5.2 Financial Leverage
So far, we have discussed the company’s WACC. Let us examine from a managerial perspective, the pros and cons of increasing the company’s leverage, or use of debt as a financing source of growth (think again: “EFN”). We shall see, by way of example, that leverage affects net income, EPS and ROE.
As a point of departure, we noted earlier that debt is the cheapest capital component. If so, why not leverage (i.e., increase debt) the company “all the way, i.e., to 100%”? We will see below that leverage increases interest expense, which decreases net income, a negative. However, under certain circumstances, which we shall see, leverage also increases EPS and ROE, positives, which should favorably affect share price, which are driven by earnings and dividends (assuming a constant payout ratio), as reflected in the DDM and the PE ratio.
We are given two alternate cases (Cases 1 and 2) for different capital structures – no debt, and 50/50 debt to equity. We are also given varying projected EBIT levels A, B, and C as below.
Case 1: 0% Debt, 100% Equity (10,000s. @ $20 book value per share)
Tax Rate (“T”) = 0.40
Case 2: 50% Debt, 50% Equity ($100,000 of debt; 5,000s. @ $20)
i = 0.12 and T = 0.40
($000)
| Pro-forma Income Statement | Case 1 | Case 2 | ||||
| A | B | C | A | B | C | |
| EBIT | 0 | 40 | 80 | 0 | 40 | 80 |
| Int Exp | 0 | 0 | 0 | (12) | (12) | (12) |
| T | 0 | (16) | (32) | 4.8 | (11.2) | (27.2) |
| NI | 0 | 24 | 48 | (7.2) | 16.8 | 40.8 |
| EPS | 0 | $2.40 | $4.80 | ($1.44) | $3.36 | $8.16 |
| ROE | 0 | 12% | 24% | (7.2%) | 16.8% | 40.8% |
Note:
EPS= NI ÷ NOSO
ROE= NI ÷ Equity
NOSO= the number of shares outstanding
You will note that, in Case 2A, taxes are stated as positive “4.8.” In effect, this means that the company will earn a tax “carry back” (similar to a credit on past taxes paid) or a tax “carry forward” against future tax liabilities. Taxes are usually paid; here, the corporation gets a tax benefit as either a refund on past taxes paid or a decrease in future taxes to be paid.
Let’s compare the results case by case. The chart below provides a summary.
| EBIT | Net Income | EPS | ROE | |
| 2A vs. 1A | $0 | Worse | Worse | Worse |
| 2B vs. 1B | $40,000 | Worse | Better | Better |
| 2C vs. 1C | $80,000 | Worse | Better | Better |
In all instances, the leveraged case (Case 2) increases interest expense (here from zero to $12,000), and thereby reduces net income. Case 2 is “worse” across the board. This says that, in terms of net income, the company is worse off with debt.
However, somewhere between EBIT of zero and $40,000, leverage enhances both EPS and ROE. In other words, leverage is desirable if you expect pro-forma EBIT to be beyond a certain level, a level, which we will determine mathematically below. In short, the negative impact of leverage on net income is overcome, in terms of EPS and ROE, by the relatively smaller number of shares outstanding in the presence of leverage. By using “other people’s money”