RTorres, Evelyn 1111 Hawkins Blvd Ste

Imagine you manage a health insurance company which is looking at adding a financial planning business to the current customer offer. This seems a good idea because your existing customers have demonstrated concern about the financial effects of ill-health, already trust your product, use your distribution channels, and you already have a funds management business to invest the health insurance premium income. Further, you have access to some customer financial details and could commence by offering the financial planning service to the higher-wealth group on the assumption that they are the most likely to buy.

The business needs investment to get it up and running. It needs to buy/develop specialist software, training courses, supporting research services, etc. This investment is $1 million. Once the business is up and running you estimate it will earn a pre-tax cash-flow return of $150,000 per year – a rate of return on investment (ROI) of 15%. (We will assume for the sake of simplicity that there is no corporate tax.) Supposing that you can finance this investment either by equity at 12% required rate of return (estimated from the capital asset pricing model using a risk-free rate of 6%, market risk premium of 6% and beta of equity of 1), or by debt at an interest rate of 8%, which will you choose?

Looks easy, doesn’t it – debt looks much cheaper than equity!

Not only does it look cheaper but your investment banking advisers say that the debt will do wonders for the return on equity (ROE). Take a look at Table I.A.5.2, prepared by the bank. It shows the return on equity for the business under three different funding arrangements from all equity to 25% equity and 75% debt.

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Table I.A.5.2: Impact of increasing leverage on return on equity Financing Method

All Equity 50% Debt

50% Equity

25% Equity 75% Debt Equity Investment

Debt Investment

$1,000,000 $500,000

$500,000

$250,000

$750,000

Total Investment $1,000,000 $1,000,000 $1,000,000

Debt / Equity Ratio 0 1 3

EBIT⁴ $150,000 $150,000 $150,000

Interest 0 40,000 60,000

Net Income $150,000 $110,000 $90,000

Return on Equity 15% 22% 36%

ROE grows as we have more debt. The logic seems OK, because the business is earning 15% on each dollar of investment and the debt-holders only want 8% for each bit they finance, leaving much more than 15% to the shareholder-financed proportion (i.e. they get 15% on each dollar they finance plus the difference between 15% and 8% on the debt-financed portion). For those who like formulae, the relationship is:

E r D ROI ROI

ROE (  _d) , I.A.5.4

that is, the return on equity is a positive linear function of the debt to equity ratio (provided ROI is greater than the interest rate rd).

What is wrong with this apparently rosy picture? The analysis assumes that $150,000 will be earned from the investment. However, this is only an estimate (or mean) from a range of possible outcomes. Look at what happens to ROE if we look at possible outcomes both higher and lower than $150,000 (Table I.A.5.3). ROE looks great if the outcome is better than $150,000 but there is a real downside – it looks much worse when the interest bill is not covered.

4EBIT means Earnings Before Interest and Tax

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Table I.A.5.3: How ROE varies if earnings vary from the mean Financing Mix Return on Equity for different EBIT levels ($’000)

0 50 100 150 200 250 300

All Equity 0% 5% 10% 15% 20% 25% 30%

50% Debt, 50% Equity -8% 2% 12% 22% 32% 42% 52%

75% Debt, 25% Equity -24% -4% 16% 36% 56% 76% 96%

Further suppose the earnings change over time, each outcome being drawn from the probability distribution of possible outcomes but appearing cyclically (to demonstrate the higher variance in return to shareholders) and the pattern is captured in Figure I.A.5.2. Notice how the variability in ROE is greater than the variability in ROI (no leverage), that is, risk is increased. So the alleged benefit of increased leverage can be a double-edged sword. The benefit to shareholders is achieved at the expense of increased risk. Not only does increasing the proportion of debt make the earnings available to shareholders more variable (increases variance) but it also increases risk (variability and beta).

Figure I.A.5.2: ROE is magnified by leverage

Time ROE

Leverage

No Leverage

Time ROE

Leverage

No Leverage

Increasing equity risk means that shareholders will require a higher rate of return, thus there are two costs associated with increasing leverage:

the explicit interest cost of debt;

x

x the implicit rise in the cost of equity in response to the higher risk they face.

These two effects offset each other exactly under certain conditions so that there is no overall benefit of the apparently cheaper debt!

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This should not be all that surprising when we recognise that the overall risk of a business is determined by its investment decision, not by the way it is financed. If the financial planning business is financed entirely by equity then clearly all the risk is borne by shareholders. If it is financed by some combination of debt and equity then that business risk is being shared, less by the debt-holders and more by the shareholders. However, this does not change the nature/risk of the business’s cash-flow earning stream, just the distribution of it. The expected business earnings are $150,000 regardless of how the business is financed. Further, the probability of possible business earnings is not changed either. The $150,000 is a function of interaction with customers and the cost of those interactions, not the interest bill. So if the underlying risk that is shared and the underlying cash flow that is also shared between the debt-holders and the shareholders do not change because of the financing mix then neither will the value. Thus capital structure will not matter.

This very important point can be made another way. Suppose you were planning to start the business financing it yourself by having equity issued to you. You would assess the risk of the business and determine the rate or return you would require on this equity. Suppose this is 12%.

If the earnings stream was a perpetuity then you would value the business at follows:

000 , 250 , 1 12 $ . 0

000 , V 150

Suppose instead you decided to finance the business yourself partly by equity and partly by debt.

What rate of return would you require? Overall there is no reason for the required return to be anything other than 12%. Nothing about the risk of the business has changed. The only difference is that you have taken debt and equity securities instead of all equity. You would require a lower rate of return than 12% on debt because it has a constant interest stream and a higher rate of return than 12% on the equity because it now has a subordinate claim to the debt, but the weighted average of the required rates of return should still be 12%. Consequently, there is no reason for the overall value of the business to change from $1,250,000 and there can be no value benefit from the different capital structure.

The circumstances that must prevail for this conclusion are reasonably stringent but the conclusion that the way a business is financed does not matter is valid under these circumstances.

It has demonstrated a very important point – that there are two costs of debt, an explicit and an implicit cost (the increase in the cost of equity due to the additional risk), and the latter is often ignored. The circumstances that must prevail revolve around there being no special tax benefits of debt or adverse consequences of default on debt.

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Before leaving this section, one of the assumptions underlying the analysis is that debt is priced

‘correctly’ with respect to risk. Cheap debt is really mispriced debt. Some argue that deposit funds are a cheaper source of funds than wholesale funds for banks. This can be true once all costs of deposit funds are accounted for. That is, a large infrastructure is required to attract and manage the low-interest-paying source of funds. Until these costs have been covered by the quantum of funds times the ‘saving’ on interest relative to wholesale funds it is hard to say that deposit funds are a cheap source of funds. Nevertheless, once the infrastructure is in place, the challenge for a bank is to use this source as much as possible.

To better understand the factors that make the capital decision relevant, we now look at changes in the special circumstances of this section by introducing both benefits and costs of adding debt to an otherwise all-equity-financed business.