Chapter 13 The Leverage Effect: Compounds Success and Accelerates Death

• Jurisdiction: United States

Chapter 13: The Leverage Effect: Compounds Success and Accelerates Death

A. Debtor Beware: The Double-Edged Sword of Financial Leverage¹⁰⁸

An aphorism attributed to Archimedes states, "Give me a lever long enough and a place on which to stand, and I shall move the world." Archimedes, a scientist and engineer, was commenting on the power of leverage to manipulate physical objects. This observation, however, is also relevant to financial economics and, in particular, when considering bankrupt or financially distressed companies.

Dealing with financial distress and bankruptcy can be complicated. Financially distressed companies and their stakeholders and financial advisers are often forced to focus on present and pressing issues. For debtor company management or restructuring advisers, this may include preserving liquidity, maintaining core businesses, selling non-operating assets, and obtaining financing. For stakeholders, it may involve discussions with the debtor company and taking legal action to protect the debtor's rights. While such activities are necessary, taking the time to gain a broader perspective on certain issues is also important. One of the higher-level issues that merits attention in any situation involving bankruptcy or financial distress is the debtor company's past, present and (possibly) future financial leverage.

What Is Leverage?

The simplest definition of "financial leverage" is the amount of debt that a company incurs to finance its assets. Financial ratios are often used to capture this concept, with one of the most common ratios being the debt to equity ratio (computed by dividing debt by equity). Consider, for example, a company that has $100 in assets. These assets are financed by $50 in debt and $50 in equity capital. The debt-to-equity ratio would be 1 (50^50=1), indicating that for every dollar of debt used to finance the company's assets, one dollar of equity was also committed. A similar company with $95 in debt and $5 in equity capital would have a leverage ratio of 19 ($95/$5=19). The higher the debt to equity ratio is, the higher the company's financial leverage.

Although important, simply examining a debtor company's debt to equity ratio may cause one to miss important elements of leverage. A company's effective leverage may be increased with mezzanine financing, management of payables, an off-balance sheet special purpose financing vehicle, and unfunded pension liabilities. Depending on the situation, almost any corporate financial obligation contributes to the company's leverage.

Regardless of its form, leverage is a powerful tool that is typically managed at the highest level in the debtor company. There is often tension as management, owners and corporate boards struggle to set proper policies that balance out the potential positive and negative effects of leverage.

Positive Aspects of Leverage

Leverage can have a number of beneficial uses, including enhancing a company's returns to equity holders. Most forms of leverage have a lower cost than that of equity capital, meaning that levering the company can reduce its overall cost of capital and improve returns. Also, certain types of leverage carry income tax advantages. Interest on corporate debt, for example, is typically tax deductible.

Consider, for example, a company with assets of $100 that earns $20 of income per year. Its return on assets (ROA) is 20 percent, and if financed entirely by equity capital, its return on equity is also 20 percent. Now consider an alternative capital structure in which the company finances its assets with equity of $50 and debt of $50 at an after-tax interest rate of 10 percent (or $5 annually). In this case, following after-tax interest payments, only $15 is left over for equity holders. However, the equity base is half the size it was. Therefore the return to equity holders, per dollar committed, is 30 percent ($15 + $50 = 30 percent). Thus, financial leverage has increased equity holders' returns, even though the actual productive capacity of the company's assets has not changed.

As a general rule, when a company's cost of debt (interest) is less than its ROA, leverage will improve shareholder returns. When its cost of debt is greater than its ROA, the reverse is true. In other words, leverage enhances both positive and negative financial results.

Using financial engineering to increase equity returns is quite common. For example, companies often buy back their stock from investors and sometimes even borrow money to do so. Fewer shares outstanding means that profits, on a per-share basis, are higher, even if the overall profitability of the company is constant or declining. Similarly, companies may elect to finance new projects using various types of leverage, including new debt, rather than by raising additional equity. The attractiveness of such a policy is that the majority of investor returns earned from new products and services go to existing equity holders.

Another goal of leverage may be to help existing owners or managers maintain corporate control. If a debtor company determines that it needs additional capital, raising new equity may bring complications. New issuances may dilute existing shareholders' stake in the company and their influence over corporate strategy as new investors request board directorships, lobby for management or strategic changes, and otherwise disrupt the company's status quo. Increasing leverage rather than equity circumvents these issues, and therefore it is a tempting strategy for managers who are concerned about control.

Analysts sometimes encounter corporate managers and boards increase leverage to make the company less attractive as a takeover candidate. Many leveraged buyout firms finance their acquisitions by borrowing...