The degree to which a company or an investor utilizes the borrowed money is known as leverage. Leverage is a very commonly used term in all fields in the world. Relating it to physics, leverage denotes the use of a lever and a small amount of force to lift a heavy object. Similarly, in Business leverage refers to the use of a relatively small investment or a small amount of debt to achieve greater profits. That is, leverage is the use of assets and liabilities to boost profits while balancing the risks involved. In business, we can commonly refer to two types of leverage: Operating Leverage and Financial Leverage. Operating Leverage relates the Operating costs of a firm with its total sales whereas financial leverage is concerned with the profits of a firm together with its earnings per share. And when we combine both Financial and Operating Leverage of a firm we account for the Total Leverage of a company.
A mini example to explain the use of leverage: A company X wanted to implement an IT program that was going to cost £1,000,000. The company contributed £200,000 and borrowed £800,000 to fund the project. A year later after the project was implemented; company X generated an extra £2,000,000 in profits because of the project. Ignore the cost of borrowing the money and assume that the company repaid the borrowed £800,000. The company gained £1,800,000 in profits even after they repaid themselves for funding the project. This clearly shows how using leverage in certain circumstances really pays off for a company. It may lead to certain types of risk which could lead a company to go bust, but would happen in cases where a company uses excess leverage to finance its projects. The most obvious risk of leverage is that it multiplies losses. A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive.
In the past, various scholars have designed various models to show how leverage is important from a company's prospective to attain profits. There have been various arguments about the use of leverage by firms in order to increase their growth and profitability and contradictions to how a company can lose everything depending on their use of leverage. Modigliani and Miller (1958) argued that the investment policy of a firm should be based only on those factors that will increase the profitability, cash flow or net worth of a firm. Many empirical literatures have challenged the leverage irrelevance theorem of Modigliani and Miller. The irrelevance proposition of Modigliani and Miller will be valid only if the perfect market assumptions underlying their analysis are satisfied. However, the corporate world is characterized by various market imperfections, due to transaction costs, Institutional Restrictions and asymmetric information. The interactions between management, shareholders and debt holders will generate frictions due to agency problems and that may result to under-investment or over-investment incentives. As stated earlier, one of the main issues in Corporate Finance is whether financial leverage has any effects on investment policies.
Modigliani et al (1963) argued that we should not "waste our limited worrying capacity on second-order and largely self-correcting problems like financial leveraging". That is firms should not be worried about till they are having good projects in hand, they will be able to find means of financing those projects. Myers (1997) has examined possible difficulties that firms may face in raising finance to materialize positive net present value (NPV) projects, if they are highly geared. Therefore, high leverages may result to liquidity problem and can affect a firm's ability to finance growth. Under this situation, debt overhang can contribute to the under-investment problem of debt financing. That is for firms with growth opportunities debt have a negative impact on the value of the firm. (Journal of Business Case Studies - September 2008)
We are now going to demonstrate by means of a model the various possibilities that may arise due to the use of financial leverage and its effects on the company's profits and losses.
Suppose a company XYZ invests in a huge piece of land to make huge profits in a few years' time. It invests £ 100,000 and in one years' time sells the land for £130,000. In this case the company pays full cash of £100,000. So the return on investment for XYZ Company is 30% and the profit before taxes in £30,000. Now, consider a case where a company decides to use financial leverage for the same piece of land. It decides to invest £10,000 cash from its pockets and borrow £90,000 from the bank at an interest rate of 15%. This time when XYZ sell the piece of land for £130,000 they return £90,000 to the bank along with £13,500 as bank interest (@15%). After deducting the initial investment amount of company XYZ from the remaining amount, the pre-tax profit for the company is £16500. Calculating the return on investment in this case comes out to be 165%. Note that the company had a net profit of £ 30,000 without leverage, but only £ 16,500 in the leveraged case. Although they earned a higher return, they had less profit. That's because in the unleveraged case they had invested £ 100,000 of their money, but in the leveraged case they had invested only £ 10,000.
Suppose, however, that the land were sold after one year for £ 70,000 rather than £ 130,000. On £100,000 unleveraged investment, the loss would be £ 30,000 before taxes. This would be a 30% loss on the original investment. In the leveraged case, the loss will be magnified. XYZ would have to repay the bank the £90,000 loan plus £13,500 of interest. These payments total to £103,500, which is £33,500 greater than the £70,000 proceeds from the sale. Further, the initial £10,000 investment was lost. The total loss is £43,500 before taxes. On the initial investment of £10,000, this constitutes a loss of 435%. That's a part of financial leverage too!
Let us put that into a table so as to see the effect of financial leverage more clearly:
(All values in GBP (£))
Original Investment
Amount Borrowed
Profit / Loss Amount
Profit / Loss Percent
100,000
NIL
30,000
30%
10,000
90,000
30,000
165%
100,000
NIL
(30,000)
(30%)
10,000
90,000
(43500)
(435%)
Clearly when the firm is going to accept this level of leverage it must decide if the165% possible gain is worth the risk of a 435% loss. Whether it is or not depends on the likelihood of the increase in value versus the probability of a decline. Of course it can accept a lower level of leverage but still the interplay of debt and equity would be there and a study of its effects in both the good times and the bad times would be important.
