Financial leverage is a technique used to multiply gains and losses by obtaining funds through debt instead of equity.
Explain the implications of leverage on a company’s risk
- In terms of investments, there exists accounting leverage, notional leverage, and economic leverage.
- In corporate finance, financial leverage involves the use of debt instruments over equity instruments to acquire additional assets, therefore keeping stakeholders at a minium and per share profits at a maximum.
- It is possible to over-leverage, which is incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments in order to maximize returns.
- There is an important implicit assumption in evaluating the risk of leverage, which is that the underlying levered asset is the same as the unlevered one.
- derivative: A financial instrument whose value depends on the valuation of an underlying asset; such as a warrant or an option.
- equity: Ownership interest in a company as determined by subtracting liabilities from assets.
- notional: Speculative, theoretical, not the result of research.
Financial leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money or buying derivatives. Examples include:
- A public corporation may leverage its equity (stocks outstanding) by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
- A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.
The term “leverage” is used differently in investments and corporate finance, and has multiple definitions in each field. In terms of investments, there exists accounting leverage, notional leverage, and economic leverage. Accounting leverage is total assets divided by the total assets minus total liabilities (or total equity). Notional leverage is total notional amount of assets plus total notional amount of liabilities divided by equity. Economic leverage is the volatility of an asset divided by volatility of an unlevered investment in the same assets.
Leverage In Corporate Finance
The concept of financial leverage is much more utilized and understood in the realm of corporate finance. Financial leverage tries to estimate the percentage change in net income for a one percent change in operating income. It involves the use of debt instruments over equity instruments to acquire additional assets, therefore keeping stakeholders at a minium and per share profits at a maximum. It is possible to over-leverage, which is incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments in order to maximize returns.
Leverage and Risk
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. There is an important implicit assumption, though, in evaluating the risk of leverage, which is that the underlying levered asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage.
From an investor’s point of view, if an individual uses a fraction of his or her portfolio to purchase derivatives and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, plus a limited downside. In short, while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. For example, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.
There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of money often end up in unfavorable situations. However, individuals who undertake such positions are not typically undertaking leverage. Instead, they are borrowing money for personal consumption. In finance, the general practice is to borrow money to buy an asset with a higher return than the cost of borrowing.
There also exists the risk of involuntary leverage. This is a situation in which a company or individual enters into financial distress and is forced to enter into a higher leveraged position. This multiplies losses as things continue to go downhill. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary.
Debt is a way for firms to access capital for operations or investment with various terms and agreements for future repayment.
Outline the characteristics of the different types of debt financing available
- A debt obligation is considered secured, if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company.
- Private debt comprises bank- loan type obligations, whether senior or mezzanine. Public debt is a general definition covering all financial instruments that are freely tradeable on a public exchange or over the counter, with few if any restrictions.
- A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan, usually many millions of dollars.
- coupon: Any interest payment made or due on a bond, debenture or similar (no longer by a physical coupon).
- unsecured debt: Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.
- Private debt: Private debt comprises bank-loan type obligations, whether senior or mezzanine.
A company uses various kinds of debt to finance its operations. The various types of debt can generally be categorized into:
- Secured and unsecured debt.
- Private and public debt.
- Syndicated and bilateral debt.
- Other types of debt that display one or more of the characteristics noted above.
A debt obligation is considered secured, if creditors have recourse to the assets of the company on a proprietary basis or otherwise ahead of general claims against the company. Unsecured debt comprises financial obligations, where creditors do not have recourse to the assets of the borrower to satisfy their claims.
Private debt comprises bank loan sorts of obligations, whether senior or mezzanine. Public debt is a general definition covering all financial instruments that are freely trade-able on a public exchange or over the counter, with few if any restrictions. A basic loan or “term loan” is the simplest form of debt. It consists of an agreement to lend a fixed amount of money, called the principal sum, for a fixed period of time, with the amount to be repaid by a certain date. In commercial loans interest, calculated as a percentage of the principal sum per year, will also have to be paid by that date, or may be paid periodically in the interval, such as annually or monthly. Such loans are also colloquially called “bullet loans”, particularly if there is only a single payment at the end – the “bullet” – without a “stream” of interest payments during the “life” of the loan.
