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Leverage Implications of Debt Financing Choices

LEVERAGE IMPLICATIONS OF DEBT FINANCING 8

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Financial leverage is a term used to refer to how far a businesscompany relies on debt. The greater debt financing a company uses inits capital structure, the greater financial leverage it incurs (Chen&amp Xu, 2012). This paper is going to evaluate the leverageimplications of debt financing choices with inclusive ofdecomposition of Return on Equity (ROE) model as well as graphicalassessment of leverage implications on Earnings per Share (EPS).

Many firms make borrowings in order to finance its operations.Leverage is measured by total liabilities to equity. Nonetheless,when some liabilities for instance bank loans are as a result offinacing, others are as a result of transactions with employees,suppliers and customers. Financial leverage can change the earningsto the company`s shareholders in a drastic way. Significantly,nevertheless, financial leverage may not have an impact on capital’sgeneral cost. If financial leverage doesn`t affect the general costof capital, then the company`s capital structure becomes unnecessary,since alterations in capital structure will not affect the company`svalue in any way (Chen &amp Xu, 2012).

Financial leverage, without taxes, has an impact on Earnings perShare (EPS) and Return on Equity (ROE). Return on Equity ratio orreturn on capital is the net income of a firm during the year to itsinvestor’s equity during the year. It is a measure of gain abilityof shareholders investment reflects net income as a percentage ofstockholder equity.

ROE = Annual Net income / Average Shareholders Equity. Net income isthe income after tax. Average shareholders’ equity is calculated bydividing the sum of shareholders equity at the beginning and the endof the year by two. Net income is fetched from income statement andaverage shareholders’ equity is gotten on balance sheet. Tocalculate average shareholders’ equity, one needs balance sheets ofthe end of the year for two simultaneous financial years.

For example, say a firm earned net income of 5,322,000 during theyear ended March 31 2012. The shareholder equity ratio on April 302011 is 18, 987,000 and March 31 2012 is 20,398,000. The firm`s ROEwould be calculated as follows

Average shareholders’ equity = 18,987,000+20,398,000/2

=19,692,500

Therefore ROE will be = 5,322,000/19,682,000

=0.27

= 27%.

EPS is the proceeds amount that is entitled for commonstockholders. In simpler terms it is the proportion of a firms’profit being allocated to every share of a capital stock. Itpositions itself as indicator of a firm’s profitability. It isworth noting that, EPS can be dispatched in terms of dividends,reinvested and retained by the firm or a combination of the two. Anyfirm that is owned publicly, in accordance to generally acceptedaccounting principle (GAAP) has to have earnings per share (EPS)beneath the net income line in its income statement. EPS is sorelevant because it gives shareholders a way in knowing the amountthe firm earned on its stockholder investment. EPS ratio iscalculated by Net income added to total number of capital stockshares (Garger, 2010). In its calculation, weighted average of sharesoutstanding is used. This is because shares outstanding usuallychange with time.

Analysis

A firm is completely financed by common stock, with an outstanding3,000 common stock shares. Additionally, the company does not pay anycommon stock dividends, and the entire profits are reserved in orderto be reinvested into the company (Tully &amp Bassett, 2010). Thefirm needs to raise 75,000 in new money. The bracket tax is 25%. Whatfinancial alternative should the financial manager use to raise themoney? To raise 75,000, financial manager is considering 3alternatives common stock, which means that the firm may vend theextra shares at the present price of 75 per share. As a result, thissignifies that 1,000 fresh shares will need to be sold (Tully &ampBassett, 2010). The preferred stock of (75,000/75 per share)indicates that the dividend yield on stock will be 6.2% of the amountmoney raised (Preferred can be sold at 50 per share), and theinterest for debt will be 6% annually. EBIT (earningsbefore interest and taxes) will be 15,000. For the 3financing alternatives, the EPS will be

Common stock preferred stock Debt

Price per share 75.00 50.00 N/A

Yearly rate N/A 6.2% 6%

Common stock 225,000 225,000 225,000

+Additional Funds +75,000 +75,000 +75,000

Total funds 300,000 300,000 300,000

EBIT 15,000 15,000 15,000

-interest expenses 0 0 3,000

Earnings before Tax 15,000 15,000 12,000

-Taxes @ 25% -3,750 -3,750 -3,000

Net income 11,250 11,250 9,000

-preferred [email protected] 6.2% 0 4650 0

Earnings available to common 11,250 6,600 9,000

No. of common shares 5,000 3,000 3,000

EPS 2.25 2.2 3.0

It is worth noting that, the table above reflects the incomeper share at an EBIT level of 15,000. In case the sales are greatlyhigh to reflect an EBIT level of 15,000, then the EPS is going to begreatest by giving debt, next highest by giving common stock andfinally the least by giving preferred stock. Nevertheless, this paperuses a chart of EPS over EBIT (Tully &amp Bassett, 2010). As aresult, this will greatly help people understand the connectionbetween EBIT and EPS completely. As EBIT grows, earnings per shareincreases as well. Assuming the firm`s EBIT wont fall below 3,000 andthe highest EBIT value in the next four years will be 20,000. It isworth noting that, the chart reflects the four values of EBIT. Theseare 3,000, 10,000, 15,000 and 20,000.

