5 How can Financial Leverage Affect the Value?

One thing is sure that wherever and whatever way one sources the finance from, it cannot change the operating income levels. Financial leverage can, at the max, have an impact on the net income or the EPS (Earning per Share). Changing the financing mix means changing the level of debts. This change in levels of debt can impact the interest payable by that firm. The decrease in interest would increase the net income and thereby the EPS and it is a general belief that the increase in EPS leads to an increase in the value of the firm.

Apparently, under this view, financial leverage is a useful tool to increase value but, at the same time, nothing comes without a cost. Financial leverage increases the risk of bankruptcy. It is because higher the level of debt, higher would be the fixed obligation to honour the interest payments to the debt providers.

Discussion of financial leverage has an obvious objective of finding an optimum capital structure leading to maximization of the value of the firm.

Important theories or approaches to financial leverage or capital structure or financing mix are as follows:

• NET INCOME APPROACH

This approach was suggested by Durand and he was in favour of financial leverage decision. According to him, a change in financial leverage would lead to a change in the cost of capital. In short, if the ratio of debt in the capital structure increases, the weighted average cost of capital decreases and hence the value of the firm increases.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts where the weights are the amount of capital raised from each source.

According to Net Income Approach, change in the financial leverage of a firm will lead to a corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the company. The Net Income Approach suggests that with the increase in leverage (proportion of debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease in the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would have a positive impact on the value of the business and thereby increase the value per share.

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.

• The increase in debt will not affect the confidence levels of the investors.
• There are only two sources of finance; debt and equity. There are no sources of finance like Preference Share Capital and Retained Earning.
• All companies have uniform dividend pay-out ratio; it is 1.
• There is no flotation cost, no transaction cost and corporate dividend tax.
• Capital market is perfect, it means information about all companies are available to all investors and there are no chances of over pricing or under-pricing of security. Further it means that all investors are rational. So, all investors want to maximize their return with minimization of risk.
• All sources of finance are for infinity. There are no redeemable sources of finance.

In case of Net Income Approach, with increase in debt proportion, the total market value of the company increases and cost of capital decreases. Reason for this conclusion is that assumption of NI approach that irrespective of debt financing in capital structure, cost of equity will remain same. Further, cost of debt is always lower than cost of equity, so with increase in debt finance WACC reduces and value of firm increase.

For Diagrammatic representation and Examples, please refer to the book.

• NET OPERATING INCOME APPROACH

This approach is also provided by Durand. It is opposite of the Net Income Approach if there are no taxes. This approach says that the weighted average cost of capital remains constant. It believes in the fact that the market analyses a firm as a whole and discounts at a particular rate which has no relation to debt-equity ratio. If tax information is given, it recommends that with an increase in debt financing WACC reduces and value of the firm will start increasing.

As per this approach, the market value is dependent on the operating income and the associated business risk of the firm. Both these factors cannot be impacted by the financial leverage. Financial leverage can only impact the share of income earned by debt holders and equity holders but cannot impact the operating incomes of the firm. Therefore, change in debt to equity ratio cannot make any change in the value of the firm.

It further says that with the increase in the debt component of a company, the company is faced with higher risk. To compensate that, the equity shareholders expect more returns. Thus, with an increase in financial leverage, the cost of equity increases.

Assumption/Features of Net Operating Income Approach

1. The overall capitalization rate remains constant irrespective of the degree of leverage. At a given level of EBIT, the value of the firm would be “EBIT/Overall capitalization rate”
2. Value of equity is the difference between total firm value less value of debt i.e. Value of Equity = Total Value of the Firm – Value of Debt
3. WACC (Weightage Average Cost of Capital) remains constant; and with the increase in debt, the cost of equity increases. An increase in debt in the capital structure results in increased risk for shareholders. As a compensation of investing in the highly leveraged company, the shareholders expect higher return resulting in higher cost of equity capital.

In the case of Net Operating Income approach, with the increase in debt proportion, the total market value of the company remains unchanged, but the cost of equity increases.

For Diagrammatic representation and Examples, please refer to the book.

• TRADITIONAL APPROACH

This approach does not define hard and fast facts. It says that the cost of capital is a function of the capital structure. The special thing about this approach is that it believes an optimal capital structure. Optimal capital structure implies that at a particular ratio of debt and equity, the cost of capital is minimum and value of the firm is maximum.

