how stable the company’s cash flows are and on how often opportunities that require fast financing appear in its market.

Service: M&A advisory on a company sale