Does your company have a financial leverage strategy? Do you know what the optimal D/E ratio is for you?

The M&M theory states that the level of leverage does not matter; the price of an organization is determined by the value of its real assets.

The intuitive logic is as follows: debt is cheaper than issuing equity, so increasing the weight of debt should increase earnings per share. Yes, earnings increase, but so does risk, and consequently, the Cost of Equity (CoE) increases. Therefore, leverage should not directly impact the stock price.

However, there are components that M&M do not consider. These are 1. Tax savings from interest expenses and 2. “Distress costs” associated with the increased probability of financial distress due to high leverage.

Thus, the “Trade-Off Theory” emerged:

Company Value = Value of an “Unlevered” Company + PV of Tax Savings + PV of Distress Costs.

Since these two additional components exist in reality, we get the picture shown in the graph below.

It is interesting to understand what is meant by distress costs. (This is not about the total loss from bankruptcy. On the contrary, bankruptcy is a financial option, which is a right of the owners, but like any option, it has its price).

  1. Bankruptcy Costs: The costs of bureaucratic services, which average 20% of the company’s value, and up to 40% in smaller companies;
  2. Indirect Costs: From suppliers, customers, employees… Uncertainty also causes problems and expenses;
  3. (Unscrupulous) Struggle Against Creditors:
  • Shifting risks to creditors, taking on more risky projects with negative NPVs – “If it succeeds, great; if not, what do we lose?”
  • Refusing to raise new capital despite having positive NPV projects because the market price of the debt increases with new capital, and creditors gain more than equity holders. Despite being a step in the right direction, such steps are not taken;
  • Cashing out and running away – withdrawing dividends before the debt payment date arrives, even though good investment opportunities might exist;
  • Prolonging processes – futile hopes that the situation will turn around;
  • Taking on more debt, thereby transferring existing creditors’ loans to a higher risk zone.

In other words, there is a conflict of interest between creditors and owners, and adventurous initiatives can lead to financial ruin.

Finally, it is important to understand that financial distress costs vary significantly based on the type of assets. Some assets are more stable, and others less so, meaning industries/sectors differ in leverage levels – hence, it is important to compare leverage against the average industry benchmark when assessing it.

Sources and photo credit.

Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myer