PART 3: CAPITAL BUDGETINGFinancial Structure and Financial Leverage
We have seen that Austral Carbonlite’s sales are extremely sensitive to the business cycle because the
company produces a luxury item. We have also observed that, because of its high operating leverage,
Carbonlite’s profits are quite sensitive to changes in sales. These factors contribute to Carbonlite’s
relatively high equity beta of 1.5 and its correspondingly high cost of equity of 14%. One other factor
looms large in determining whether companies have high or low equity betas. Remember that Carbonlite’s
financial structure is 100% equity. In practice, it is much more common to see both debt and equity on
the right-hand side of a company’s balance sheet. When companies finance their operations with debt
and equity, the presence of debt creates financial leverage, which leads to a higher equity beta. The effect
of financial leverage on equity betas is much the same as the effect of operating leverage. When a
company borrows money, it creates a fixed cost that it must repay regardless of whether sales are high
or low.^2 As was the case with operating leverage, an increase (decrease) in sales will lead to sharper
increases (decreases) in earnings for a company with financial leverage than for a company that has only
equity on its balance sheet.
Table 11.2 illustrates the effect of financial leverage on the volatility of a company’s cash flows
and on its beta. The table compares companies A and B, which are identical in every respect except
that Company A finances its operations with 100% equity, while Company B uses 50% equity and 50%
long-term debt with an interest rate of 8%. For simplicity, we assume that neither company pays taxes.
These companies sell identical products at the same price; both have $100 million in assets; and both
face the same production costs. Suppose that over the next year, both companies generate EBIT equal
to 20% of total assets, or $20 million. Company A pays no interest, so it can distribute all $20 million to
its shareholders, a 20% return on their $100 million equity investment. Company B pays 8% interest on
$50 million ($4 million). After paying interest, Company B can distribute $16 million to shareholders,
which represents a 32% return on their equity investment of $50 million. Suppose that under a different
scenario, both companies have EBIT equal to just 5% of assets, or $5 million. Company A pays out all
$5 million to its shareholders, a return of 5%. Company B pays $4 million in interest, leaving just $1
million for shareholders, a return of only 2%. Thus, when business is good, the debt that it uses causes
shareholders of Company B to earn higher returns than shareholders of Company A, and the opposite
happens when business is bad.
When companies use debt to finance operations, discount-rate selection becomes complicated in
two ways. First, debt creates financial leverage, which increases a company’s equity beta relative to the
value it would have if the company financed investments only with equity. Second, when a company
issues debt, it must satisfy two groups of investors rather than one. Cash flows generated from capital
investment projects must be sufficient to meet the return requirements of bondholders as well as
shareholders. Therefore, a company that issues debt cannot discount project cash flows using only
its cost of equity capital: it must choose a discount rate that reflects the expectations of both investor
groups. Fortunately, finance theory offers a way to find that discount rate.2 We use the term fixed cost here to mean a cost that does not vary with sales rather than simply a cost that is constant over time. Even when
a company agrees to a loan with a variable interest rate, which means that interest payments are not constant over time, the cost of repaying
the debt does not generally vary as a function of sales.financial leverage
The magnification of both
risk and expected return that
results from the fixed cost
associated with the use of
debt. As a result, it leads to a
higher equity beta