Financial Leverage and Value Creation

Optimal level of leverage

In general, financial leverage creates value (tax-shield) for the firm. However, optimal level of
financial leverage is an outcome of trade-off between benefits of leverage and risk (of financial
distress, bankruptcy etc.).

MM Proposition – I (assuming T= 0)
✔ Financial Leverage has no impact on firm value
Illustration 1:
Assume two firms (Firm A & Firm B) having same level of operating income.
Firm A (all equity firm): Market value equals to INR 100 crore
Firm B (levered firm): Market value equals to INR 150 crore
As both the firms generates same operating income. Investors of Firm B decided to sell 50%
stake for INR 75 crore and buy 50% stake in Firm B using INR 50 crore. Thus, Investors of
Firm B are left with surplus INR 25 crore but have same operating income. Thus, using home-
made leverage, investors of Firm B may have an advantage. High supply (sale pressure) of
Firm B stocks and high demand (buy pressure) of Firm A stocks remove this opportunity and
both are priced same. Therefore, Firm A and Firm B have the same valuation.

MM Proposition – II (assuming T= 0)
✔ Required/expected return of equity holders increases with leverage
Illustration 2:
As both firms, unlevered and levered, have same operating income and valuation. Therefore,
both firms will have same overall cost of capital (R0).
𝐸 𝐷
𝑅0 = 𝑉 * 𝑟𝑒 + 𝑉 ∗ 𝑟𝑑
𝐷
⇨ 𝑟𝑒 = 𝑅0 + (𝑅0 - 𝑟𝑑 ) * 𝐸

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MM Proposition – I (T ≠ 0)
𝑉𝐿 = 𝑉𝑈 + Tax-shield

✔ Firm’s value is maximized at 100% debt

✔ Tax-shield = Tax rate * Value of the debt (T*D)
𝑉𝑈 = EBIT * (1-T)/𝑟0

MM Proposition – II (assuming T ≠ 0)

𝑅0 = 𝑟𝑒 * E/V + 𝑟𝑑 * (1-T) * D/V

On rearranging,
𝐷
𝑟𝑒 = 𝑅0 + (𝑅0 - 𝑟𝑑 ) * (1 – T) * 𝐸

✔ WACC is minimized at 100% debt

Valuation Methods
● Adjusted Present Value (APV) approach
● Flow to Equity (FTE) approach
● WACC approach
APV approach:

✔ Useful when quantum of new debt raised is known

PV of project (new) = PV of project (old) + additional value created (tax-shield)
NPV project (new) = NPV project (old) + additional value created (tax-shield)
FTE approach:
Levered CFs to equity holders (LCF) = Income after paying interest and taxes
PV of project = LCF/ cost of equity
NPV project = PV of project - Equity investments
WACC approach:
Unlevered CFs (UCF) = Income after paying taxes but before interest
𝑊𝐴𝐶𝐶 = 𝑟𝑒 * E/V + 𝑟𝑑 * (1-T) * D/V
PV of project = UCF/ WACC
NPV project = PV of project – total investments

Note: FTE and WACC approaches are helpful for known financial leverage (ratio)
ss

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 Project Analysis
Project analysis is very critical to select a project that creates value for the shareholders. Risks
associated with a project must be analysed properly before accepting a project. One should not
be caught by surprises if things go wrong later. Proper analysis helps in early detection of
danger signals and ready to apply corrective measures if required.
As forecasts are based upon assumptions, an element of uncertainties is always there. Project
analysis helps to analyse the impact of uncertainty over the project outcome.
Project Analysis Techniques:
a) Sensitivity Analysis
b) Three Level Estimates
i) Optimistic ii) Most Likely iii) Pessimistic
c) Scenario Analysis
i) Expected Value Method ii) Decision Tree Method

