Risk & Leverage

How Does Financing Structure Affect Risk?

In essence, the financing structure does not impact the value of an organization. Value is created by the assets, and it doesn’t matter how the cash flows generated by these assets are distributed among the financing sources.

Because the cost of debt is lower than the cost of equity, increasing leverage naturally boosts the profitability for equity holders. However, we know there is no free lunch—higher profitability is associated with higher risks, and the cost of risk remains the same…

The higher the leverage, the more sensitive the profitability of equity holders is to market conditions. The graph below provides an example of how equity holders’ profitability changes in positive and negative scenarios, depending on the level of leverage (D/A).

Let’s assume the organization has no debt and the return on invested capital can be -10% or +10%. The diagram shows that if half (50%) of the assets are financed with debt, the return for equity holders varies from -25% to +15% (considering the same scenarios).

Pay attention to the significant fact that the deviation does not occur proportionally on the positive and negative sides—we arrive at a moment of truth—leverage not only increases the range of uncertainty but also skews it in favor of the negative side…

Excel File

P.S.
It should be noted that the existence of debt does lead to one significant economy, which is tax savings. Since interest is a deductible expense, it reduces the tax on profits…

Source:

Value: The 4 Cornerstones of Corporate Finance – by McK&Co., T. Koller, R. Dobbs, B. Huyett