Finance

Leverage

Firms can raise money through a variety of means. Usually, money is raised through the issuance of different types of securities (such as stocks and bonds). The capital structure of a firm is the proportion of each type of security that the firm has used. Most firms have both debt and equity in their capital structure. In general, debt is referred to as leverage and firms with debt in their capital structure are levered.

Because firms have debt, we can divide the risk of owning a stock into two parts:

1) Business (or Operating) Risk: This is the risk associated with the assets of the company. In other words, it is the risk involved in the business activities of the firm. If the firm were 100% equity financed, this would be the only risk in the companies stock.

2) Financial Risk: When a firm is levered, its stock will have more risk. This derives from the fact that holders of the debt of the firm must be paid their interest before the stockholders can receive anything (i.e. dividends). Because of financial risk, the beta of a stock of a levered company will be greater than the stock of an identical, but unlevered, company.

Example:

Consider two firms with identical operations. Each has raised $1,000,000 in financing.

Firm A financed 100% with equity (sold 100,000 shares at $10 each).

Firm B financed with $500,000 in debt (at 10% interest) and sold 50,000 shares at $10 each.

Three possible outcomes for next year, depending on the economy:

Firm A:

| |Recession |Average |Boom |

|EBIT |$50,000 |$200,000 |$350,000 |

|Interest |0 |0 |0 |

|Taxable Income |50,000...