Financial Leverage and Capital Structure: A Comprehensive Guide

Financial leverage is a powerful tool that can amplify returns, but it also increases risk. A company's capital structure is the foundation upon which financial leverage is built.

The optimal capital structure is a delicate balance between debt and equity, with a general rule of thumb being that 50% of capital should come from debt and 50% from equity. This balance can vary depending on the company's industry and risk profile.

A company's debt-to-equity ratio is a key indicator of its capital structure, with a higher ratio indicating more debt and less equity. A debt-to-equity ratio of 1:1 means a company has equal amounts of debt and equity.

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Financial leverage is a powerful tool that can help businesses grow and succeed, but it's essential to understand how it works. By borrowing money at a risk-free interest rate, you can increase your cash flows and create more value for your shareholders.

Borrowing $17,000 at a 4% interest rate results in a debt of $17,680 at the end of the year. This means that if your business generates at least $18,000 in cash, you can borrow the $17,000 without any risk of defaulting.

The equity holders in your business expect it to generate $52,000 in cash flows. This means that after paying off the debt, there will be $34,320 left for the shareholders.

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The trade-off theory of capital structure suggests that companies balance the benefits of debt financing, such as tax shields, against the costs, including bankruptcy and financial distress costs.

This theory implies that firms will choose a capital structure that maximizes their overall value, taking into account both the benefits and costs of debt and equity financing.

The capital structure substitution theory proposes that company management manipulates capital structure to maximize earnings per share, leading to testable predictions about market averages and company behavior.

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Companies with high valuation ratios tend to have little or no debt, while those with low valuation ratios are more likely to be leveraged.

The Modigliani-Miller theorem states that, in a perfect market, a firm's capital structure is irrelevant to its value, but this result is purely theoretical and disregards important factors like fluctuations and uncertain situations.

In a perfect capital market, firms and individuals can borrow at the same interest rate, and investment returns are not affected by financial uncertainty, but this is a mirage and unattainable in reality.

The Modigliani-Miller theorem is a fundamental concept in finance that forms the basis for modern academic thinking on capital structure. It was proposed by Franco Modigliani and Merton Miller in 1958.

In a perfect market, the theorem states that how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant.

Assuming a perfect capital market with no transaction or bankruptcy costs, perfect information, and equal interest rates for firms and individuals, Modigliani and Miller made two key findings. Their first proposition was that the value of a company is independent of its capital structure.

The second proposition stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. As leverage increases, risk is shifted between different investor classes, while the total firm risk is constant.

Under a classical tax system, the tax-deductibility of interest makes debt financing valuable, and the cost of capital decreases as the proportion of debt in the capital structure increases. This led Modigliani and Miller to conclude that the optimal capital structure would be to have virtually no equity at all, consisting of 99.99% debt.

The Modigliani-Miller theorem is generally viewed as a purely theoretical result, as it disregards many important factors in the capital structure process, such as fluctuations and uncertain situations that may occur in the course of financing a firm.

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The pecking order theory suggests that companies prioritize their sources of financing according to the law of least effort, or of least resistance.

This means that internal financing is used first, followed by debt, and then equity as a financing means of last resort.

Companies prefer internal financing because it's the least costly option, and debt is preferred over equity if external financing is required.

According to Myers (1984), equity is a less preferred means to raise capital because when managers issue new equity, investors believe the firm is overvalued and managers are taking advantage of the assumed over-valuation.

The form of debt a firm chooses can act as a signal of its need for external finance, making it a crucial aspect of the pecking order theory.

Discover more: Pecking Order Theory

Arbitrage is a strategy that seeks to profit from price differences between similar instruments issued by the same corporation.

A capital structure arbitrageur looks for opportunities to exploit these differences, such as between traditional bonds and convertible bonds.

Convertible bonds have a stock-option component that can be valued separately. The value of the whole instrument should be the sum of the value of the traditional bonds and the extra value of the option feature.

If the spread between convertible and non-convertible bonds grows excessively, the arbitrageur will bet that it will converge to a more reasonable level.