A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan, usually many millions of dollars. In such a case, a syndicate of banks can each agree to put forward a portion of the principal sum. Loan syndication is a risk management tool that allows the lead banks underwriting the debt to reduce their risk and free up lending capacity. A bond is a debt security issued by certain institutions such as companies and governments. A bond entitles the holder to repayment of the principal sum, plus interest. Bonds are issued to investors in a marketplace when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a number of years; with long-term bonds, lasting over thirty years, being less common. At the end of the bond’s life, the money should be repaid in full. Interest may be added to the end payment, or can be paid in regular installments (also known as coupons) during the life of the bond. Bonds may be traded in bond markets, and are widely used as relatively safe investments in comparison to equity.
Lending to stable financial entities such as large companies or governments are often termed “risk free” or “low risk” and made at a so-called “risk-free interest rate”. This is because the debt and interest are highly unlikely to be defaulted. A good example of such risk-free interest is a US Treasury security – it yields the minimum return available in economics, but investors have the comfort of the (almost) certain expectation that the US Treasury will not default on its debt. A risk-free rate is also commonly used in setting floating interest rates, which are usually calculated as the risk-free interest rate plus a bonus to the creditor based on the creditworthiness of the debtor (in other words, the risk of him or her defaulting and the creditor losing the debt). In reality, no lending is truly risk free, but borrowers at this rate are considered the least likely to default.
Debt allows people and organizations to do things that they would otherwise not be able, or allowed, to do. Commonly, people in industrialised nations use it to purchase houses, cars and many other things too expensive to buy with cash on hand. Companies also use debt in many ways to leverage the investment made in their assets, “leveraging” the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the more debt per equity, the riskier. For both companies and individuals, this increased risk can lead to poor results, as the cost of servicing the debt can grow beyond the ability to pay due to either external events (income loss) or internal difficulties (poor management of resources).
Companies can use equity financing to raise money and/or increase shareholder liquidity (through an IPO).
Explain the process of financing a firm through equity
- The equity, or capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders.
- Shares represent a fraction of ownership in a business. A business may declare different types or classes of shares, each having distinctive ownership rules, privileges, or share values.
- In finance, the cost of equity is the return (often expressed as a rate of return ) a firm theoretically pays to its equity investors, (i.e., shareholders ), to compensate for the risk they undertake by investing their capital.
- Preferred Stock: Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock and that has priority to common stock in liquidation.
- Common stock: Shares of an ownership interest in the equity of a corporation or other entity with limited liability entitled to dividends, with financial rights junior to preferred stock and liabilities.
- par value: The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.
The equity, or capital stock (or stock) of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is different from the property and the assets of a business which may fluctuate in quantity and value.
The stock of a business is divided into multiple shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the minimum amount of money that a business may issue and sell shares for in many jurisdictions, and it is the value represented as capital in the accounting of the business.
Shares represent a fraction of ownership in a business. A business may declare different types or classes of shares, each having distinct ownership rules, privileges, or share values. Ownership of shares is documented by the issuance of a stock certificate. A stock certificate is a legal document that specifies the amount of shares owned by the shareholder, and other specifics of the shares, such as the par value, if any, or the class of the shares.
Stock typically takes the form of either common or preferred. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.
Financing through Equity
The owners of a private company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use. They can achieve these goals by selling shares in the company to the general public, through a sale on a stock exchange. This process is called an Initial Public Offering, or IPO.
By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends.
Public companies may issue additional shares (thus diluting current equity holders) to raise money to fund operations or capital investments.
Financing a company through the sale of stock in a company is known as equity financing. Alternatively, debt financing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company. Unofficial financing known as trade financing usually provides the major part of a company’s working capital (day-to-day operational needs).
