Financial Leverage and Cost of Equity

Sanjoy Sircar

For a typical stock investor, the returns from holding a stock is accrued through
dividends and price appreciation, or capital gains. If we assume that the typical
stock investor is risk averse, then the expected return on a stock must equal the
risk free rate p[us a risk premium commensurate with the degree of risk assumed
by the investor. In modern finance literature, the risk borne by the stock investor
holding a well diversified portfolio is referred to as systematic or market risk. The
risk premium expected to be earned by the investor is a result of the operating or
business risk of the firm as well as the additional financial risk imposed on the
stockholder in the presence of debt in the capital structure of the firm. The
objective of this note is to demonstrate a method to estimate the degree of
incremental risk imposed on the shareholder of a firm with debt in its capital
structure and measure the impact on the firms cost of equity capital,

Financial Leverage and Risk

Any business investment subjects its shareholders to the operating rik inherent in
the business in which the assets are being invested
which we call operating risk . The business risk is determined by various factors
which influence the variability in a firms sales and overall profitability.

Operating leverage is a measure that can be used a surrogate of business risk .
We characterize operating leverage as a firms variability in operating income
due to change in sales. Let us take the hypothetical example of two firms A and
B :

Firm A Firm A Firm B Firm B
2004 2005 2004 2005
Sales 100 50 100 50
Variable Cost 30 15 50 25
Fixed Cost 40 40 20 20
EBIT 30 -5 30 5

As we can see, both the firms sales have been negatively affected in 2005
compared to 2004, but Firm As operating income is more adversely impacted by
the presence of a grater proportion of fixed costs in its total cost structure. In a
similar situation where sales of both the firms double, Firm As gains will be
proportionately more than that of Firm B. This additional variability of Firm As
operating earnings due to a change in its sales is the result of business risk that
is borne by the shareholders of the firm. He impact of business risk can be due
to the industry structure, choice of technology and degree of automation, efforts
to achieve minimum economies of scale etc.

When firms raise funds by issuing debt securities, the fixed amount of interest
payments (implicitly) guaranteed to bondholders ahead of any dividends payable
to shareholders impose an additional risk to shareholders of firms with debt in
their capital structure (levered firms) as opposed to (unlevered ) firms with no
debt in their capital structure.
Let us look at two firms to examine the impact of debt in the capital structure on
shareholder returns:

Levered Levered Unlevered Unlevered Y
2004 2005 2004 2005
EBIT 100 50 100 50
Interest 30 30 0 0
EBT 70 20 100 50
Taxes at 30
percent
21 6 30 15
Net Income 49 14 70 35

While a 50 percent reduction in the operating profits of the unlevered firm results
in a proportionate loss to the net income available to shareholders, for the
levered firm a 50 percent reduction sales results in a 71 percent decline in net
income available to investors. This additional variability in earnings is a source of
risk to stockholders and is a result of financial leverage which is imposed upon
stockholders due to the presence of debt in the firms capital structure. Please
note that if the interest payments were a fixed percentage of the firms operating
earnings that were allowed to rise and fall in level with the firms operating
income (EBIT) then the returns to the shareholders of the levered and unlevered
firm will be affected in the same proportion as the change in the firms operating
profits and thus not impose an additional risk to the levered firms shareholders.
As shareholders are entitled to residual earnings, the presence of debt and the
resulting fixed charge on operating income to bondholders forces the
stockholders of levered firms to assume a disproportionately higher degree of
risk compared to that of the shareholders of the unlevered firm.

If we look at the expected return on a stock as

Expected return = Risk free rate +Risk premium,

Then we can now decompose the risk premium according to the source of
uncertainty, that is,

Expected return = Risk free rate + Business Risk premium + Financial Risk
premium .

As per our previous discussion, the shareholders of the unlevered firms would
receive compensation only for the business risk while the shareholders of the
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levered firm will be compensated through a total risk premium paid a risk
premium for both the business and financial risk assumed by them.

