CAPITAL STRUCTURE
Financial Leverage

Centuries ago, the Greek physicist, Archimedes, gave the world the mechanical principle of leverage, which is the idea that with the specific application of levers or pulleys, substantial weights can be moved or controlled with only a fraction of the power otherwise necessary. The key is in the multiplier effect of the leverage technique applied Therefore the concept of leverage has come to mean any situation where a multiplier effect arises from the application of some technique.

In financial matters, it is a simple and direct concept. There are, essentially, only two ways to finance the income producing assets of any business enterprise: by using owners money from stock sales or net earnings, or by borrowing money. Financing by selling stock or using retained earnings requires an equal distribution of the wealth generated from the purchase of such income producing assets in proportion to the ownership interest. In other words, profit is shared proportionately among all the common shareholders, in that an equal dividend is distributed or the earnings are reinvested to proportionately increase the value of the shares. Thus using equity financing does not offer the opportunity to multiply value by a greater percentage than what is invested by the shareholder.

When money is borrowed, however, such as when bonds are sold, the cost of using the money is usually fixed and the bondholder receives a fixed return on the debt investment. Thus all money earned on the asset over the required return of the bondholder goes to the common shareholder and, therefore, the common shareholder in a growing company enjoys the multiplier effect of financing asset with fixed return dollars, with all of the excess over the required fixed interest payment going to increase the value of the common shares. Notice, however, that the assumption is that business condition are favorable. In adverse business conditions the multiplier effect operates in reverse, and having to pay the fixed cost debt regardless of market conditions can hasten the demise of a business.

Nevertheless, the borrowed dollar is an inexpensive dollar in our system, with the cost of borrowing lower than the cost of equity, and especially since the cost of debt is a tax deductible expense, while the cost of sharing profits with other shareholders cannot be deducted on the corporate income tax return. Therefore a substantial amount of borrowing is required in favorable economic conditions to earn competitive profits and to encourage further investment. A typical American company will have as much as 50% to 60% of is assets structure financed by debt in favorable economic times.

When the over all economic conditions are not as favorable, having less debt lowers the risk of business failure, since regardless of cash flow, debt has to be paid in a timely fashion. Whereas, if financing is done by reinvestment of earnings or new stock sales, there is no mandate on the part of the corporation to pay dividends, or other wise pay or reward shareholders.

The bottom line is to manage leverage and adjust to the current economic reality.


Copyright © 1998 South-Western College Publishing. All Rights Reserved.
webmaster