Companies have essentially two sources of capital. One is equity, which it gets from shareholders, and the other is loans from lenders.
Companies with no debt on their Balance Sheet have an unlevered Balance Sheet and have obtained their capital from the equity markets.
A company that borrows money and puts debt on its Balance Sheet now has a levered Balance Sheet. Once a company borrows money (leveraging up the Balance Sheet) it places the company at risk of not being able to meet its obligations.
Unlike dividends, interest payments have to be made, so taking on debt not only increases the company's risk of meeting obligations but in addition allocates a portion of its cash flow to making interest payments and repaying the debt, thus reducing the cash flow available for other purposes.
Debt is generally less expensive than equity and is attractive because it reduces the company's weighted average cost of capital (WACC). By doing so, it reduces the hurdle rate and increases the opportunity set of investments management can consider.
The purpose of borrowing money and leveraging the Balance Sheet is to increase the return to shareholders or the Return on Equity (ROE). It accomplishes this at the expense of the Return on Capital Employed (ROCE).
LIBOR is an acronym for “London Inter-Bank Offered Rate” and it is the interest rate that banks charge each other for interbank loans.
When the terms of a loan are negotiated, one of the ...
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