Cost of Equity
In finance, the cost of equity is the return, often expressed as a rate of return, a firm theoretically pays to its equity investors, (i.e., shareholders) to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest and equity investors seek dividends and/or appreciation in the value of their investment (capital gain). From a firm’s perspective, they must pay for the capital it obtains from others, which is called its cost of capital. Such costs are separated into a firm’s cost of debt and cost of equity and attributed to these two kinds of capital sources.
While a firm’s present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. According to finance theory, as a firm’s risk increases/decreases, its cost of capital increases/decreases. This theory is linked to observation of human behavior and logic: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier investment instead of a safer one. If an investment’s risk increases, capital providers demand higher returns or they will place their capital elsewhere.
Three common examples of long term loans are government debt, mortgages, and debentures (bonds).
Outline the characteristics of three types of long term loans: debt, mortgages and bonds
- Government debt (also known as public debt or national debt) is owed by a central government. Government debt is one of several methods of financing government operations.
- A mortgage is a loan secured by real property. It requires a mortgage note affirming the existence of the loan and the encumbrance of the realty through the granting of a mortgage securing the loan.
- A debenture is a document that either creates or acknowledges a debt, and the debt is one without collateral.
- Long term loans: Loans that are generally understood to be over a year in duration – often much longer.
Long Term Loans
Long term loans are generally over a year in duration and sometimes much longer. Three common examples of long term loans are government debt, mortgages, and bonds or debentures.
Government debt (also known as public debt or national debt) is the debt owed by a central government. Government debt is one of numerous methods of financing government operations.
Governments may create money to monetize their debts, thereby removing the need to pay interest. This practice, also known as quantitative easing, reduces government interest costs but does not actually cancel government debt. Governments usually borrow by issuing securities, government bonds, and bills. Less creditworthy countries sometimes borrow directly from a supranational organization (e.g., the World Bank) or international financial institutions.
Government bonds are issued by a national government. Such bonds are often denominated in the country’s domestic currency, and they are sometimes regarded as risk-free bonds, as national governments can raise taxes or reduce spending up to a certain point. In many cases, governments print more money in order to redeem the bond at maturity. Most governments in developed countries are prohibited by law from printing money directly, as this function is generally assigned to their central banks. However, central banks may buy government bonds in order to finance government spending, thereby monetizing the debt.
A mortgage is a loan secured by real property. It requires a mortgage note affirming the existence of the loan and the encumbrance of the realty through the granting of a mortgage securing the loan. In U.S. property law, a mortgage occurs when an owner (usually of a fee simple interest in realty) pledges his or her interest ( right to the property) as security or collateral for a loan.
A home buyer or builder can obtain a loan to purchase or secure against the property from a financial institution, such as a bank, or either directly or indirectly through intermediaries. Features of mortgage loans such as the size of the loan, maturity of the loan, interest rate, method of paying off the loan, and other characteristics can vary considerably.
Mortgage loans are generally structured as long term loans, the periodic payments for which are similar to an annuity and calculated according to the time value of money formulae. The most basic arrangement requires a fixed monthly payment over a period of ten to thirty years, depending on local conditions. Over this period, the principal component of the loan (the original loan) is slowly paid down through amortization. However, many variants on this arrangement are possible within different countries.
Many types of mortgages are used worldwide, though several characteristics, subject to local regulations and legal requirements, define most mortgages:
- Interest: Interest may be fixed for the life of the loan or variable, and it may change at certain pre-defined periods; the interest rate may rise or fall.
- Term: Mortgage loans generally have a maximum term, or a number of years after which an amortizing loan will be repaid. Some mortgage loans may have no amortization or require full repayment of any remaining balance at a certain date; others may have negative amortization.
- Payment amount and frequency: The amount paid per period and the frequency of payments may change, or the borrower may have the option to increase or decrease the amount paid.
