A company can create value through decisions of distinct natures: operations, investments and financing. Analyzing this through the optics of financing, creation of value is maximized through an optimal balance between Third Party Capital (Debts) and shareholder capital, which minimizes the weighted average capital cost (WACC).

The financial literature specifies a series of benefits of engaging in debt, among which: 1) creation of fiscal benefits through financial expense; 2) reduction of agency costs, by mitigating the risk of overinvestment; and 3) sending a positive signal to the market as to the expected future results. On the other hand, excess debt increases the probability of the company facing financial distress and/or, for lack of financial flexibility, refusing projects that create value.

The decision for leverage should vary from company to company, due to its own distinct economic realities. This fact, by the way, is corroborated in a study by Stern Stewart, in which large public companies1 in Brazil are considered and a large dispersion in net leverage2 is verified. At the end of August 2008, the quartile of most leveraged companies had at least 25% third party capital (maximum of 60%), whereas the quartile with the least leverage had 6%, at most (minimum of 0%).

Based on the initial sample, we selected some different business segments: Retail, Heavy-Duty Industry, and Utilities3. This separation enables a clearer understanding of drivers that influence the decision of an optimal level of leverage.

The Retail group has an average net leverage of 14%. This segment is characterized by a low operational margin, partly as a consequence of an Asset-Light model – low capital investment, high costs, and fixed expenses. In this situation of high operational leverage, there is little encouragement to engage in debt, as the fiscal benefit will not suffice to compensate the risk of Financial Distress.

In turn, Heavy-Duty Industry has 25% leverage, which may be related to a lower operational leverage and better access to credit. In many cases, companies in this segment are large exporters of commodities and equipment. This being so, the solidity of sale agreements and the receivables in dollars reduce the risk, allowing access to lower-cost credit instruments, longer deadlines, and greater sophistication.

The Utilities group, generally having a high operational margin and strong cash generation with low variability, should be the most leveraged. However, what is seen in practice is a structure with little leverage in Brazil (22%), 20 percent less than their international peers. This fact may be related to the domestic regulatory risk, which results in greater uncertainty as to future cash generation. It becomes evident that the Brazilian model is harmful from the capital structure standpoint.

Because each company has very particular characteristics, comparison with peers does not ensure an optimal structure. Actually, many studies show low leverage of American companies relative to their potential. Definition of the adequate capital structure should be based on a complete framework, simulating all costs and benefits and including the company’s business plan, taking into account the future opportunities for investment, fiscal planning, minimum operational cash, and investment schedule, among others.

1 83 Brazilian companies listed at Bovespa with Firm Value (Gross Debt Market Value of Stock) above R$ 2 billion. Excludes the financial segment, holdings, and companies with low-liquidity stock.

2 Net Leverage = Net Debt / (Net Debt Market Value of Stock).

3 Heavy-Duty Industry (example: Steel, Paper and Cellulose, Capital Goods); Utilities (example: Telecommunications, Electrical Energy, Sanitation).

The opinions expressed herein are those of the consultancy, and not necessarily those of the magazine.