While individuals and households tend to use debt to finance consumption, companies channel some or all borrowed funds into investments. If the borrowed funds are used intelligently and the payoff exceeds the interest expense of the loan, the firm will become more valuable. This effect can be so pronounced that even the mere news of an approved loan can raise a firm's stock price as a result of investor expectations. Taking out a loan to pay back other loans, however, usually will not have the same effect.
How This Works
Say a pizza chain has a secret sauce, great name recognition in a geographic area and dynamic management team. It desires to expand into a new state but lacks the funds to finance the opening of the five new locations it has identified. It secures a loan of $2 million at an interest rate of 8 percent and opens up the five stores, which two years later are worth $600,000 each based on earnings. At the end of two years, the outstanding loan is $2 million + ($2 million * .16) = $2.32 million, whereas the stores are worth 5*$600,000 = $3 million. The firm's value therefore has grown by $680,000 because of the borrowing and the resulting investment.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.