5.9 Implications of Financial Leverage
Leverage, or the increased use of debt as a financing source, reduces net income because of the added interest expense debt entails; the effect on net income is mitigated, but not eliminated, due to the tax deductibility of interest expense. Further, debt increases financial risk as interest must be paid timely; this puts some stress on the company’s solvency ratios. There must be a good reason to use debt. We have observed that the use of debt, in lieu of equity, potentially increases EPS and ROE. Shareholders should like that.
The guiding principle of the “optimal” or ideal level of leverage is to maximize firm (stock) value, i.e., minimize WACC (due to inverse price/discount rate relationship). Since the cheapest source of funds is debt capital, increasing debt would be best. It would also provide leverage for the shareholders, providing higher EPS and ROE, and share price – in theory.
However, as leverage increases so too does the risk of bankruptcy (as measured by the TIE and other ratios), which would, contrarily, diminish the value of the company’s stock. This will cause the firm’s equity Beta to rise, with the result that the “Required Return” (“R”) from the CAPM for the firm will also go up. This “R,” in turn, serves as the firm’s discount rate in the dividend discount model. If the discount rate rises, the firm’s intrinsic value (price) will decline. Neither too much – nor too little – debt is desirable.
Of course, there is more to this. As we have seen, leverage can be a good thing – providing more with less, so to speak. If the capital funds that debt provides are profitably utilized by careful capital budgeting and planning, the positive effect is that ROE and EPS will rise. If earnings (per share) rise, ceteris paribus (i.e., assuming a constant payout ratio), dividends will also rise. If dividends (and if the dividend growth rate – G) rise, price should also rise, via the Dividend Discount Model! So, as you see, there are offsetting considerations here.
Variability of EPS and ROE is greater in leveraged case, i.e., leverage magnifies gains and losses. (Note: Variability can be measured by standard deviation.) A leveraged company is riskier! Take note that the more leverage, the steeper the EPS/ROE versus EBIT line (see graph above); this means that EPS and ROE move more for every unit change in EBIT than were the line flatter – the very definition of volatility!
This is a static analysis because it ignores the possibility that the cost of debt-capital itself may rise as leverage increases (or as market-conditions / yield-curve may change).
If a corporation’s capital structure does not match the structure an investor targets for himself, he can, as we shall soon see, create the amount of leverage he desires by either borrowing or lending with his personal portfolio and thereby retaining the personal payoff effects desired. This is sometimes called “Homemade Leverage.”
According to Modigliani and Miller (M&M), capital structure hence will not affect stock price, in stark contrast with the above notion of leverage and its purported effect on price. “The size of the pie (the Balance Sheet) doesn’t depend on how it’s sliced.” You will soon note M&M’s counter argument (below) that the firm’s riskiness is a function of the volatility of its basic (business) earnings power, EBIT (or equivalent).
