When does financial leverage create economic value?

Abstract

This paper addresses an overriding question in the theory of capital structure concerning how external financing contributes to economic value creation. Adjusted Present Value rule for capital-investment decisions (see [5], [6]) is used as performance metric of added value. This frame spotlights the contribution to added value attributable to each financing source. We show that levered project and financial leverage add value, at any debt level, if Net Present Value of the investment project and Net Present Value of debt are both positive. However if Net Present Value of debt is negative, external financing destroys economic value and should be taken at the minimum necessary. 554Christos E. Kountzakis et al.