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The Effect of Financial Leverage

In this section, we examine the impact of financial leverage on the payoffs to stockholders. As you may recall, financial leverage refers to the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.

As we describe, financial leverage can dramatically alter the payoffs to shareholders in the firm. Remarkably, however, financial leverage may not affect the overall cost of capital. If this is true, then a firm`s capital structure is irrelevant because changes in capital structure won`t affect the value of the firm.

THE IMPACT OF FINANCIAL LEVERAGE

We start by illustrating how financial leverage works. For now, we ignore the impact of taxes. Also, for ease of presentation, we describe the impact of leverage in terms of its effects on earnings per share, EPS, and return on equity, ROE. These are, of course, accounting numbers and, as such, are not our primary concern. Using cash flows instead of these accounting numbers would lead to precisely the same conclusions, but a little more work would be needed.

Financial Leverage, EPS, and ROE: An Example

The Trans Am Corporation currently has no debt in its capital structure. The CFO, Ms. Morris, is considering a restructuring that would involve issuing debt and using the proceeds to buy back some of the outstanding equity. Table B.3 presents both the current and proposed capital structures. As shown, the firm`s assets have a market value of $8 million, and there are 400,000 shares outstanding. Because Trans Am is an all-equity firm, the price per share is $20.

The proposed debt issue would raise $4 million; the interest rate would be 10 percent. Since the stock sells for $20 per share, the $4 million in new debt would be used to purchase $4 million/20 _ 200,000 shares, leaving 200,000 outstanding. After the restructuring, Trans Am would have a capital structure that was 50 percent debt, so the debt- equity ratio would be 1. Notice that, for now, we assume that the stock price will remain at $20.

To investigate the impact of the proposed restructuring, Ms. Morris has prepared Table B.4, which compares the firm`s current capital structure to the proposed capital structure under three scenarios. The scenarios reflect different assumptions about the firm`s EBIT. Under the expected scenario, the EBIT is $1 million. In the recession scenario,

EBIT falls to $500,000. In the expansion scenario, it rises to $1.5 million. To illustrate some of the calculations in Table B.4, consider the expansion case. EBIT is $1.5 million. With no debt (the current capital structure) and no taxes, net income is also $1.5 million. In this case, there are 400,000 shares worth $8 million total. EPS is therefore $1.5 million/400,000 _ $3.75 per share. Also, since accounting return on equity, ROE, is net income divided by total equity, ROE is $1.5 million/8 million _ 18.75%.

With $4 million in debt (the proposed capital structure), things are somewhat different. Since the interest rate is 10 percent, the interest bill is $400,000. With EBIT of $1.5 million, interest of $400,000, and no taxes, net income is $1.1 million. Now there are only 200,000 shares worth $4 million total. EPS is therefore $1.1 million/200,000 _$5.5 per share versus the $3.75 per share that we calculated above. Furthermore, ROE is $1.1 million/4 million _ 27.5%. This is well above the 18.75 percent we calculatedfor the current capital structure.

EPS versus EBIT

The impact of leverage is evident in Table B.4 when the effect of the restructuring on EPS and ROE is examined. In particular, the variability in both EPS and ROE is muchlarger under the proposed capital structure. This illustrates how financial leverage acts to magnify gains and losses to shareholders.

In Figure B.3, we take a closer look at the effect of the proposed restructuring. This figure plots earnings per share, EPS, against earnings before interest and taxes, EBIT, for the current and proposed capital structures. The first line, labeled ¬No debt, ­ represents the case of no leverage. This line begins at the origin, indicating that EPS would be zero if EBIT were zero. From there, every $400,000 increase in EBIT increases EPS by $1 (because there are 400,000 shares outstanding).

The second line represents the proposed capital structure. Here, EPS is negative if EBIT is zero. This follows because $400,000 of interest must be paid regardless of the firm`s profits. Since there are 200,000 shares in this case, the EPS is Ј$2 per share as shown. Similarly, if EBIT were $400,000, EPS would be exactly zero. The important thing to notice in Figure B.2 is that the slope of the line in this secondcase is steeper. In fact, for every $400,000 increase in EBIT, EPS rises by $2, sothe line is twice as steep. This tells us that EPS is twice as sensitive to changes in EBIT because of the financial leverage employed.

Another observation to make in Figure B.2 is that the lines intersect. At that point, EPS is exactly the same for both capital structures. To find this point, note that EPS is equal to EBIT/400,000 in the no-debt case. In the with-debt case, EPS is (EBIT Ј $400,000)/200,000. If we set these equal to each other, EBIT is: EBIT/400,000 _ (EBIT Ј $400,000)/200,000 EBIT _ 2 _ (EBIT Ј $400,000) EBIT _ $800,000

When EBIT is $800,000, EPS is $2 per share under either capital structure. This is labeled as the break-even point in Figure B.2; we could also call it the indifference point. If EBIT is above this level, leverage is beneficial; if it is below this point, it is not.

There is another, more intuitive, way of seeing why the break-even point is $800,000. Notice that, if the firm has no debt and its EBIT is $800,000, its net income is also $800,000. In this case, the ROE is $800,000/8,000,000 _ 10%. This is precisely the same as the interest rate on the debt, so the firm earns a return that is just sufficient to pay the interest.