When does financial leverage create economic value?

Journal of Economic Theory, 1987

This study investigates how balancing internal and external financing sources can create economic value. We set a financial scorecard, consisting of the Cost of Debt (COD), Return on Investment (ROI), and the Cost of Equity (COE). We show that COE should be a cap for COD and a floor for ROI in order to increase the Net Present Value at Weighted Average Cost of Capital and the Adjusted Present Value of the levered investment. However, leverage should be carefully monitored if COD and ROI go off the grid. Situations where leverage has the opposite effect on value creation and the Equity Internal Rate of Return are also discussed. Illustrative examples are given. The proposed model aims to help corporate management in financial decisions.

Journal of Financial and Quantitative Analysis, 2013

We examine capital structures of 2,572 project-financed investments in 124 countries for the period 1997-2006. In contrast to the general prediction of the trade-off theory, we find that project companies use more leverage when project risk is high, but they use less leverage in the presence of risk-reducing features including offtake agreements. Project companies use less leverage and instead rely more on offtake agreements when the control benefits of cash flow from the project are high, suggesting that leverage and contract structures in the project company are important hedging mechanisms.

Journal of Business Finance & Accounting, 1980

One of the most discussed aspects of corporate finance has been the capital structure of the f m . Modighani and Miller (1958) discussed the risk-class assumption and compared the value of the levered firm with an otherwise -identical unlevered firm. However, they as well as many other writers on the theory of capital structure have not given adequate attention to the effect of corporate income tax.1 This is unfortunate, because some of the most interesting and realistic results appear when the tax effect is considered. As Brennan and Schwartz (1978) pointed out "an analysis of the effects of the corporate income tax is of interest not only because corporate income taxes do in fact exist but because the analysis appears to lead to the conclusion that an optimal structure will consist almost entirely of debt". Despite the fact that the composition of the capital structure and the use of financial leverage is fundamental to corporate finance, few attempts have been made to clearly examine the relationship between financial leverage and return on equity. Hunt (1961) did distinguish between leverage and trading on the equity and attempted to provide precise definitions of each. He differentiated between balance sheet leverage (trading on the equity)2 and income statement leverage. In addition, he derived a formula for the ratio of trading on the equity and developed a chart which illustrated how the advantage of trading on the equity varied with changes in the debtequity proportions. However, his analysis did not stress the fact that financial leverage can be either positive or negative. Nor, did he clearly show the impact of using preferred stock as a financing alternative. Thus, although Hunt's definitions and measurements provided precision and perspective that was much needed, it is hoped that this paper will provide an additional dimension, by formulating an even more precise definition of financial leverage. This new formulation w i l l clearly illustrate the difference between positive and negative financial leverage and will allow an easy calculation of the effect of financing with debt or preferred stock.

In this study, the effect of leverage on investment is analyzed by employing panel data methods for the Turkish non-financial firms that are quoted onİstanbul Stock Exchange. For one-way error component models, it is shown that there is a negative impact of leverage on investment for only firms with low Tobin's Q. These results are in conformity with the previous literature and agency theories of corporate finance stating that leverage has a disciplining role for firms with low growth opportunities. However, when the model is extended to include the time effects in a two-way error component model, the relation between leverage and investment disappears.

Applied Mathematical Sciences

International Journal of Economics and Financial Issues, 2023

Debt is an essential component of capital structure for firms. Companies use leverage to impact the returns that equity shareholders yearn for. In this study, the author attempts to establish a stochastic relationship between the use of leverage and the profitability of cement manufacturing firms worldwide primarily to assess whether leverage affects firm profitability. The study extends further to examine whether the level of debt affects the return on equity, return on assets and net profit margin in similar ways, as they are all proxies of profitability. The empirical analysis is performed on data from major cement companies listed on public exchanges worldwide. The data is collected from 2012 to 2018 with the sample size of the thirteen most prominent companies in the world in the cement manufacturing industry for 7 years consisting of ninety-one observations. Panel data regression analysis using the fixed effect model is applied to the data to investigate the relationship between the variables. Firstly, the study finds that financial leverage has a statistically significant inverse impact on profitability within the cement industry worldwide. Secondly, the study expands to determine that not all profit measures are influenced in the same way. The variables of profitability that really matter include the return on assets indicating the profit measured relative to the efficient use of resources and net profit margin that measures the returns from sales and by minimizing costs. The study does not find similar outcomes in relation to return on equity which contradicts theories that support debt as adding value to shareholders. The theory posits the stance of the benefit of tax-deductibility of debt, leveraged to increase profitability, and this study illuminates the incongruity of practical experiences to that of theory. The results of this study would assist corporate decision-makers in their capital structure decisions to critically examine the level of the worthiness of the benefit of tax deductibility of debt contributing to the firm's financial performance.

International Journal of Islamic and Middle Eastern Finance and Management, 2020

Purpose This paper aims to investigate the impact of debt maturity on the relationship between financial leverage and future financing constraints. Moreover, it attempts to analyze the moderating role of short-term debt and the mediating role of future financing constraints in the relationship between financial leverage and future investment. Design/methodology/approach To test the moderating role of debt maturity, all the observations are divided into two groups based on short-term debt to total debt ratio. Moreover, Sobel, Aroian and Goodman tests are used to analyze the mediating role of future financing constraints. The sample used in this research includes firms listed on the Tehran Stock Exchange from 2006 to 2018. Findings It is shown that financial leverage is inversely (positively) related to future financing constraints for firms with higher (lower) use of short-term debt and, short-term debt moderates the relation between financial leverage and future investment. The find...

SSRN Electronic Journal

Rather than examining firm-level data on capital structure and asset structure, we connect the financing choice to the characteristics of specific investments. We hand-collect and classify those characteristics. Controlling for a firm's existing assets, capital structure and valuation, we document a strong link between an investment's characteristics and the type of security issued if the investment is externally financed. Investments with more volatile and distant payoffs tend to be equity-financed. Investments in assets that are both tangible and non-unique tend to be debt-financed. The likelihood of debt financing increases with the need for monitoring and convertibles are relatively more common when payoffs are volatile and investment life is uncertain. Factor analysis indicates that the principal dimension determining the form of financing is the R&D-like nature of an investment.

Thesis (Ph. D.)--University of Rochester. William E. Simon Graduate School of Business Administration, 2009. Chapter 1 presents a model of capital structure that endogenizes investment and financial policy and has fixed costs of recapitalization. The model reproduces known relations between firm size, leverage and growth opportunities. The model predicts that firms time capital structure adjustments to their target leverage ratios with the exercise of their growth options. Compared with growth firms, asset-in-place firms are more likely to recapitalize outside of large investment projects. More profitable firms have higher leverage. Firms facing low corporate tax rates choose not to issue any debt. Increases in volatility accelerate investment when volatility is high. Chapter 2 tests the model's predictions with respect to financial policy by identifying large investment projects in a sample of U.S. industrial firms. The tests support the model's predictions. I also find tha...