Question

Discuss how leverage impacts the cost of capital, taxes, firm value, and risks. Explain why most investors demand that companies have a reasonable amount of leverage. Define and discuss the pros and cons of using the MM proposition.

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Answer 1

IMPACT OF LEVERAGE ON COST OF CAPITAL , TAXES , FIRM VALUE AND RISK -

Leverage in finance actually has multiple definitions, based on a single concept - using borrowed money - usually from fixed-income securities like debt and preferred equity or preferred shares of stocks - to increase a company's return on investment.

A highly common business and finance strategy, leverage can be used by a business to leverage debt to build financial assets. Financial leverage is largely defined as the leveraging of various debt instruments to boost a business's return on investment.

There is no guarantee that financial leverage will produce a positive outcome. Basically, the higher the amount of debt a company uses as leverage, the higher - and the riskier - is its financial leverage position.

Also, the more leveraged debt a company absorbs, the higher the interest rate burden, which represents a financial risk to companies and their shareholders.

Financial Leverage Formula

The formula for calculating financial leverage is as follows:

Leverage = total company debt/shareholder's equity.

Take these steps in calculating financial leverage:

Calculate the entire debt incurred by a business, including short- and long-term debt. Total debt = short-term debt plus long-term debt.

Count up the company's total shareholder equity (i.e., multiplying the number of outstanding company shares by the company's stock price.)

Divide the total debt by total equity.

The resulting figure is a company's financial leverage ratio.

A high leverage ratio - basically any ratio of three-to-one or higher - means higher business risk for a company, threatens the company's share price, and makes it more difficult to secure future capital if it's not paying its old/current debt obligations.

Examples of Financial Leverage

For more clarity on financial leverage, consider these opposing scenarios.

• A business steers $5 million to purchase a choice piece of real estate to build a new manufacturing plant. The cost of the land is $5 million. Since the company isn't using borrowed money to purchase the land, this is not financial leverage.
• If the same business used $2.5 million of its own money and $2.5 million of borrowed cash to buy the same piece of real estate, the company is using financial leverage.
• If the same business borrows the entire sum of $5 million to purchase the property, that business is considered to be highly leveraged.

Anyone who buys a home can understand the metrics behind financial leverage.

Let's say you buy a home for $100,000, with a $5,000 down payment. That translates into a financial leverage ratio of 20 (meaning that each dollar of equity represents $20 in assets for the homebuyer.)

Pros and Cons of Financial Leverage

There are upsides and downsides to financial leverage.

Benefits of Leverage

• A solid way to access capital. Financial leverage, deployed correctly, can turbo-boost the amount of financial capital a company deploys. Used adeptly, financial leverage enables companies to produce a higher rate of investment return than it likely could without using leverage.
• Good for business expansion ventures. Leverage financing is a solid way to successfully address a specific, short-term business growth objective, like engaging in an acquisition or buyout of another company, or by paying out a one-time dividend to shareholders.  

Negatives of Leverage

• Risk can be high. With financial leverage, companies can use debt as a tool to enable their business - and their revenues - to grow faster. But if a company takes on too much debt, the risk of financial loss grows as well.
• It can be cost-prohibitive. By using leveraged loans and debt financing tools like high-yield bonds to grow their business, a company must pay interest to investors and lenders, a scenario that could lead to higher costs the more financial risk a company takes on. That's especially problematic in lean economic times, when a company can't generate enough sales revenue to cover high-interest rate costs.

By and large, if a company has a short-term need for capital, or is involved in a complex business transaction like an acquisition, using financial leverage to get the job done can be a savvy business financing move.

Just know going in that accompanying costs can escalate, the economics of financial leverage can be exceedingly complex, and financing risks can be higher for companies using financial leverage.

Different Types of Leverage

There are multiple forms of financial leverage, and businesses and investors should understand each to make the best decision on potential leveraging strategies:

Financial leverage

This type of leverage is the most pervasive used by companies and investors - it represents the use of debt to place a company in a more advantageous financial position. The more debt a company takes on, however, the more leveraged that company becomes. That's primarily due to the higher interest payments owed to the lender by the borrowing business. Yet if the leverage leads to a higher investment return, compared to the rate of interest a company is paying on a loan, the level of leverage is reduced. If the opposite occurs, and interest payments are higher than the return on investment, the company could possibly be put into a perilous risk situation - and may even face bankruptcy.

Operating leverage

This form of leverage involves a company or organization trying to boost operating income by hiking revenue. A company that produces sales figures with a robust gross margin and low costs comes out of that scenario with high operating leverage. With operating leverage, a company's minor change in sales can trigger a boost in operating profits, as expenses are fixed and won't likely rise with sales. In general, high operating levels is a positive when company-wise sales rise, and they're a negative when sales are in decline.