Financial theory and common sense tell us that business owners can use debt to increase the value of the equity in their companies. If they can borrow at 7% and earn 10% on the incremental assets, they will increase earnings and cash flow, provided of course that they really can earn more than their borrowing costs and that they do not borrow so much that they cannot safely pay back interest and principal, even if interest rates rise and business activity declines. In the old days, when I was a commercial banker, before calculators and computers, we calculated debt capacity by hand on ledger paper using “worst-case scenarios” in which we assumed higher interest rates and lower sales and earnings to limit how much we would loan. (We also considered personal guarantees, collateral, and the character of the borrower, but that is another story.)
Having said this, however, I would venture that maybe one in ten of my business owner clients thinks about using debt to increase the value of their businesses. Many of them have a visceral distaste for debt, borne out of experience with the Depression (the 1929 one or the 1981 one which clobbered Northeastern Ohio) and will simply not consider it, regardless of its economic potential. Others borrow only when they need to make capital investments and do not have sufficient funds on hand. Still others borrow seasonally, just to fund changing inventory requirements, and repay their credit lines in full as inventory runs down. Moreover, most of the business owners who do use debt are either in businesses that fundamentally require it (car dealerships are a good example) or are aggressive real estate investors who lever up their properties and distribute the proceeds.
The reason I mention all this is that, when you are valuing a business, one of the most important assumptions in your financial forecast is the level of debt. Think about it: at the margin, with everything else held constant (i.e. cash outflows), every dollar of additional debt drops almost completely to the bottom line (cash flow to equity) net of interest expense after taxes. Today, many good businesses are being forced to reduce debt because their owners are unsure about the future and / or because their banks are pressuring them to do so. For a business that has unused debt capacity (see above), if the owner decides to borrow more, cash flow will increase in the short run (and decrease in the long run as debt is repaid). If they borrow less (repay debt), cash flow will decrease in the short run and increase in the long run. This can have a HUGE impact on cash flow to equity and the ultimate value conclusion. Regardless of whether you are valuing a control or a minority interest, you need to ask about the control owner’s intentions for and attitude about debt and reflect that appropriately.