As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in the reduction in value of the firm.

It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement.

Assumptions Under Traditional Approach: 

• The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases.
• The expected rate by equity shareholders remains constant or increases gradually. After that, the equity shareholders start perceiving a financial risk and then from the optimal point and the expected rate increases speedily.
• As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure.

For Diagrammatic representation and Examples, please refer to the book.

• MODIGLIANI AND MILLER APPROACH (MM APPROACH)

The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component has no bearing on its market value. Rather, the market value of a firm is solely dependent on the operating profits of the company.

The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating Income Approach.

Proposition I: It says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same and value would not affect by the choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.

Assumptions of Modigliani and Miller Approach

1. There are no taxes.
2. Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
3. There is a symmetry of information. This means that an investor will have access to the same information that a corporation would and investors will thus behave rationally.
4. The cost of borrowing is the same for investors and companies.
5. There is no floatation cost, such as an underwriting commission, payment to merchant bankers, advertisement expenses, etc.
6. There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of debt and equity) is the same as the value of an unleveraged firm (a firm that is wholly financed by equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.

Formula

The Modigliani-Miller theory believes that valuation of a firm is irrelevant to its capital structure. The equation describing this relationship is as follows:

VU = VL

where VU is the market value of an unlevered firm (capital is represented by equity only), and VL is the market value of a levered firm (capital is represented by a mix of debt and equity).

Thus, the market value of a firm depends on the operating income and business risk rather than its capital structure. Therefore, the market value of an unlevered firm can be calculated using the following formula:

VU = VL =            EBIT

——–

ke0

where EBIT is earnings before interest and taxes, and ke0 is the required rate of return on equity of an unlevered firm.

The Modigliani-Miller theory of capital structure also believes that the weighted average cost of capital (WACC) is fixed at any level of financial leverage and equals the required rate of return on equity of an unlevered firm (ke0).

WACC = ke0

Another proof of the Modigliani-Miller theory of capital structure is arbitrage, i.e., simultaneous buying and selling of shares with the same business risk but with different prices. In this case, investors will sell overvalued stock and buy undervalued stock; therefore, the price of overvalued stock will decline, and the price of undervalued stock will increase until they are equal, i.e., until the moment when market equilibrium will occur. When the market reaches equilibrium, arbitrage becomes impossible. Therefore, the market value of firms within the same class of business risk will be the same regardless of their capital structure.

• Proposition II: It says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.

It says that financial leverage is in direct proportion to the cost of equity. With an increase in the debt component, the equity shareholders perceive a higher risk to the company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction here is that Proposition 2 assumes that debt shareholders have the upper hand as far as the claim on earnings is concerned. Thus, the cost of debt reduces.

This theory recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible. However, the same is not the case with dividends paid on equity. In other words, the actual cost of debt is less than the nominal cost of debt due to tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress, i.e., the cost of bankruptcy, exceeds the value of the tax benefits. Thus, the increased debts, until a given threshold value, will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus infers that a change in the debt-equity ratio has an effect on the WACC (Weighted Average Cost of Capital). This means that the higher the debt, the lower the WACC. The Modigliani and Miller approach is one of the modern approaches of Capital Structure Theory.

Please refer to the book for Examples and detailed diagrams.

Criticism of MM Approach

The Modigliani-Miller theory of capital structure was criticized because the assumption that capital markets are perfect is completely unrealistic. The arbitrage, as proof of the Modigliani-Miller theory, was also strongly criticized. If there are no perfect capital markets, the arbitrage will be useless because a levered and an unlevered firm within the same class of business risk will have different market values.

The reasons why arbitrage does not allow market equilibrium in real life are as follows:

• Transaction costs. If there are transactions costs, buying stock will require bigger initial investments, but the return remains the same. Therefore, the market value of a levered firm will be higher than an unlevered one, assuming that both of them are within the same class of business risk.
• The cost of borrowing is not the same for individuals and firms. The cost of borrowing depends on the individual credit rating of the borrower.
• Institutional constraints. Institutional investors slow down arbitrage because they limit the use of financial leverage by their clients.
• Bankruptcy cost. The higher the financial leverage, the higher is the probability of bankruptcy. Therefore, bankruptcy costs have a strong influence on firms.

Many critics of the Modigliani-Miller theory of capital structure believe that assumptions are unrealistic and that the market value of a firm as well as WACC depends on financial leverage.