Financial leverage is a powerful tool that can help businesses achieve greater earnings per share, but it also comes with risks. The use of debt in a company's capital structure can permit it to achieve greater earnings per share than would be possible by issuing equity.

The interest paid by the firm on the debt is tax-deductible, which reduces taxes and allows more of the company's operating income to flow through to investors. This related increase in earnings per share is called financial leverage or gearing.

Financial leverage can be beneficial when the business is expanding and profitable, but it is detrimental when the business enters a contraction phase. The interest on the debt must be paid regardless of the level of the company's operating income, or bankruptcy may be the result.

The following table illustrates the different leverage ratios used to measure the proportion of debt and equity in a company's capital structure:

These ratios can help financial analysts compare companies and make informed decisions about investments.

The Unlevered Firm is a concept that's crucial to understanding financial leverage and capital structure. An unlevered firm is one that has no financial leverage, meaning it's financed entirely by equity.

In other words, the firm has no debt in its capital structure. According to Example 1, a business opportunity with a $40,000 up-front investment and expected cash flows of $52,000 could be entirely financed by selling ownership shares to family and friends.

The value of the stock would be equal to the present value of the expected future cash flows. This means that the potential stockholders would expect to receive $45,614 in one year, which is the present value of the expected cash flows discounted at a 14% rate.

If you sell all of the equity in the company for $45,614 and purchase the equipment necessary for the project for $40,000, you have $5,614 to keep as the entrepreneur who created the business. This is a good outcome, but it's essential to understand that an unlevered firm has no financial leverage.

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A levered firm is one that uses a combination of debt and equity to finance its operations. This is in contrast to an unlevered firm, which is financed solely by equity.

When a firm takes on debt, it can use the interest paid on that debt as a tax deduction. This can increase the firm's cash flows and make it more attractive to investors. For example, if a firm borrows $17,000 at a 4% interest rate, it will owe $17,680 at the end of the year. If the firm generates at least $18,000 in cash flows, it can pay off the debt without defaulting.

The firm's value is determined by the present value of its expected future cash flows, not by the manner in which those cash flows are financed. This means that the firm's value will not change simply because it takes on debt.

Here are some key facts about levered firms:

Note: The debt-to-capital ratio is a widely used measure of a firm's leverage. It is calculated as the dollar amount of debt divided by the dollar amount of total capitalization.

Return on Assets is a key metric to consider when evaluating a company's financial performance. It's calculated by dividing net income by total assets. This ratio indicates how efficiently a company is using its assets to generate revenue. Companies with high return on assets are often more attractive to investors.

A high return on assets ratio can also indicate a company's ability to control costs and manage its resources effectively. For example, a company with a high return on assets ratio may be able to maintain a leaner staff or negotiate better deals with suppliers. This can lead to increased profitability and competitiveness in the market.

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Agency costs are a significant consideration when it comes to financial leverage and capital structure. They arise from the separation of ownership and control, where management's interests may not align with those of shareholders.

The asset substitution effect is a type of agency cost that occurs when management takes on riskier projects as the debt-to-equity ratio increases. This is because debtors bear the downside of unsuccessful projects, while shareholders reap the benefits.

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Management has an incentive to reject positive NPV projects when debt is risky, as the gain from the project will accrue to debt holders rather than shareholders. This is known as the underinvestment problem or debt overhang problem.

Increasing leverage can impose financial discipline on management, which is beneficial for firm value. This is because it reduces the likelihood of management destroying firm value through empire building and perks.

Three types of agency costs are:

The free cash flow problem occurs when management has an incentive to destroy firm value unless free cash flow is given back to investors.

Financial leverage can have a significant impact on a company's value and cost of capital. In perfect capital markets, the choice of capital structure will not impact the value of the firm or the cost of its financing, but in the real world, capital markets are not perfect and tax considerations can affect the value of the firm.

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Using debt financing can lower a company's taxes, as interest payments are tax-deductible. This is known as the interest tax shield, which can be calculated as 0.28×interest payments. For example, if a company pays $280 in interest, the interest tax shield would be $78.40, which can increase the total value of the levered firm.

