Financial leverage




Дата канвертавання19.04.2016
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FINANCIAL LEVERAGE

We previously considered the effects of financial leverage when we looked at financial statement analysis. Let’s look once again at the example but in a little more detail.


Recall that we viewed a firm with three different possible debt financing strategies, ranging from no debt to 90% debt. Also, we assumed that the interest rate on any debt employed was 10% and that the firm had a tax rate of 40%.
Interest Rate = 10%

Tax Rate = 40%


1 2 3

=== === ===

DEBT 0 500 900

EQUITY 1,000 500 100

--       --       --      

TOTAL ASSETS 1,000 1,000 1,000

As noted before, since the effect of financing doesn’t appear until we go below the Operating Income (EBIT) line, we can jump straight down to the operating income to analyze the effect of financial leverage. Assume first that the EBIT is $140 for the firm; then, the calculation of Net Incomes, and the rates of return that the Net Income represents on the equity invested, are as follows:
1 2 3

=== === ===

EBIT 140 140 140

  INT 0 (50) (90)

--       --       --      

TAX. INC. 140 90 50

  TAX (56) (36) (20)

--       --       --      

NET INCOME 84 54 30

ROE = 8.4% 10.8% 30.0%


When times are good, and the EBIT is sufficiently high, the Return on Equity is magnified by the use of debt. The more the debt that is employed, the greater the magnification.
Now let’s see what happens when the EBIT is $100:
1 2 3

=== === ===

EBIT 100 100 100

  INT 0 (50) (90)

--       --       --      

TAX. INC. 100 50 10

  TAX (40) (20) ( 4)

--       --       --      

NET INCOME 60 30 6
ROE = 6% 6% 6%
Why is the ROE the same for all three? Is there a relationship between the EBIT of $100 and the assets of $1,000 that corresponds to anything?
The EBIT of $100 represents a before-tax return on assets of 10%. This is the same as the before-tax cost of debt. When EBIT was $140, firms borrowing at 10% were investing in assets that yielded a 14% rate of return. The extra 4% went to shareholders and increased their ROE. The more debt borrowed at 10% and invested to earn 14%, the higher the ROE. When money is borrowed at 10% and invested in assets that only yield 10%, there is nothing left over to benefit the stockholders so there is no advantage to using debt.
What happens when you borrow money at 10% and invest it in assets that only yield a 6% rate of return? Who makes up the difference? (Stockholders)
1 2 3

=== === ===

DEBT 0 500 900

EQUITY 1,000 500 100

--       --       --      

TOTAL ASSETS 1,000 1,000 1,000

EBIT 60 60 60

  INT 0 (50) (90)

--       --       --      

TAX. INC. 60 10 (30)

  TAX (24) (4) 12

--       --       --      

NET INCOME 36 6 (18)
ROE = 3.6% 1.2%  18.0%

Suppose we call financing alternative #1, with no debt, the equity alternative and the one with 50% debt (alternative #2) the debt alternative and plot the results of the previous three scenarios:





As may be observed, the use of debt can be advantageous at high levels of EBIT and disadvantageous at low levels of EBIT. The X-axis could also be Sales rather than EBIT, while the Y-axis could be some other measure of shareholder returns, such as Earnings Per Share or Market Price Per Share. The increased risk is also apparent from the chart. Notice that the change in ROE is much greater for debt than equity as the EBIT changes.





What factors influence how much debt a firm uses?




  • Growth rate in sales and income. The higher the growth rate, the more debt that can be utilized.

  • Stability of sales. The more stable the sales, the more debt that can be employed. The probability of being unable to service the debt is smaller.

  • Profit margin. A larger profit margin allows for more of a cushion if sales fall.

  • Asset structure. A capital intensive firm relies more upon debt than a non-capital intensive firm. The fixed assets are better collateral for debt.

  • Management attitudes. There is a trade-off between the risk of debt and the loss of control of the firm if equity is sold instead.

  • Lender attitudes. Lenders are concerned with risk and may not be willing to lend.

The purpose of considering the capital (or financial) structure of the company is because of its impact on the cost of capital to the firm. The relationship between the use of debt, as measured by the debt/asset ratio, and risk is the following:

A
nd as we have seen previously, the relationship between risk and the required rate of return is


Combining the two, we find the relationship between the Debt/Asset ratio and the Required Rate of Return to be

A
s the use of debt increases, the risk increases and, hence, the required rate of return of investors increases. The firm has no money of its own. All of the funds are provided by either shareholders or lenders. Since debt is less risky than equity (from the investor’s viewpoint), and it is tax deductible, the cost of debt funds is cheaper than the cost of equity funds. The objective of the financial structure decision is to minimize the average cost of capital.



Is minimizing the average cost of capital consistent with maximizing shareholder wealth, or maximizing the value of the firm? Yes.


What is the value of anything in a financial sense? The present value of the future cash flows. The value of a firm is the present value of the future cash flows to the firm. What happens to present values when the discount rate is lowered? The present value of the future cash flows goes up. So by minimizing the average cost of capital, or the discount rate, we are maximizing the present value of the cash flows to the firm.


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