Question

Consider two firms that are the same in every aspect, except one is levered and the other is unlevered. The Federal Reserve announces that it will lower the benchmark interest rate in response to the pandemic. How will this affect the value of the levered firm and the unlevered firm? Explain the effects on each firm separately.

Answer 1

The two firms under consideration are ABC and XYZ. ABC and XYZ are same in every aspect expect that ABC has borrowed funds that is it is levered but XYZ is unlevered that is doesnt have borrowed funds and functions on its own funds.

The ABC levered firm profit after announcement by Federal reserve would increase as it has to pay lower interest on the borrowed funds. This might even increase the valation of the ABC firm. Before the announcement the valuation of the ABC firm would be lower because it has debt in it and people see debt ridden firm with a fear that is credit risk or default risk.The effect after announcement would be favourable as it its ratios would improve because it will be left with higher profit due to to decreased interest. The ratios that will improve would be profitability ratios such as return on assets,return on capital employed, return on equity and debt infact the margin ratios will also increase like net profit margin. The Interest Coverage ratio would also improve as interest lower. This would be good indication for ABC firm on a whole.

The XYZ firm that is unlevered would surely have higher valuation when compared to ABC as people have much more faith in firms that are debt free.There would not be much impact on ratios of the XYZ Firm because it is debt free.Post the announcement of the federal reserve XYZ may borrow additional funds as it is available at a cheaper cost this would help the firm increase its production and profitability thereby.If the profitability increases then most of the major ratios would increase like return on assets,return on capital employed, return on equity,Net profit margin etc. So overall it would be beneficial if XYZ raise more funds and expand its operations.

So it can be concluded that the valuation of XYZ is higher pre announcement and most probably would be higher post announcement too if it decides to raise capital on a cheaper cost and increase its Revenue thereby increasing its profit.