FINANCE Corporate financial policy and R and D Management

not written down unless there is a failure or reorganization. The zero re-
turn placed on current liabilities is thus, in a sense, a fixed return, and it ac-
cordingly widens the possibilities for gains and losses on the ownership
investment just as does any other borrowing from outside sources.
The use of current debt is a cheap method of financing; carried too far,
it may become quite risky. Current liabilities constrict the firm’s net work-
ing capital position. Although current liabilities carry a minimum interest
charge, if any, the principal amount is continually coming due. From this
point of view, fixed debt, when it can be obtained on favorable terms, is a
safer component of leverage than current debt. The interest charges on
long-term debt reduce the profits derived from successful leverage and in-
crease the possibilities of loss in case of downturn, but at least the repay-
ment of the principal of the debt is delayed into the future. Thus the firm
has a chance to recover its financial position before the due date.
Leverage is profitable if the rate of earnings on total assets is higher
than the going rate of interest on the debt. Of course, the risk to the stock-
holders of loss and failure in case of a downturn must always be consid-
ered. It is generally felt that to finance safely with leverage, the stability of
the earnings, or better the cash flow, is more important than its level.
Let us follow the Lerner-Carleton derivation of a return on equity and
the issue of leverage. The operating return on assets (ROA or R) is the ra-
tio of the firm’s EBIT to total assets. The firm pays interest on its liabilities
(L) with a coupon rate of r.

EBIT = R(Total assets)

Operating income (EBIT) = R(Liabilities + Equity) = R(L+ E)

Less interest paid = –I= r(Liabilities) = rL

Earnings before taxes (EBT) = R(L+ E) – rL

Taxes paid (–Taxes) = t[R(L+ E) – rL]

Earnings after taxes (EAT) = (1 – t)[R(L+ E) – rL]

The return on equity is given by earnings after taxes divided by equity.

ROE==

−+−

=

−+−

=−+−













EAT

E

tRL E rL

E

tRL RE rL

E

tR R r

L

E

()[( ) ]

()[ ]

() ( )

1

1

1

Definition of Leverage—Profits and Financial Risk 43