d) Break-Even Analysis
e) Monte Carlo Simulation
Sensitivity analysis measures impact of one variable over project’s outcome. Key variables,
adversely affecting the project, are identified and ranked. Rank one denotes maximum change
in outcome (smallest NPV) because of changes in assumptions. Margin of safety suggests the
percentage change (of one variable) a project may absorb before changing the decision (accept
to reject).
Scenario analysis estimates probability of occurrence of each scenario and expected NPV is
computed. In decision tree model, at each node decision about the project is made. If not worth
moving ahead, project is dropped.
Break-even analysis is useful in analysing minimum sales to recover investments. Sometimes
managers pose it differently, like how much bad sales can get before the project begins to lose
money.
Monte Carlo Simulation (MCS) is based upon random selection an event (CFs) from a list of
possible events for each variable and project outcome is calculated. Same process gets repeated
multiple times. Thereafter, project outcomes are interpreted.
Step-1: Identify the important variables and factors influencing each variable
Step-2: Define probability for each variable
Step-3: Assign a number range corresponding to the probability of each outcome
Step-4: Run the simulation (generate multiple sets)
Step-5: Calculate present values and interpret the simulation results
Note: As all topics but Monte Carlo simulation were covered in FM-I, our discussion would be
limited to MCS. For solved examples of each type, kindly refer PPT on Project Analysis.

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Illustration 3:
Assume a project with life of two year requires initial investments of INR 50,000. Under
different scenarios, income generated from the project are as follows:
Year 1:
INR 20,000 (P = 0.20)
INR 40,000 (P = 0.40)
INR 60,000 (P = 0.40)
Year 2
INR 20,000 (P = 0.40)
INR 40,000 (P = 0.20)
INR 60,000 (P = 0.20)
INR 80,000 (P = 0.20)
Solution:
Step-1: Identify the important variables and factors influencing each variable
Here impact of the important variables is summarised. There are three variables in year-
1 and four variables in year-2.
Step-2: Define probability for each variable
Year 1:
INR 20,000 (V1: 20%); INR 40,000 (V2: 40%); INR 60,000 (V3: 40%)
Year 2
INR 20,000 (V1: 40%); INR 40,000 (V2: 20%)
INR 60,000 (V3: 20%); INR 80,000 (V4: 20%)
Step-3: Assign a number range corresponding to the probability of each outcome
Probabilities are multiple of 20%. Numbers (1-5) are selected (one number represents
probability of 20%).

Year 1: Number 1 is assigned to V1, Number 2 & 3 to V2, and number 4 & 5 to V3.
Year 2: Number 1 & 2 are assigned to V1, Number 3 to V2, Number 4 to V3 and number
5 to V4.

Step-4: Run the simulation (generate multiple sets)

Let’s assume random numbers generated are as follows:
Set 1: (3, 4)
Set 2: (3,3) … and so on.

Step-5: Calculate present values and interpret the simulation results

Corresponding cash flows for year 1 and year 2 are:
Set 1: (3, 4) => (V2, V3) => (40K, 60K)
Set 2: (3, 3) => (V2, V2) => (40K, 40K) … and so on.

Calculate the present value and project NPV for each set. Now interpret the results.

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 Financing Decision

Financing Decision
The goal of the financing decision is to maximize net present value, like investment decision.
However, it’s hard to add value through financing decision as capital markets are very
competitive. Majority of investment decisions are unique, but comparable financial assets are
available. Opportunity of having positive NPV of financial investment is rare and largely
depends upon the market efficiency.

Bubble Theory:
Applies to any asset that rises well above its fundamental value
Investor expectations can drive prices higher than anticipated
Untimely correction may be rapid, and investors may lose faith
Illustration 4:
Assume a firm declared dividend of INR 40 per share and expected return per annum is 10%.
From dividend model:
Share Price = 𝐷0 (1 + 𝑔)/(𝑟 − 𝑔)
To get the share price, a major assumption about the firm growth rate (g) is required.
𝑆1 = 2,160 [g = 8%]
𝑆2 = 4,360 [g = 9%]
Kindly note, variation of just one percent in growth rate leads to very high variation in the
share price. Therefore, a small variation in important parameters may lead to huge change in
prices.

