Financial Leverage - Understanding and Its Effects - Literature review Example

Table of Contents Table of Figures Figure 1: Firm A (Financial Scholar, 2012) 6 Figure 2: Firm B (Financial Scholar, 2012) 6 Figure 3: Relationship between Rd, Ra and D/E (Financial Scholar, 2012) 8 Financial leverage: Understanding it and its effects Financial leverage is a term that is used to refer to a level where when you get the total value of debt and equity and the ratio of debt. Other experts that talk about it describe it as an interphase where you use money that you borrow to invest and make sure that you return on that investment (Smith, 2012). The correlation between stock returns and the volatility of stock is negative. This means when the prices stocks go down, stock returns become more volatile. This can be seen when examining how expected returns are related to volatility. When there is a rise in the volatility of a stock, it is expected that the returns will increase. This, in turn, pushes the price of the stocks down (Aydemir et al., 2007). This is one explanation of how volatility and stock returns are correlated negatively. Another way to look at it is to examine it on the financial leverage of the organization. When the prices of stocks begin to drop, leverage starts to rise. This causes stock return volatility to increase significantly. However, there has never been complete agreement in the academic fields on how stock volatility is affected by financial leverage. Most studies that have been conducted tend to produce conflicting results. This is due to the fact that most of these studies face several difficulties when they are conducted. The main challenge is that when the studies are being conducted, they rely heavily on market debt valuations. These are not easy to obtain practically. In addition, there is no theorem on this subject that has been completely exhausted (Aydemir et al., 2007). For most companies, it is quite risky for them to have very high ratios of financial leverage. When the level of this leverage is on the higher side, there tends to be an increase in the profit that is anticipated by the company. So when the leverage is being used in whatever circumstance of the financial process, there has to be several alterations of cash flow and how the position of the company lies financially. According to Smith (2012), there are four main positions that have a direct relationship with financial leverage. First, there is a relation between the equity of an organization and its debt. A good example is rate of capital. The second one is how the middle level of leverage relates to the financial leverage ratio of an organization. There also is the issue of how the operating philosophy, mission and vision are related to the financial leverage of the company. Finally, there is how the leverage affects the entire production and life cycle of the organization. One major effect of financial leverage is how it affects the growth and income levels of the organization. This mainly happens in companies that are still maturing businesswise and have a lot of room for growth. The leverage ratio of any organization is not very compatible with its stability. This means that a company that has very leverage levels are not really on the same financial position as those that have a lower leverage level but still with a smaller leverage level. One other major effect that has a considerable effect on an organization’s financial leverage is how flexible it is to changes in external and internal factors. These could be from basic changes like technology to more complicated changes like political or industrial changes in the environment they operate in. Most companies that have relatively high levels of financial leverage have a low allowance to manoeuvre. This is because they are required to have first accounted their changes to creditors and other parties they are financially obliged to. In fact, when some companies get into financial agreements with creditors, they are required to sign contracts that restrict them from investing and using their capital in certain ways until the debt has been settled. This means that when companies want to change from one situation to another, they do not have the flexibility of other organizations that have a low level of leverage. Therefore, when an opportunity arises, these companies are not able to take advantage of the opportunities they have and make the changes they need to. Also, when using this phenomenon to try and raise the level of revenue of the organization, there is a significant risk. This is because at the end of the day, there still is a positive change in both the debt of the organization and its profits. This is because whenever there is an increase in profit in relation to the equity of the organization, the level of debt is still higher than the profit and for this reason, any leverage that the organization might have obtained is immediately lost (Smith, 2012). The research done by Aydemir et.al (2007) takes a look at the relationship between the dynamics of stock volatility and the financial leverage of an organization. They do this based on the assumption that the economy being explored has an interest rate that is realistic and that the market price of risk dynamics are within the accepted range. In their research, they are able to prove that from the perspective of the entire market, changes in equity volatility and financial leverage are directly proportional. They also are able to prove that a the stock volatility of a smaller firm is more affected by financial leverage, both in terms of idiosyncratic risk and market risk. They, however, emphasize that the most important variables in the dynamics of the process are interest rates and market price of risk, and how they fluctuate. When determining the rate of return in relation to the return of leverage, they calculate the difference in rate of interest and rate of debt. The result is subsequently multiplied by the amount of liability to the equity that shareholders collectively own. Most companies that are experiencing fast growth are able to allocate only little levels of leverage, unlike companies that are experiencing relatively stable growth. A look at Modigliani’s and Miller’s propositions Modern