5.2 Financial Leverage
So far, we have discussed the company’s WACC. Let us examine from a managerial perspective, the pros and cons of increasing the company’s leverage, or use of debt as a financing source of growth (think again: “EFN”). We shall see, by way of example, that leverage affects net income, EPS and ROE.
As a point of departure, we noted earlier that debt is the cheapest capital component. If so, why not leverage (i.e., increase debt) the company “all the way, i.e., to 100%”? We will see below that leverage increases interest expense, which decreases net income, a negative. However, under certain circumstances, which we shall see, leverage also increases EPS and ROE, positives, which should favorably affect share price, which are driven by earnings and dividends (assuming a constant payout ratio), as reflected in the DDM and the PE ratio.
We are given two alternate cases (Cases 1 and 2) for different capital structures – no debt, and 50/50 debt to equity. We are also given varying projected EBIT levels A, B, and C as below.
Case 1: 0% Debt, 100% Equity (10,000s. @ $20 book value per share)
Tax Rate (“T”) = 0.40
Case 2: 50% Debt, 50% Equity ($100,000 of debt; 5,000s. @ $20)
i = 0.12 and T = 0.40
($000)
| Pro-forma Income Statement | Case 1 | Case 2 | ||||
| A | B | C | A | B | C | |
| EBIT | 0 | 40 | 80 | 0 | 40 | 80 |
| Int Exp | 0 | 0 | 0 | (12) | (12) | (12) |
| T | 0 | (16) | (32) | 4.8 | (11.2) | (27.2) |
| NI | 0 | 24 | 48 | (7.2) | 16.8 | 40.8 |
| EPS | 0 | $2.40 | $4.80 | ($1.44) | $3.36 | $8.16 |
| ROE | 0 | 12% | 24% | (7.2%) | 16.8% | 40.8% |
Note:
EPS= NI ÷ NOSO
ROE= NI ÷ Equity
NOSO= the number of shares outstanding
You will note that, in Case 2A, taxes are stated as positive “4.8.” In effect, this means that the company will earn a tax “carry back” (similar to a credit on past taxes paid) or a tax “carry forward” against future tax liabilities. Taxes are usually paid; here, the corporation gets a tax benefit as either a refund on past taxes paid or a decrease in future taxes to be paid.
Let’s compare the results case by case. The chart below provides a summary.
| EBIT | Net Income | EPS | ROE | |
| 2A vs. 1A | $0 | Worse | Worse | Worse |
| 2B vs. 1B | $40,000 | Worse | Better | Better |
| 2C vs. 1C | $80,000 | Worse | Better | Better |
In all instances, the leveraged case (Case 2) increases interest expense (here from zero to $12,000), and thereby reduces net income. Case 2 is “worse” across the board. This says that, in terms of net income, the company is worse off with debt.
However, somewhere between EBIT of zero and $40,000, leverage enhances both EPS and ROE. In other words, leverage is desirable if you expect pro-forma EBIT to be beyond a certain level, a level, which we will determine mathematically below. In short, the negative impact of leverage on net income is overcome, in terms of EPS and ROE, by the relatively smaller number of shares outstanding in the presence of leverage. By using “other people’s money” (i.e., debt) the shareholder gets to “keep,” in a sense, relatively more earnings for himself. In accounting and financial language, the shareholders’ equity interests are not “diluted” by the issuance of additional shares.
We note in summary:
- Debt (leverage) does not affect “operating risk” (i.e., EBIT and ROA variability).
- Debt increases “financial risk,” and causes investors to demand higher ROE.
- Debt is a negative in that it reduces net profits, erodes the TIE ratio, and increases default and bankruptcy risks. (This assumes that the component cost of debt is not increased with more debt.)
- Debt is cheaper than equity; increased debt will lower a firm’s weighted average cost of capital, or “WACC.”
- Debt is a positive, in that it enhances EPS and ROE – provided that the EBIT exceeds the “crossover point” (i.e., in this example somewhere between $0 and $40,000). If EBIT does not exceed the crossover point, debt is ill-advised.
- Debt does not “work” unless it adds to operating profits in a manner, which is greater than the cost of debt. When it does add profits, the benefits increase as operating profits increase.
- Debt does not “dilute” ownership interests. (We note, in passing that increased debt magnifies default risk.)
This framework may be used in corporate investment planning, i.e., the conceptual means by which an accepted capital project may be financed. We use the concept of “incrementalism” here to evaluate how much additional capital is needed and whether the requirement should involve debt or equity (or some combination). Thus, the $200,000 capital figure alluded to in this example, may be incremental and for the sole purpose of financing a particular capital project.
Note:
Some Important Financial Leverage Ratios:
In the Introduction to Financial Analysis text (by this author), we reviewed numerous financial ratios and, in particular, we looked at three Debt or “Solvency” Ratios.
The solvency ratios are intended to provide a gauge of the extent to which the firm is indebted. Thus, we examine both the Debt/Equity and the Debt/Total Assets ratios. A higher solvency ratio means that the firm has a higher default risk than a lower ratio. “Default” refers to the failure of a company to pay its debt obligations in full and on time.
We also examine the “TIE” or “Times Interest Earned” ratio in order to gauge the firm’s ability to generate sufficient operating cash flow, or EBIT, with which to pay its interest expense. The firm should have more EBIT than interest expense. EBIT ÷ Interest Expense should therefore exceed one.
EBIT and Operating profits are accounting data that are subject to the various accounting schemes which the auditor may legitimately employ under GAAP accounting. (Much space was devoted to these “schemes” in the above cited text.) Thus, we now introduce a third ratio: EBITDA ÷/Interest Payable. This ratio provides a more realistic view of the cash demands interest payments make and the firm’s ability to honor those demands. This ratio should also exceed one.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Taxes are paid after interest has been paid. Interest is a tax deduction.
Depreciation and amortization are non-cash expenses that the accountant reports. In adding back these deductions, we get a truer image of the firm’s operating cash flow (“EBITDA”).
Summary Debt Ratios
| Debt ÷ Equity | TIE = EBIT ÷ interest expense |
| Debt ÷ Total Assets | TIE = EBITDA ÷ interest payable |