Efficient Market Hypothesis (EMH)

An ‘efficient’ market is defined as a market where there are large numbers of rational, profit
‘maximisers’ actively competing, with each trying to predict future market values of individual
securities, and where important current information is almost freely available to all participants.
In an efficient market, competition among the many intelligent participants leads to a situation
where, at any point in time, actual prices of individual securities already reflect the effects of
information based both on events that have already occurred and on events which, as of now,
the market expects to take place in the future. Thus, in an efficient market at any point in time
the actual price of a security will be a good estimate of its intrinsic value.

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Fama (1970) identified three distinct levels at which a market might be efficient.
Weak-form Efficiency:
Current price is reflection of past prices (information)
Future price change depends on availability of new information.
Excess returns cannot consistently be achieved through the study of past price movements.

Semi-strong form Efficiency:

Current price reflects information content of past prices and all other publicly available
information.
Market quickly digest the publication of relevant new information and a new equilibrium price
is achieved and an investor cannot benefit over and above the market by trading on that new
information
Therefore, neither technical analysis nor fundamental analysis would be reliable strategies to
achieve superior returns
Only private information unavailable to the market at large will be useful to gain an advantage
in trading
Future price change depends on availability of new information.
Excess returns cannot consistently be achieved through the study of past price movements.
Strong-form Efficiency:
Prices reflect all available information, public as well as private
As stock prices reflect all information (public as well as private), no investor, including a
corporate insider, would be able to make excess profit above the average investor.

Lessons from EMH:

Market prices reflect intrinsic values
Prices change only in response to new information
Price changes cannot be forecast
Trust market prices: Share price has all information
Markets have no memory: Past price changes contains no information about future changes
Read the entails: Prices speak about future
The do-it-yourself alternative: Why pay management fee? Why to appreciate diversification?
Seen one stock, seen them all: All stocks are almost perfect substitute

….. Happy Learning .....

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 Working Capital Management
Operating Cycle
In general, operating activities in a firm includes (a) Procurement of Raw Materials (b)
Conversion of RMs to Finished Goods ready for sale (c) Finished Goods are sold against cash
or credit (Let’s assume ‘Cash sales’ means ‘Zero-days credit’) (d) Collection of receivables
(pending dues). Time and capital, both are involved in each activity. This cycle of operating
activities (of time) is termed as Operating Cycle or Gross Operating Cycle.
Purchases (RMs) => Processing & Sales => Collection of sales
Furthermore, capital required to support these activities are “Working Capital”. Please note
cash and cash equivalents is also required for smooth and uninterrupted operations.
A firm must make a trade-off between Cash and Marketable securities, though, Marketable
securities are highly liquid, but it involves conversion cost. Further, access cash means loss of
opportunity to earn benefits (opportunity cost).

Net Operating Cycle

A firm may use suppliers’ money (accounts payable) for the benefit of operations. For example,
if a firm is not making upfront payment against purchases, the requirement of capital to support
operating activities reduces. Thus, net operating (cash conversion) cycle is reduced by the
credit period extended by suppliers.
Net Working Capital = Current Assets – Current Liabilities
The CCC shows the amount of time taken by a firm to convert its investments to cash.
Table 1: Working capital Calculation

Raw Material (RM)

+ New Purchases 1,000
- Change in RM-stock (Closing - Opening) 100
RM Consumed 900
+ Processing Expenses* 200
- Change in WIP-stock -50
Production Cost 1,150
+ Processing Expenses* 250
- Change in FG-stock 100
Cost of Goods Sold 1,300
+ Gross Profit Margin 200
Net Sales 1,500
*Processing expenses booked against WIP and FG