corporate economics owes a significant deal to the Miller and Modigliani propositions. According to them, the value of any firm does not depend on its capital structure. They also state that a firm’s cost of equity capital is a positive linear function of its capital structure. Modigliani explains it as follows: … with well-functioning markets (and neutral taxes) and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets. It follows, in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns – paid out as dividends or reinvested (profitably) (Villamil, n.d.). Proposition I The first proposition is that the financial value of any firm is not dependent on the capital structure of the organization. A simple way to examine this is to take a look at two organizations that have similar business operations and similar assets. This means that on the left side of their balance sheets, the columns are exactly the same. However, on the right side, there are a number of differences. The liabilities, in particular, are different. To examine them further, two diagrams will be used to illustrate. Figure 1: Firm A (Financial Scholar, 2012) Figure 2: Firm B (Financial Scholar, 2012) For the first organization, firm A, the stocks of the organization make up seventy per cent of the entire capital structure. The remaining percentage is taken up by bonds, which are debts. For the second organization, the exact opposite is true. The graphs of the two organizations appear exactly as they do because their capital structures are exactly the same. This means that, according to their first proposition, it does not matter how the debt or the equity of the firm are structured. The main factor that determines how the firm is valued is real assets and not how the capital is structured. Proposition II According to this proposition, there are three things that the value of a firm is reliant upon. These are the required rate of return on the assets of the organization, the cost of debt in any organization and how debts and equity are related. These three phenomena can be abbreviated as Ra for rate of return, Rd for cost of debt and D/E for the ratio of debt and equity of the organization. Figure 3: Relationship between Rd, Ra and D/E (Financial Scholar, 2012)1 Using the graph above, it is easy to examine their second proposition. According to the graph, Re is a straight line with a slope of (Ra-Rd). The reason the curve slopes upwards is because as a company continues to borrow more, there is an even larger risk of it going bankrupt. This means therefore that with increasing risk, there is a higher chance that the shareholders will ask for a higher rate of return in order to protect themselves from the risk. They will place the operations of the firm at even higher pressure to make sure that it does keep up with the accumulating debt and the firm is able to break even and pay off its debts comfortably without having to live too close to the brink of bankruptcy. The other curve, the WACC one, remains straight. This is an indication that there is no relationship between this variable and the debt/equity ratio. This goes back to what the proposition says, about how the organization does not depend on its capital structure when it comes to its value. Even if the company continues to borrow so much, the Weighted Average Cost on Capital remains exactly the same. There is no relationship between the two (Villamil, n.d.). Optimal capital structure Optimal capital structure may be summarized as that mix of debt and equity where the value of the firm is maximized or a situation where the cost of capital is minimized. It is a mix of the debt and the equity and how it is maintained by the firm (Roshan, 2009). It is the financial structure of that organization. This phenomenon is very important because it is a basic indication of how the firm is able to relate to and meet the needs of the stakeholders. The basis of this was introduced to the financial world through the theories of Miller and Modigliani. As seen above, their argument was based on the fact that there absolutely is no relationship between the capital structure of the firm and its value. Although there are several studies to show that there is no relationship, several other scholars argue to the contrary. One of the most famous and well known papers to argue against MM was Lubatkin and Chatterjee’s Extending modern portfolio theory into the domain of corporate diversification: Does it apply? Notably, Modigliani and Miller argued that there was no need to take tax into consideration when calculating the financial leverage. This is because, as they argue, tax subsidies on debt interest payments always cause the value of the firm to rise. This was particularly was applicable in cases where traded is traded for equity. Determining optimal capital structure There are several different methods that are used by firms when they are determining the optimal capital structure of a firm. These different methods are preferred depending on the intention of the researcher. However, most of them are based on the MM theories and those of other researchers. A paper by Smith (2011) goes about determining the optimal capital structure suing firm specific costs and firm-specific benefit functions for debt. In their research, the benefit functions when plotted on a graph slope download, showing an inverse relationship between incremental value of debt and debt itself. However, there is a direct relationship between the estimated costs of a firm and how debt is used up. This is indicated by an upward sloping curve of the cost functions. By using these functions, they are able to recommend to firms how to get the optimal amount of debt that they should use. This figure is done specifically for a firm, meaning that their model is only specific to different firms. This specificity is caused by the different costs and debt sources of and levels that the different firms have. In theoretical economics, equilibrium is usually arrived at when demand and supply are equal, or where the supply and demand curves meet. A similar approach is used by Smith, just like most other researchers. The demand and supply are replaced by marginal benefit of debt and marginal cost of debt. This is the basic definition of optimal