13 -1 WHAT IS FINANCIAL LEVERAGE AND
WHAT ARE ITS EFFECTS?
When companies use debt in their capital structures, we say that they are using financial leverage.
Similarly, a company with debt on its balance sheet is a levered company, and a company that finances its
operations entirely with equity is an unlevered company. The term leverage implies that debt magnifies a
company’s financial performance. That effect can be either positive or negative, depending on the returns
a company earns on the money it borrows. A simple example illustrates this principle.
Consider the decision facing Susan Kelly, chief financial officer of High-Tech Manufacturing
Company (HTMC), a publicly traded company with no debt and 200,000 outstanding ordinary shares.
Analysts expect HTMC to generate $1,000,000 of total profits each year for the foreseeable future. Given
HTMC’s risk, shareholders require a 10% return on their investment. Using the present value formula
for a perpetuity (see Equation 3.10 on page 92), we find the company’s value equals $10,000,000
($1,000,000 ÷ 0.10). By dividing total company value by the number of shares outstanding, we see that
HTMC’s share price is $50 ($10,000,000 ÷ 200,000).
A shareholder suggests to Ms Kelly that, by issuing bonds and retiring some of its outstanding
shares, HTMC could increase earnings per share (EPS) and thereby increase its share price. To be
more specific, the shareholder proposes that HTMC should issue $5,000,000 in long-term debt, at an
interest rate of 6.0%, and use the proceeds to repurchase half the company’s ordinary shares (100,000
shares). This recapitalisation would result in a dramatic shift in the company’s financing mix. Ignoring, for
the time being, any effects of this transaction on the company’s equity value, HTMC’s capital structure
would change from 100% equity to 50% debt and 50% equity. In other words, this strategy would convert
HTMC’s debt-to-equity ratio from 0 to 1.0. Table 13.2 summarises HTMC’s current and proposed
capital structures.
TABLE 13.2 CURRENT AND PROPOSED CAPITAL STRUCTURES FOR HIGH-TECH
MANUFACTURING COMPANY (HTMC)Current Proposed
Assets $10,000,000 $10,000,000
Equity $10,000,000 $5,000,000
Debt $0 $5,000,000
Debt-to-equity ratio 0 1.0
Shares outstanding 200,000 100,000
Share price $50.00 $50.00
Interest rate on debt – 6.0%recapitalisation
Alteration of a company’s
capital structure to change the
relative mix of debt and equity
financingThis chapter describes the key influenceson managers’ decisions to finance with debt
or with equity. We begin by showing why
companies may choose to substitute debt for
equity capital, even in a world without corporate
income taxes. We then show that the common
practice of allowing companies to deduct
interest payments from taxable income provides
a strong incentive for corporations to substitute
debt for equity.13: Capital Structure