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In the Table 1, RM is getting converted to WIP and then to Finished Goods available for sales.
Thus, each activity involves a processing time. Time period collectively taken by all the
inventories (RM, WIP, FG) from purchases to sales is termed as Days Inventories
Outstanding (DIO) or Inventory Days.
The time period from sales to collection of receivables is termed as ‘Days Sales Outstanding’
(DSO) or Receivable Days. Similarly, from purchases to making payment is termed as ‘Days
Payable Outstanding’ (DPO) or Payable Days.
Operating Cycle = DIO + DSO
Cash Conversion Cycle = DIO + DSO - DPO

Turnover Ratio(s)
These ratios are helpful to observe an operating activity and see how many times such activities
can be performed in a year. If conversion from RM to WIP is one month, it shows 12 such
cycles may be completed in a year. So, RM Turnover Ratio equals to ‘1 Year divided by one
month’.
RM Turnover = 365 days/RM conversion period
Or
Cost of RM consumed in a year/Avg. RM
* Avg. RM = 0.5 * (Opening RM + Closing RM)

Note: Kindly refer to Table 1 and observe the changes in numerator and denominator.
RM Turnover = Cost of RM consumed /Avg. RM
WIP Turnover = Cost of Goods Manufactured/Avg. WIP
FG Turnover = COGS/Avg. FG
Inventory Turnover = COGS/Avg. Inventory

Receivable Turnover (RT) = Sales/Avg. Receivable

Creditors Turnover (CT) = Purchases/Avg. Payables
Assets Turnover = Sales/Avg. Assets
PS: Lower operating cycle means more quickly assets are getting converted to sales. Thus,
higher the operating efficiency.

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 DuPont Analysis

Return on Assets (ROA): Measures how efficiently a firm generates income using its assets.
ROA = Net Income / Total assets (NI/TA)
𝑁𝐼 𝑆𝑎𝑙𝑒𝑠
𝑅𝑂𝐴 = ∗ = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 (𝑃𝑀) ∗ 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑅𝑎𝑡𝑖𝑜 (𝐴𝑇𝑅)
𝑆𝑎𝑙𝑒𝑠 𝑇𝐴

Return on Equity (ROE): Measures how efficiently a firm generates income using its equity.
It includes leverage aspects as well.
ROE = Net Income / Equity Capital
𝑁𝐼 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = ∗ = 𝑅𝑂𝐴 ∗ 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
𝑅𝑂𝐸 = 𝑃𝑀 ∗ 𝐴𝑇𝑅 ∗ 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
DuPont Corporation first analysed ROE by breaking it into three parts.
Thus, return for equity holders can be maximized by enhancing any one or combination of
profit margin, assets turnover, and leverage. However, these factors can’t be increased beyond
a point. Profit margin can be increased till revenue is maximised. Financial leverage enhances
return only if cost of capital is lowered. Assets turnover is a function of plant capacity and can’t
be increased beyond a point.
Q. Now, what if all the three parameters are already optimized and firm plans to increase sales.
The firm will have to install new units.
Let’s assume, a firm wants to see next year growth in sales (g) by 50%.
 Production to be increased by 50%
 New investment in Total Assets

Total investments in assets creation = g ‘times’ TA = 0.50 * TA

 Liabilities will increase by the same amount (TA = Total Labilities)

Investment Required = g * TA
Sources of Capital:
a) Projected Profit Retained = Projected Profit * retention ratio (b)
= Profit Margin * Projected Sales * Retention = PM * Sales * (1 + g) * b
*Assuming no capital is used from reserves and surplus fund
b) Additional credit extended by suppliers as purchases increase = g * spontaneous
liabilities (a/c Payable)

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 c) External Fund
External Fund Needed (EFN) = g * TA – [ PM * sales * (1+g) * b + (g * SL)]

𝐸𝐹𝑁 = 𝑔 ∗ (𝑇𝐴 − 𝑆𝐿) − 𝑏 ∗ 𝑃𝑀 ∗ 𝑠𝑎𝑙𝑒𝑠 ∗ (1 + 𝑔)

For b = 1; No dividends are paid
𝐸𝐹𝑁 = 𝑔 ∗ (𝑇𝐴 − 𝑆𝐿) − 𝑃𝑀 ∗ 𝑠𝑎𝑙𝑒𝑠 ∗ (1 + 𝑔)
Internal Growth Rate (IGR): This is the sales growth rate a firm can have if “No external
capital” is raised (EFN = 0).

