Optimal Leverage Range

The optimal level of financial leverage is determined, on the one hand, by the amount of tax savings an organization receives by deducting interest expenses, and on the other hand, by the magnitude of the probabilistic costs of bankruptcy arising from increased risks.

However, one component that I haven’t encountered in academic literature but have seen with McKinsey is the impact of the degree of organizational independence on its value. The higher the debt, the more restricted the organization is in decision-making.

The results of a 25-year study of publicly traded organizations by John Graham and others are reflected in the diagram below. There are two findings here: 1. The theoretical optimal range of leverage levels is quite large (blue segment), and 2. Excessive leverage is associated with much greater losses than under-leverage.

Also, below is an interesting graph by McKinsey, which is based on the fundamental formula of value creation and shows that the EV/EBITDA multiple does not change significantly within a fairly wide range of EBITDA/Interest. This means that the conclusion is that tax savings obtained through leverage are not as significant a component as is often perceived from academic literature…

Source:

Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels