Financial risk refers to the additional variability of earnings per share and the increased probability of insolvency that arises when a firm uses fixed-cost sources of funds, such as debt and preferred stock, in its capital structure. (Insolvency occurs when a firm is unable to meet contractual financial obligations —such as interest and principal payments on debt, payments on accounts payable, and income taxes —as they come due.) Fixed capital costs represent contractual obligations a company must meet regardless of the EBIT level.
The use of increasing amounts of debt and preferred stock raises the firm’s fixed financial costs; this, in turn, increases the level of EBIT that the firm must earn in order to meet its financial obligations and remain in business. The reason a firm accepts the risk of fixed cost financing is to increase the possible returns to stockholders.
The use of fixed -cost financing sources is referred to as the use of financial leverage. Financial leverage causes a firm’s earnings per share (EPS) to change at a rate greater than the change in operating income (EBIT). For example, if a firm is 100 percent equity financed and EBIT increases decreases) by 10 percent, EPS will also increase (decrease) by 10 percent. When financial leverage, such as long-term debt, is used, a 10 percent change in EBIT will result in a greater than 10 percent change in EPS. Figure illustrates the concept of financial leverage. Line A represents the financial leverage used by a firm financed entirely with common stock. A given percentage change in EBIT results in the same percentage change in EPS.
Line B represents a firm that uses debt (or other sources of fixed -cost funds) in its capital structure. As a result, the slope of the EPS-EBIT line is increased, thus increasing the responsiveness of EPS to changes in EBIT. As can be seen in Figure, a given change in EBIT yields a larger change in EPS if the firm is using debt financing (_EPSB) than if the firm is financed entirely with common stock (_EPSA).
It is also clear from Figure that the use of financial leverage magnifies the returns— both positive and negative —to the shareholder. When EBIT is at a relatively high level, such as EBIT2, Firm B’s use of financial leverage increases EPS above the level attained by Firm A, which is not using financial leverage. On the other hand, when EBIT is relatively low— for example, at EBIT0 —the use of financial leverage decreases EPS below the level that would be obtained otherwise; that is, EPS_0 < EPS0. At EBIT0, the use of financial leverage results in negative EPS for Firm B.
Financial Risk: Systematic or Unsystematic Risk?
Financial risk, like business risk, contributes to both the systematic and unsystematic risk of a firm’s securities. To the extent that the use of financial leverage magnifies variations in operating income that come about because of unsystematic risk factors, financial leverage contributes to the unsystematic risk of a firm’s securities.
Financial researchers have also studied the contribution that financial leverage makes to the systematic risk of a firm’s securities. It is well established that systematic risk is a function both of financial risk and operating risk. Hence, security analysts and investors find the measurement of a company’s financial risk to be an important element of good financial analysis.
Illustration of Financial Leverage
Effect of Financial Leverage on Stockholder Returns and Risk
Firms employ financial leverage to increase the returns to common stockholders. These increased returns are achieved at the expense of increased risk. The objective of capital structure management is to find the capital mix that leads to shareholder wealth maximization. To illustrate the effects of financial leverage on stockholder returns and risk, consider the following example of KMI Technology, Inc.
As can be seen in Table , KMI has total assets of $1 million. Suppose KMI expects an operating income (EBIT) of $200,000. If KMI uses debt in its capital structure, the cost of this debt will be 10 percent per annum. Table shows the effect of an increase in the debt to total assets ratio (debt ratio) from 0 percent to 40 percent and to 80 percent on the return on stockholders’ equity. With an all equity capital structure, the return on equity is 12 percent.
At a debt ratio of 40 percent, the return on equity increases to 16 percent, and at a debt ratio of 80 percent, the return on equity is 36 percent. KMI is earning 20 percent (pretax) on its assets. The cost of debt is 10 percent pretax. Thus, when KMI uses debt in its capital structure, the difference between the return on its assets and the cost of debt accrues to the benefit of equity holders. However, this increased equity return is achieved only at the cost of higher risk. For example, if EBIT declines by 25 percent to $150,000, the return on equity for the all -equity capital structure also declines by 25 percent to 9.0 percent. In contrast, at a 40 percent debt ratio, the return on equity declines by 31.25 percent to 11 percent.
At an 80 percent debt ratio, the return on equity declines by 41.67 percent to 21 percent. The effects of a 60 percent reduction in EBIT to $80,000 are even more dramatic. In this case, the pretax return on assets is less than the pretax cost of debt. To pay the prior claims of the debt holders, the equity returns are reduced to a level below those that prevail under the all -equity capital structure. In the case of a 40 percent debt ratio, the return on equity is only 4.0 percent, and in the case of an 80 percent debt ratio, the return on equity is 0 percent.
Thus it can be seen that the use of financial leverage both increases the potential returns to common stockholders and the risk, or variability, of those returns. Generally, the greater a firm’s business risk, the less the amount of financial leverage that will be used in the optimal capital structure, holding constant all other relevant factors.
Effect of Financial Leverage on Stockholder Returns
and Risk at KMI Technology, Inc.
Financial Management Related Interview Questions
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Financial Management Tutorial
The Role And Objective Of Financial Management
The Domestic And International Financial Marketplace
Evaluation Of Financial Performance
Financial Planning And Forecasting
The Time Value Of Money
Risk And Return On At&t Common Stock
Fixed-income Securities: Characteristics And Valuation
Common Stock: Characteristics,valuation, And Issuance
Capital Budgeting And Cash Flow Analysis
Capital Budgeting: Decision Criteria And Real Option Considerations
Capital Budgeting And Risk
The Cost Of Capital
Capital Structure Concepts
Capital Structure Management In Practice
Working Capital Management
The Management Of Cash And Marketable Securities
Management Of Accounts Receivable And Inventories
Lease And Intermediate-term Financing
Financing With Derivatives
Internationan Financial Management
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