𝑔 ∗ (𝑇𝐴 − 𝑆𝐿) − 𝑏 ∗ 𝑃𝑀 ∗ 𝑠𝑎𝑙𝑒𝑠 ∗ (1 + 𝑔) = 0

[PM * sales = Net Income (NI)]
 𝑔 ∗ (𝑇𝐴 − 𝑆𝐿 − 𝑏 ∗ 𝑁𝐼) = 𝑏 ∗ 𝑁𝐼

 𝑔 = 𝑏 ∗ 𝑁𝐼/(𝑇𝐴 − 𝑆𝐿 − 𝑏 ∗ 𝑁𝐼)
Dividing numerator and denominator by Total Assets
 𝑔 = 𝑏 ∗ 𝑅𝑂𝐴/(1 − 𝑏 ∗ 𝑅𝑂𝐴)
[(TA-SL)/TA ≈ 1; SL/TA ≈ 0]

𝐼𝐺𝑅 = 𝑏 ∗ 𝑅𝑂𝐴/(1 − 𝑏 ∗ 𝑅𝑂𝐴)

Sustainable Growth Rate (SGR): This is the sales growth rate a firm can have when financial
leverage is maintained. It suggests that firm can raise additional debt against additional equity
capital (projected earnings retained). Thus, making no change in the financial leverage.

𝑆𝐺𝑅 = 𝑏 ∗ 𝑅𝑂𝐸/(1 − 𝑏 ∗ 𝑅𝑂𝐸)

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 Modified DuPont Analysis
DuPont Analysis: Traditional
𝑅𝑂𝐸 = 𝑃𝑀 ∗ 𝐴𝑇𝑅 ∗ 𝐸𝑞𝑢𝑖𝑡𝑦 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
Limitations:
✓ Profit margin includes interest expense
✓ No separate effect of operating performance and leverage
✓ Assets include cash
Modified DuPont: Derivation
✓ Separates effect of operating performance and financial leverage

ROE = Net Income/Equity

Net Income = PAT = EBIT * (1 – Tax) – INT * (1 – Tax)
 NI = NOPAT – Net Interest Expense
*NOPAT = Net operating PAT assuming all equity firm.
Net Interest Expense (NIE) = Total Interest Expense (INT) - Tax benefit of interest
NIE = INT – INT * Tax = INT * (1 – Tax)

NI = NOPAT – NIE

ROE = (NOPAT – NIE)/Equity

 NOPAT/Assets * Assets/Equity – NIE/Equity
 Operating ROA * (1 + D/E) – NIE/Debt * Debt/Equity
 Operating ROA + D/E * (Operating ROA – NIE/Debt)
 Operating ROA + Leverage * (Operating ROA – Net Borrowing Cost)
 Operating ROA + Leverage * Spread

ROE = Operating ROA + Leverage * Spread [Modified DuPont]

* Operating ROA = NOPAT/Sales * Sales/Assets = Return on Sales * Assets Turnover
Modified DuPont: Relevance
Operating ROA:
✓ Profitability of the firm when all equity financed
Leverage (D/E):
✓ Measure of net financial leverage
Total Debt (D):
✓ Financial liabilities: Interest bearing only (includes zero-coupon bond)
Spread:
✓ Spread = ROA (all equity) – Borrowing Cost (net)
✓ Profitability gain over net borrowing cost
✓ Leverage creates value when spread is positive