Abstract
This study investigates how balancing internal and external financing sources can create economic value. We set a financial scorecard, consisting of the Cost of Debt (COD), Return on Investment (ROI), and the Cost of Equity (COE). We show that COE should be a cap for COD and a floor for ROI in order to increase the Net Present Value at Weighted Average Cost of Capital and the Adjusted Present Value of the levered investment. However, leverage should be carefully monitored if COD and ROI go off the grid. Situations where leverage has the opposite effect on value creation and the Equity Internal Rate of Return are also discussed. Illustrative examples are given. The proposed model aims to help corporate management in financial decisions.
Highlights
A long-standing question in corporate management is how to balance internal and external financing sources in levered industrial investments in order to increase creation of added value.By setting up a Key Perfomance Index (KPI) dashboard consisting of the Cost of Debt (COD), the unlevered Cost of Equity (COE) and Return on Investment (ROI), we formalize the intuitive condition that debt cost should be sufficiently cheap and investment should be sufficiently profitable
We show that COE shoud be a cap for COD and a floor for ROI
Leverage may destroy added value, which is measured by the Net Present Value at Weighted Average Cost of Capital (NPV at WACC) and the Adjusted Present Value (APV)
Summary
A long-standing question in corporate management is how to balance internal and external financing sources in levered industrial investments in order to increase creation of added value (see Brealey et al, 2016 among others). By setting up a Key Perfomance Index (KPI) dashboard consisting of the Cost of Debt (COD), the unlevered Cost of Equity (COE) and Return on Investment (ROI), we formalize the intuitive condition that debt cost should be sufficiently cheap and investment should be sufficiently profitable. We show that situations may exist where leverage pushes Equity IRR up and destroys economic value at the same time. These findings are illustrated by didactic examples.
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