Question

What does it mean when the financial leverage of the company goes up? Is it good or bad for the company?

Answer 1

Financial leverage refers to the proportion of debt in the capital structure. It can be calculated as Total debt/Total equity or Total debt/Total assets.

The goal of financial mangement is 'maximization of shareholders' wealth', which is achieved when the net present worth of decisions is maximized. To maximize net present worth, the cost of capital [WACC] needs to be minimized. To minimize WACC, the proportion of the cheaper source of fund is to be increased. But, can that be done without any limit?

The cheaper source of capital is debt. It is cheaper for two reasons.

The first reason is that, the debt suppliers are satisfied with lower return than equity as, they have priority over the equityholers with respect to payment of return and repayment of capital.

The second reason is that, the interest on debt is tax deductible, thereby reducing the effective cost of debt to rd*(1-t) instead of rd [before tax cost of debt]

So, it pays to increase the debt content to reduce the WACC and as a result increase the net present worth of cash flows/net present worth.

But, this can be done only upto point of leverage, which is considered normal for the type of business that the firm is in. When the leverage is within this limit, both the debt suppliers and equity suppliers will be willing to supply capital at a constant rate.

Beyond such a normal leverage, the firm will be perceived as becoming increasingly risky and both the equity suppliers and debt suppliers, will start demanding more returns. The WACC will then start increasing and the NPW will decrease with additions of debt.

Hence, leverage is good up to a point considered normal for the industry in which the firm is in. Beyond that point, leverage will be bad.