Question

If a company increases its financial leverage how will this affect the WACC of the company? How does this influence the ability of the company to earn positive residual operating income, explain in relation to changes of required return?

Answer 1

Financial leverage refers to the proportion of debt funds to equity funds. An increase in the financial leverage is caused by an increase in the debt capital relative to the equity capital.

Generally, debt funds are cheaper than equity. This has a certain logical explanation. While debt capital assures a safe return for the holders, equity has no such guaranteed returns. As a matter of fact, though equity shareholders are given dividends, there is no guarantee of the same, and there is no statutory compulsion to pay out any dividends. Furthermore, at the time of liquidation, debeture/debt holders are paid off first, and the equity shareholders are paid off last. Because of this order of priority, often, equity shareholders do not recover all of their investment in case of a liquidation. In some cases, they are even required to pool in additional funds. This makes equity a much riskier investment in comparison to debt. In order to compensate potential investors for the excess risk taken, companies have to offer a higher return on equity.

Therefore, if the proportion of debt increases, the Weighted average cost of capital decreases, as there is a higher proportion of less expensive funds.

In theory, residual income is the amount of net income generated in excess of the minimum rate of return required. The minimum rate of return required from an investment of funds is the rate paid to aquire those funds in the first place, which is WACC.

If a lower discount rate is used to discount funds, we get a higher net income. Therefore, as the WACC decreases, the ability of the company to earn a positive residual operating income increases.