The EBIT/EPS chart

From the above graph, it shows that the debt alternative is higherthan common and preferred stocks. This means that, debt is notexpensive form of financing choice that the finance manager for thisfirm can choose since it will have greater protection in case ofbankruptcy. Another very important advantage of using debt financingchoice is that interest on debt is tax free whereas common stockdividends aren’t free from tax (Tully &amp Bassett, 2010).Looking at this example, it implies that EPS will always begreater under debt financing as compared to common stock financingsince they offer same effects of leverage under fixed rate (e.g., 6%and 6.2%). Preferred stock financing choice has a minimum level ofleverage. Debt financing will offer the greater earnings per sharewhich is a big advantage to the firm (Tully &amp Bassett, 2010).

As noted by Mooij &amp Keen (2013),signaling theory states that alteration individend policy shows information on transitions in coming period’scash flow. It proposes good relationship between asymmetryinformation and the dividend policy. It illustrates that, the greaterthe information asymmetry, the greater the sensitivity of dividendsin future cash flows of a company. Thus, signaling theory in financeis a phrase used to explain the actions of two departments that havevariable information. It illustrates that corporate financialdecisions are signs that are sent by financial managers toshareholders in order to make them shake up (Mooij &amp Keen,2013). Constraining manager theory is amanagement model that attempts to look at any management system of afirm as having limitations or shortfalls in endeavoring to achieveits vision and mission. Constraint manager theory says that theremust be at least one constraint in the organization of a firm andidentifies this through a focusing process and also reorganizing theremaining organization with it. Constraining manager theory can bewell applied in various steps. The first step is to know theconstraint. What is the weakest link because this is an effect thatholds back the managers in most cases? Is it lack of training andskills for the staff or lack of communication among the staff or evenweak team-work?

In the pecking order theory, finances arefetched from mostly three sources. These are internal funds, newequity and debt. Most firms choose internal funds followed by debtfinancing choice and lastly equity. In case internal funds financingoption fails then debt is issued and if it is depleted, the lastresort will be issuing equity (Garger, 2010).Pecking order theory begins with asymmetrical information sincefinancial managers understand their firm’s expectations, crisis aswell as value compared to external shareholders. Irregularinformation has an effect in choosing from outside funds and internalfinancing choice as well as equity and debt. Asymmetrical informationtends to favor the debt choice compared to equity (Tully &ampBassett, 2010).

As noted by Mooij &amp Keen (2013), awindow of opportunity is the period when an asset that is unreachablewill become accessible. This theory has to be considered by a companyso as to buy assets or capital in order to get more acquisition orreturn. In corporate finance, a window of opportunity basically is anotion of a time when a product that was thought to be not attainablewill eventually become available. Managers should take windows ofopportunity into consideration so as to minimize costs and maximizereturns (Tully &amp Bassett, 2010).This will make the company be seen as the best investment forcreditors. For instance, when a company gives an Initial PublicOffering (IPO), it gets much more shareholders to give it capital forthe company`s future expansion, debt repayment or even workingcapital. IPO will issue `a window of opportunity` to the viableshareholders to get on new equity by the time the company can affordit. This will have a huge return on investment, which will beattainable (Tully &amp Bassett, 2010).

Conclusion

From the above discussions, some organizations tend to makeuse of more debt while others don`t. This mostly depends with themanagers` decisions. Actual debt choices differ in variousorganizations as well. But in most cases, those organizations thatuse debt choices seem to be more advantageous then choosing eitherequity, internal funding financial choice, preferred stock as well ascommon stock choices.

References

Chen, H., &amp Xu, Y. (2012). Systematic risk, debt maturity, andthe term structure of credit spreads. Cambridge, Mass.: NationalBureau of Economic Research.

Garger, J. (2010). The Leverage Factor in Corporate FinancialPlanning. Retrieved From,http://www.brighthub.com/office/finance/articles/18890.aspx

Mooij, R. A., &amp Keen, M. (2013). Taxation, bank leverage, andfinancial crises. Washington, D.C.: International Monetary Fund.

Tully, S., &amp Bassett, R. (2010). Restoring confidence in thefinancial system see-through leverage a powerful new tool forrevealing and managing risk. Hampshire, Petersburg: HarrimanHouse Ltd..