The presence of the interest tax shield encourages firms to use debt financing in their capital structures. The WACC with taxes is calculated as WACC = (E/V) x Re + (D/V) x Rd x (1-T), where E/V is the market value of equity divided by the market value of the firm, D/V is the market value of debt divided by the market value of the firm, Re is the cost of equity, Rd is the cost of debt, and T is the corporate tax rate.

Financial leverage can significantly impact the equity value of a company. This is evident in the example of a T-shirt business that borrowed $17,000 at a 4% interest rate, ensuring it would generate at least $18,000 in cash.

The equity holders of this business expect the firm to generate $52,000 in cash flows, leaving $34,320 for shareholders after paying off debt holders. This shows how debt can affect the distribution of cash flows.

The enterprise value of a company remains unchanged by the addition of debt, as seen in the example where debt increased to $700. However, the equity value dropped to $400.

The price-to-earnings ratio also fell to 8.7, illustrating how changes in capital structure can distort this ratio. This is why using a PE multiple to value a company can be misleading, especially when there are large cash balances or debt balances involved.

A company's value is determined by the present value of its expected future cash flows, not by the manner in which those assets are financed. This means that the firm's value will not change as a result of taking on leverage, as long as the expected future cash flows remain the same.

Using financial leverage can have a significant impact on growth, particularly for small businesses.

Increased access to capital can lead to rapid expansion and increased market share.

However, over-leveraging can also lead to financial distress and even bankruptcy.

A 20% increase in debt-to-equity ratio can result in a 10% decrease in stock price.

Rapid growth can also lead to increased demand for resources, including management talent.

This can be a challenge for businesses that are not prepared to scale quickly.

In the case of XYZ Corporation, a 50% increase in revenue was matched by a 30% increase in employee count.

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Macroeconomic conditions have a significant impact on capital structure choice. Korajczyk, Lucas, and McDonald (1990) found that equity issues cluster following a run-up in the equity market.

Firms that can time their issue choice to coincide with periods of favorable macroeconomic conditions tend to make different choices. Macro conditions are significant for issue choice for these firms.

Constrained firms, on the other hand, cannot time their issue choice and are affected differently. Levy and Hennessy (2007) highlight that trade-offs between agency problems and risk sharing vary over the business cycle.

These patterns can result in the observed patterns in capital structure choice. Others have related these patterns with asset pricing puzzles, but the specifics are still being researched.

Startup companies like Pinterest often rely on equity for funding, as their cash flows are unpredictable and can't guarantee regular interest payments.

Mature businesses, on the other hand, are well-established in their industries and have stable income, making them more attractive to lenders.

These companies, such as Airbnb, can take advantage of tax deductibility on interest, lowering the cost of their overall financing.

As a result, mature companies tend to gravitate towards debt, which is generally cheaper than equity to raise and maintain.

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Startup/High Growth Companies are often reliant on equity financing due to their unpredictable revenue streams.

These companies may have cash, but it's often from interested investors who believe in the idea, rather than from generating profits.

Think of a company like Pinterest, which didn't make any revenue until 2014 and has yet to reliably create profits.

As a result, banks might think twice before lending to such companies due to the uncertain interest payments that debt would demand.

Pinterest's cash comes from equity, and at the time of writing, its gearing is 0, meaning it has no debt.

Mature businesses are well-established in their industries, profitable, and cash-flow positive, making them attractive to investors.

They can meet regular debt interest and repayments, reducing the risk to investors. Their cash flows are predictable, which is a key advantage.

As a result, mature businesses can take advantage of tax deductibility on interest, lowering the cost of their overall financing.

These companies often have a higher proportion of debt in their capital structure, which can be beneficial.

Airbnb is a great example of a mature business, with stable income and a history of profitability.

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Companies within a peer group tend to have similar financial risk, which often translates to a similar capital structure over the long-term.

You can expect companies in the same industry to have comparable levels of debt and equity, making it easier to compare their financial health.

However, there will always be outliers, such as companies that have recently made a debt-financed acquisition, which can disrupt their usual capital structure.

A company's capital structure is closely tied to its business risk, and changes in the business can lead to changes in the capital structure.

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