- Prepayment: Some types of mortgages may limit or restrict prepayment of all or a portion of the loan, or they may require payment of a penalty to the lender for prepayment.
A debenture is a document that either creates or acknowledges a debt, and the debt is one without collateral. In corporate finance, debenture refers to a medium- to long-term debt instrument used by large companies to borrow money. In some countries, the term is used interchangeably with bond, loan stock, or note. A debenture thus resembles a certificate of loan or a loan bond, evidencing the fact that the company is liable to pay a specified amount with interest. Although the money raised by the debenture becomes part of the company’s capital structure, it does not become share capital.
In general, debentures are freely transferable by the debenture holder. Debenture holders have no right to vote in the company’s general meetings of shareholders, but they may hold separate meetings or votes (regarding, for instance, changes to the rights attached to the debentures). The interest paid to debenture holders is a charge against profit in the company’s financial statements.
A corporate bond is issued by a corporation seeking to raise money in order to expand its business.
Explain how an organization can finance their operations through bonds
- The term corporate bond is typically applied to longer-term debt instruments with a maturity date falling at least a year after the issue date.
- Corporate bonds are often listed on major exchanges (and referred to as listed bonds) and ECNs, and the coupon (i.e., the interest payment) is usually taxable.
- Corporate debt falls into several broad categories: secured debt and unsecured debt; senior debt and subordinated debt.
- default: The condition of failing to meet an obligation.
A corporate bond is issued by a corporation seeking to raise money in order to expand the business. The term corporate bond is usually applied to longer-term debt instruments with a maturity date falling at least a year after the issue date. (The term commercial paper is sometimes used for instruments with a shorter maturity period. ) Sometimes, corporate bond is used in reference to all bonds with the exception of those issued by governments in their own currencies. Strictly speaking, however, the term only applies to bonds issued by corporations.
Corporate bonds are often listed on major exchanges (and known as listed bonds) and ECNs, and the coupon (i.e., the interest payment) is usually taxable. Sometimes, the coupon can be zero with a high redemption value. However, though many are listed on exchanges, the vast majority of corporate bonds in developed markets are traded in decentralized, dealer-based, over-the-counter markets.
Corporate bonds and corporate debt fall into several broad categories:
Secured loan /debt:
A secured loan is one in which the borrower pledges some asset (e.g., a car or property) as collateral for the loan, which in turn becomes a secured debt owed to the creditor of the loan. The debt is thus secured against the collateral, and in the event that the borrower defaults, the creditor takes possession of the collateral asset and may sell it in order to recover some or all of the amount loaned.
The opposite of secured debt is unsecured debt, which is not linked to any specific piece of property. In the case of unsecured debt, the absence of collateral means that the creditor may only satisfy the debt against the borrower. The comparative security of secured debt for the lender generally results in lower interest rates for secured than for unsecured debt. However, the borrower’s credit history and ability to repay, as well as the expected returns for the lender, are factors that also affect rates.
Senior debt, frequently issued in the form of senior notes and sometimes referred to as senior loans, is debt that takes priority over unsecured or junior debt owed by the issuer. Senior debt has seniority over subordinated debt in the issuer’s capital structure. In the event of bankruptcy or liquidation, senior debt must be repaid before any other creditors receive payment. Senior debt is often secured by collateral on which the lender has placed a first lien, which typically covers all the assets of a corporation and is frequently used in the resolution of credit lines.
Subordinated debt is repaid after other debts in the case of liquidation or bankruptcy. Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status relative to the normal debt. Subordinated debt has a lower priority than the issuer’s other bonds and ranks below the liquidator, government tax authorities, and senior debt holders in the hierarchy of creditors. Because subordinated debt is repaid only after other debts have been paid, they are riskier for lenders. Subordinated debt is also unsecured and has a lower priority than any additional debt claim on the same asset.
In the event of a default, the higher one’s position in the company’s capital structure, the stronger one’s claims to the company’s assets.