Financial Leverage

3 Key excerpts on "Financial Leverage"

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  eBook - ePub

  Basic principles of financial management

  • Brümmer LM, Hall JH, Du Toit E(Authors)
  • 2017(Publication Date)
  • Van Schaik Publishers

    (Publisher)

  An extension of the study of capital structure, after investigating the EBIT-EPS approach, would be to include the concept of Financial Leverage and its implications. In studying this concept, we shall observe the implications of varying capital structures in attempts to boost returns to owners, and also the implications of the financial risk associated with such variations will become evident. This concept will be discussed in the following section.

  Financial Leverage

  Introduction

  The concept of total leverage consists of two sub-concepts or levers. The first one (the primary lever) is called operating leverage, and the second (the secondary lever) is called Financial Leverage. Because of their relatively close conceptual relationship, these two sub-concepts are often discussed together. However, in order to preserve the continuity in our discussion of capital structure and Financial Leverage in this chapter, operating leverage will be discussed in the next chapter (Chapter 13 ).

  The main reason for this departure from normal practice is that Financial Leverage is more closely related to capital structure than is operating leverage, which is why they are being discussed in this chapter. In order to preserve the relationship between operating and Financial Leverage, however, there will be a certain amount of repetition in Chapter 13 to aid cross-reference. For example, the definition of Financial Leverage will be given in this section and repeated when we discuss operating leverage so that we do not lose sight of the relationship between the two concepts constituting total leverage. 212

  The reason for employing Financial Leverage

  Why would an organisation apply the principle of Financial Leverage? The answer is: in order to maximise returns to owners. This practice is followed by both creditor and debtor organisations. Consequently, knowledge of the risk implications in Financial Leverage is important to all financial managers and investors when they examine the financial position of an investment prospect.

  It is generally accepted in financial circles that maximising owners’ wealth is to be preferred to maximising profits. Nevertheless, the role of capital structure is of paramount importance in both instances of wealth and of maximising profitability. In either instance, a discussion of Financial Leverage becomes necessary.

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  eBook - ePub

  Stock Markets and Corporate Finance

  • Michael Dempsey(Author)
  • 2017(Publication Date)
  • WSPC (EUROPE)

    (Publisher)

  required rate of return on equity responds to leverage precisely as required to maintain the validity of their Proposition I. The ability to reconcile these foundational theoretical arguments of MM with the evidence of both intuition and history as summarized at the outset of this chapter, will represent the chapter’s essential intellectual challenge.

  8.2Leverage of the firm’s capital structure

  As we observed in Chapter 1 , a firm employs a mix of debt (borrowings) and equity (shareholders’ contributions) to finance its activities. The market value of the firm’s debt in relation to the combined market value of its debt and equity identifies the firm’s Financial Leverage or gearing, in what we term the firm’s capital structure. Thus, we identify the firm’s (or project’s) leverage (L) as2

  where V

  D

  denotes the market valuation of the firm’s (project’s) debt and V

  E

  denotes the market valuation of the firm’s (project’s) equity.3 The proportion of the capital structure contributed by equity is then determined as , so that we have

  The terms “leverage” and “gearing” are both descriptive words. A lever is that which on a fulcrum allows for a small force to move a greater force.4 A gear, in a car or bicycle, for example, is that which translates an input rate of revolution into a higher rate of revolution. To see why we use the words “lever” and “gear” to express a firm’s level of debt, consider the following two alternatives by which we might choose to finance an investment.

  An investment opportunity

  For many of us, a house purchase with a mortgage represents our greatest exposure to Financial Leverage.

  Suppose, you see a property, which you believe presents a good investment opportunity. Suppose that the property can be purchased for $100,000, but that you can afford only $10,000. Conceptually, two strategies to raise the full $100,000 present themselves:

  Strategy A: Become heavily levered/geared by borrowing $90,000 at, say, 10% interest per annum. In this case, you finance your investment with a combination of equity (your own cash investment, representing ownership, $10,000) and debt (your mortgage, representing borrowing

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  eBook - ePub

  Building Wealth in the Stock Market

  A Proven Investment Plan for Finding the Best Stocks and Managing Risk

  • Colin Nicholson(Author)
  • 2011(Publication Date)
  • Wrightbooks

    (Publisher)

  Chapter 10: Managing Financial and Liquidity Risks

  In the previous chapters I have discussed my strategy for dealing with the two main types of risk: market risk and specific risk. However, in devising an investment strategy, there is a need to also deal with other types of risk. The two principal risks still to be considered are financial risk and liquidity risk. Financial risk is the most straight-forward and will be dealt with first. After that, I will go through how I deal with liquidity risk. I will round out the discussion of my investment strategy by looking at several other aspects. All of them involve some element of specific or liquidity risk. They are often not given sufficient explicit attention by beginners.

  Financial risk: gearing and leverage Financial risk results from borrowing money. The more money that is borrowed, the greater the financial risk that is involved. To understand this, consider a simple example. A highly geared company may be financed like this:

  If the company makes $15 million profit (after interest payment on the debt), then the return on stockholders’ funds is 150 per cent. If the whole $60 million capital had been contributed by stockholders, then the return would have only been 25 per cent.

  This is the bright side of gearing. The dark side is that it also works in reverse. Suppose that instead of making a profit of $15 million, the company ran into trouble and made a loss of $15 million. In that case, the stockholders will have lost all their capital. The company could become insolvent and the directors or the lenders would call in receivers, unless stockholders were prepared to subscribe more capital.

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