capital structure, and how it is determined. Just like with the demand and supply scenarios coming to equilibrium, it is very difficult to find and determine optimal capital structure. It is not realistic to expect that in the real world, the marginal benefit of debt will equal the marginal cost of debt. However, organizations use this point as a target. The closer they get to the optimal value, the better their financial standing. Theoretical models are used in all aspects of science, from economics to physics and chemistry. Roshan (2009) provides a simple explanation as to why it is unrealistic to expect the real world to work the same as the theoretical models. He gives a scenario that happens in most firms across the world. In any firm, the performance of the organization is not dependent on how the top managers are compensated. In addition, most of these managers surround themselves with luxuries and other amenities that drain profits and resources, as opposed to getting the profit and sharing it among the shareholders. This is known as the principal agent problem, and it is faced by several shareholders. It is a common problem that they have to deal with in most organizations. Roshan reviews literatures in his paper and uses the information he derives from them to determine that there is strong evidence between the capital structure of a firm and its capital structure. Like many researchers, he also concludes that there is no consensus among researchers on how best to determine the capital structure of an organization. It is difficult for any firm to, for example, maximize performance while at the same time dealing with the principle agent issue discussed in previous paragraphs. There are key shortcomings in both equity as well as debt financing. Debt financing is a preferred method because there is an allowance for the deductibility of tax. There also is a mechanism that is provided to deal with how managers can behave and deal with profit sharing. Debt or Equity: A Central Choice In an article by this title, Michel Habib discusses how he believes that there is a relationship between capital structure and company valuation. His argument is particularly against the theories of Modigliani and Miller, where there are no taxes or bankruptcy costs taken into consideration. Most theories indicate that there is no relationship between capital structure and its value. However, in practice, there are several important implications of this process. How a company structures its financial policy relies heavily on its capital structure. It does so particularly when it comes to how equity and debt are structured. In order to find out just how important these elements are, the effect of how they affect business when they go wrong is a good way of indicating this. Habib expresses surprise that the key theories formed in relation to this subject are based on the Miller and Modigliani theories, which do not conform to real world scenarios. in the presence of taxes and the cost of bankruptcy, interest payments can be deducted from corporate taxes. However, dividend payments cannot. For this reason, there is usually a preference for debt financing instead of equity financing. In the real world, however, there is a problem with this because in most cases, debt financing gets affected by personal taxes. These have always been lower on equity than they have been on debt. Based on this, when making the choice about the capital structure, there is a trade-off between using taxes and the costs of bankruptcy and the choice not to. Whenever there are any changes in tax rates, these changes have a direct relationship with the capital structures of most corporations. An example given by the writer is how the US bankruptcy laws were changed in the 70s, there was a significant change in how companies constructed their capital structures. There was a significant increase in financial leverage in the subsequent years. There is also a key importance when it comes to the real world and how cash flow is affected by both the assets of the company and how they are managed. In his article, Habib indicates that there have been studies that show how there is a direct effect of capital structure on efficiency, depending on how these assets are managed. For example, if an entrepreneur wants to raise equity and expand his firm, he could raise the equity himself. If he does so, he still has to share the profits with the shareholders and it could be argued that this person could put in less effort than before he put up the equity himself. This manager could also be less reluctant to undertake business structures that are risky, unlike the stakeholders that do not have much attachment to the company since they did not invest in it. As a result, the manager might go ahead and get in unprofitable diversification simply to lower the riskiness of the cash flow of the organization. Bibliography Aydemir, A., Gallmeyer, M. & Hollifield, B., 2007. Financial Leverage and the Leverage Effect - A Market and Firm Analysis. Tepper: Carnegie Mellon University Tepper School of Business. Financial Scholar, 2012. Modigliani & Miller (M&M Propositions I & II) - Capital Structure of Corporations. [Online] Available at: HYPERLINK "http://www.financescholar.com/modigliani-miller-propositions.html" http://www.financescholar.com/modigliani-miller-propositions.html [Accessed 19 May 2012]. Habib, M., 1997. Debt or Equity? A Central Choice. Business Weekly Review, 05 April. p.78. Roshan, B., 2009. Capital Structure and Ownership Structure: A Review of Literature. Journal of Online Education, pp.1-8. Small, R.C., 2011. Optimal Capital Structure. [Online] Available at: HYPERLINK "http://blogs.law.harvard.edu/corpgov/2011/04/22/optimal-capital-structure/" http://blogs.law.harvard.edu/corpgov/2011/04/22/optimal-capital-structure/ [Accessed 20 May 2012]. Smith, D., 2012. The Effects of Financial Leverage. [Online] Available at: HYPERLINK "http://www.streetdirectory.com/travel_guide/162419/finance/the_effects_of_financial_leverage.html" http://www.streetdirectory.com/travel_guide/162419/finance/the_effects_of_financial_leverage.html [Accessed 19 May 2012]. Villamil, A.P., n.d. The Modigliani-Miller Theories. Chicago: University of Illinois University of Illinois. Read More