The Capital Asset Pricing Model (CAPM) provides a methodology of measuring
these risk premia and estimating the impact of financial leverage on expected
returns.

The Effect of Financial Leverage on Beta

Though CAPM is an idealized representation of the manner in which efficient
capital markets price securities and thereby determine expected returns, it is
universally applied in practice to model the trade off between risk and expected
returns. So we can use CAPM to examine the impact of financial leverage on
shareholder expected returns or from the firms perspective, the cost of equity
capital.

In CAPM, systematic or market risk is the only risk relevant in the pricing of
securities or their expected returns . Systematic risk is measured by beta which
measures the co-movement of a firms stock returns with that of the market ( in
practice a broad based value weighted index ). CAPM explain a stocks
expected returns as

R
e
= R
f
+ Risk premium or

R
e
= R
f
+ ( R
M
R
f
)

This basic CAPM relationship is known as the Security Market Line (SML),
where the stocks expected return is the risk free rate plus a risk premium. He
risk premium applicable to each stock is a function of the degree of (systematic)
riskiness of the stock as represented by beta and the average reward per unit
earned by stock investors which is represented by the expression R
M
R
f
, or
market risk premium.

For an unlevered firm, the beta is simply a representation of its business risk. In
such cases, we characterize the beta as the unlevered beta or
U
. For a firm with
debt in its capital structure, the systematic risk, beta consists of an element of
business risk as well as financial risk, which we represent as
L
, or levered beta
. he betas published by various financial service organizations reflects both the
business and financial risks affecting the overall risk level to the stockholder.

If we consider the Balance Sheet of a firm with debt in its capital structure, the
liabilities side ( sources of long term funds ) represents a portfolio comprisjng the
debt and equity of the firm. The Asset side represents the firms application of
funds and the total riskiness of the firms investment in assets is shared by both
the bondholders and equity shareholders, though not in proportion ot the capital
invested by each party. Typically the stockholders bear a greater proportion of
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the risk in terms of an adverse impact on firm earnings due to the residual nature
of cash flows available to stockholders.

So if we characterize the total risk of the firm in terms of its unlevered beta ( or
asset beta as it is sometimes called ) then the portfolio of the long term sources
of funds will have a total risk which is a weighted average of the risk borne by
each class of investors, that is, bondholders and stockholders in proportion to
their investment of capital in the firm. Hat is

U
=
D
* D / V +
L
* E/V where V = D+E

U
is the beta of the unlevered firm ( representing total business risk ),
D
and
L

represent the systematic risk of the firms debt and equity respectively. D/ V and
E/V measure the proportion of capital invested in total capital of the firm by each
class of stakeholders.

Assuming
D
equal to zero ( as the systematic risk of bondholders is quite
negligible unless the firm is in financial distress due to the priority in payment
enjoyed by bondholders over stockholders ), we have

U
=
L
* E/V

or
L
= V / E *
U

A stocks levered beta is an increasing function of its debt equity ratio. As the
level of debt in the total capital increases, the stockholders are subjected to an
increasing degree of (systematic ) financial risk which is reflected by the increase
in beta. The resulting increase in expected returns is simply a reflection of the
additional risk premium demanded by risk averse stockholders as compensation
for bearing additional risk.

This results can be employed to estimate the impact of a change in a firms
capital structure on its cost of equity capital. He approach is illustrated in Exhibit
1. For a firm employing debt in its current capital structure, its observable (
publicly available ) beta is composed of both business and financial risk that is
levered beta. The beta which the stock would have if it changed its debt ratio can
be estimated through a two step procedure.

The first step involves unlevering the stocks beta. Given the firms current debt
ratio, and its current
L
, the firms unlevered beta
U
can be calculated from the
equation presented above. The second step involves relevering the stocks beta
to reflect a change in capital structure. Given the
U
computed in the previous
step, we can use the same equation in reverse to incorporate the new debt
equity ratio and re-compute the firms
L
, the new leveraged beta of the firm
under the hypothetical capital structure.

