About 25 years ago, when Japanese companies were “eating our lunch”, many analysts noted that those companies had highly leveraged capital structures — lot’s of debt and little equity. Looking at the WACC formula suggests that more debt relative to equity might lower WACC. Is leverage “always” good or “always” bad? If it depends on the industry, please suggest which ones would be expected to have greatest and least leverage.
- Imagine two independently owned gas stations standing next to each other and selling gas (and other goods) at about the same price, so they have the same revenues, cost structure and effective tax rate of 35%. Assume that every year they have average EBIT of $ 500,000 (I know, it’s quite optimistic) without any anticipated growth. One owner finances all operations out of own pocket, while another borrows $ 500,000 for five years and refinances this debt every five years without repaying principal.
Discuss the difference in value (if any) of these two stations
Answer :1
In simple term we could say that leverage is the ratio to company’s debt to its value of equity. It adds risk to the company and also create opportunity to boost return on equity. If the business takes on more debt, the bond rating agencies might lower their ratings. The result is that borrowing costs would rise and any reduction in WACC might be at least partially lost. In other words we could say that there is a WACC-minimizing level of debt for most companies, though one may not be able to calculate it precisely.
In my opinion I could say that leverage is a way of taking on risk. The underlying premise is that a company that is insufficiently risky will not earn outstanding returns. Thus, regulated public utilities, as monopolies, regularly take on a lot of leverage, since they are not particularly risky to begin with.in general public utilities commission’s generally require that they take on a lot of debt, since they set prices based on return on equity, which is boosted via leverage. On the other hand I mean contrast to this, oil and gas exploration is inherently highly risky, hence has little debt finance Other inherently risky businesses include high-tech, which tend not to have much debt finance
Answer :2
As in the earlier discussion i have said that oil and gas exploration is inherently highly risky, hence has little debt finance. In the prasent situation we have been given that two independently owned gas stations standing next to each other and selling gas (and other goods) at about the same price, so they have the same revenues, cost structure and tax rate with average EBIT of $ 500,000 without any anticipated growth .Now we could check the leverage and non leverage concept
Suppose on this case interest rate is 10% then earning available to share holder are as follow
Levered
Not levered
EBIT
500,000
500,000
Less: Interest On debt
50,000
0
EBT
450,000
500,000
Tax @35 %
157500
175000
Earning Available to share Holder
292,500
325,000
We can say that Non -Levered firm is better because it has more earning available to share holder
