Operating and Financial Leverage^81
How Much Financial Leverage Is Enough
In practice, the leverage decision is based on firm policy. Some firms raise almost all of
their funds from issuing share to shareholders and from earnings retained in the firm.
Other firms borrow as much as they possibly can and raise additional money from
shareholders only when they can no longer raise any additional money by borrowing.
Most firms are somewhere in the middle. In the example that we discussed above, you
didn't have to borrow Rs 90,000 or nothing; you could have chosen to borrow some
amount in between the two. Likewise, some firms maintain one-fourth as much debt as
equity, some firms equal amounts of debt and equity, and some firms more debt than
equity.
The firm's top corporate managers and the board of directors make this decision.
Generally, project managers evaluating the potential of individual projects do not make
the decision of issuing share or borrowing money.
Debt or Equity?
In making a decision regarding whether additional funds should be raised from issuing
debt or equity, there are several factors to be considered. The first rule of financial
leverage is that it only pays to borrow if the interest rate is less than the rate of return
on the money borrowed. If your firm can borrow money and invest it at a high enough
rate so that the loan can be repaid with interest and still leave some after-tax profit for
your shareholders, then your shareholders have profited. They have made extra profit
with no extra investment. This greatly magnifies the rate of return on the amount they
invested.
Why are lenders so generously allowing you to benefit at their expense? How can
there be a system where a firm can increase profits to its shareholders without extra
investment from them? The key is risk. The shareholders of your company don't increase
their investment, but they do increase their risk. The lender may not reap all of the
possible profits from the use of his money. But the lender does earn a contractually
guaranteed rate of return. The lender gets back his money plus a set amount of interest,
whether we make a fortune or lose our shirts.
The amount that lenders let you borrow depends largely on your available collateral.
Merely desiring to be highly leveraged doesn't guarantee that you can borrow enough
to be highly leveraged. Because the lender isn't a partner if you strike it rich, he doesn't
want to be a partner if you go bankrupt.
Assuming that you have enough collateral to borrow as much as you might want, what
factors should you consider in trying to arrive at a reasonable level of leverage? To a
great degree, your desired leverage position depends on the degree to which your sales
and profits fluctuate. The greater the fluctuation in sales and profits, the less leverage
you can afford. If your firm is a stable, noncyclical firm that makes money in good
times and bad, then use of debt will help improve the rate of return earned by your
shareholders. If cyclical factors in your industry or the economy at large tend to cause
your business to have both good and bad years, then debt entails a greater risk.