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The newly computed levered beta ,
L
is an estimate of the beta the firms stock
would have had if it had changed its capital structure in the hypothetical fashion.
The new beta can now be plugged into the familiar CAPM expression, the
Security Market Line to estimate the stocks expected return associated with the
new debt ratio.

An example of unlevering and relevering the beta for Tata Motors is presented in
Exhibit 2.

Application to Corporate Finance

CAPM facilitates the examination of a stocks expected return to the riskiness
represented by the firms business risk (represented by its asset structure) and
financial risk ( capital structure). A firms cost of equity capital is simply the
expected rate of return on the firms stock. If the firm cannot at least expect to
earn at least R
e
on the equity financed portion of its investments, the firm is
better off not reinvesting any profits and paying out its entire distributable earning
to its shareholders as dividends. CAPM can be used by corporate financial
mangers to obtain an estimate of the firms stockholders expected rates of return
from investing in the firms equity and examine the impact of any change on
expected returns due to change in the firms capital structure.

A firms cost of equity capital is by definition the expected return on its stock.
Since the basic CAPM, expression, the Security market Line, links expected
returns to riskiness borne by the equity investors, it can be also used to estimate
the equity cost of capital. Hence, the CAPM concepts and techniques relating
expected returns and financial leverage can also be applied in the context of
estimating equity cost of capital from the corporate perspective.















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Exhibit 1 The Relationship of Expected Return and Financial Leverage with
CAPM


CAPM Equations :

The Security Market Line (SML ): R
e
= R
f
+ (R
M
R
f
)

(Re) Levering Beta :
L
=
U
V/E

Unlevering Beta:
U
=
L
*E/V


Notation Definitions:

Re = Stocks expected returns

RM = expected return on the market

E/V = the firms ratio of equity to total value ( based on market value where V =
value of debt + value of equity )

L
= the levered beta on a firms stock with D/E > 0

U
= the unlevered beta on a firms stock with D/E = 0


Estimating the Impact of a Change in Capital Structure

Step 1 :Estimate the unlevered beta

Given, current D/E and D/V and current
L
( either estimated or obtained from
publicly available sources )

Unlever the beta by solving
U
=
L
* E/V

Step 2 :Re-Lever the beta in line with the new Debt Equity Ratio

Given
U
from Step 1 and the new D/E or E/V ( where V = D +E )
Levewr the beta by using
L
=
U
* V/ E

Use the re-levered beta estimated in Step 2 in the SML equation to obtain the
new estimate of the expected rate of return consequent upon a change in
financial leverage.


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Exhibit 2 Sample Analysis of the Impact on Expected Return of Financial
Leverage with CAPM for Tata Motors Limited.


Assumptions : R
f
= 6 %;

Market Risk Premium (R
M
R
f
) : 9%

Current B
L
Tata Motors
:1.17 (Source:National Stock Exchange )

Tata Motors Current Equity : Rs. 31883 crores ( Source:National Stock Exchange )

Tata Motors Book Value of Debt : Rs. 2495.42 crores (Source:Tata Motors Annual
Report)

E/V for Tata Motors: :31883 / (31883+2495.42) : 0.93

CAPM

Equations :

Levering Beta : Security Market Line

L
=
U
V/E R
e
= R
f
+ (R
M
R
f
)


Proposed E/V ratio : 60 %

1.17 =
U
(1/0.93) So
U
= 1.09 At the proposed E/V ratio, re-lever the beta as
follows:
L
= 1.09 * ( 1/0.60) = 1.82

So estimated cost of equity capital : R
e
= R
f
+ (R
M
R
f
); 6 + 1.82*9 = 22.38%


E/V Tata Motors B
L
Tata Motors Expected Return

Currently 0.93 1.17 17.53%

Unlevered 1 1.09 15.81%

Proposed 0.60 1.82 22.38%
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