Financial Leverage on ROA and the Required Rate of Return

1. What are bankruptcy costs and what are the two types of bankruptcy costs?

Bankruptcy costs are costs that firms face when they are in financial distress. Direct

bankruptcy costs are out-of-pocket costs, such as the payments that are made to

lawyers, accountants and consultants, as well as court costs, when a firm gets into

financial distress. Indirect bankruptcy costs result from changes in the behaviour of

the people that contract with the firm when they learn that it is in distress. For

example, there may be less demand for a distressed firm’s product because of the

concern that the firm will not exist to provide customer support in the future or

suppliers might demand cash on delivery out of concern that the firm will not be able

to pay for supplies. Consequently, the financial leverage, if leads to higher financial

stress, will reduce the ROA. Since creditors require the periodic repayment in terms

of interest cost (and coupon payment and the face value at maturity) and thus higher

financial leverage has potential to lead to higher likelihood of financial distress. As

the result, higher financial leverage could associate with higher required rate of return

by creditors.

2. Briefly discuss costs of financial distress to a firm that may arise when employees

believe it is highly likely that the firm will declare bankruptcy.

If the employees of a firm understand that the firm has a significant chance of filing

for bankruptcy, then costs to the firm could be manifested in a number of ways,

including:

a. Lower productivity due to lower morale and job hunting. This could be as simple as

employees spending time gossiping about what is going to happen to them as well as

employees actively pursuing other jobs while on the payroll of the troubled firm.
b. Higher recruiting costs. New employees, understanding that working for the firm is a

risky venture, will seek compensation for this additional risk. Therefore, recruiting

employees will become more expensive due to greater recruiting efforts as well as

greater compensation expense when a new employee is finally located and hired. As

such, the impact of financial leverage on ROA will be the outcome as well.

3. What are agency costs and how are they related to the use of debt financing?

Agency costs are costs that are incurred when someone delegates decision-making
authority to someone who has different objectives from the principals. Agency costs
might arise in relationships between shareholders and the managers. The role and
objectives of managers and shareholders in the firm is different. Managers are
employees hired by the shareholders who provide external finance to the firm.
Managers typically have a higher level of risk aversion, compared to shareholders.
Managers care about the possible loss of human capital if the firm they are working
for takes higher business risk and is not able to have a long term sustainable future.
Thus, managers can have incentives to invest in low-risk projects that do not
maximise shareholder value. Also, when a firm has excess cash available for
managers, managers might want to waste the available cash to enhance their private
interest but is bad for shareholders. One typical example is called empire building of
management. In business, empire-building is demonstrated when individuals attempt
to gain control over key projects and initiatives to maximize job security and
promotability. In an organization, empire-building can also be demonstrated when an
individual eagerly and proactively suggests and pursues functions, activities or
projects that are of questionable value to try to enhance future value. Since the
managers are employees of the shareholders, the managers of a firm would rather
work as little as possible, given a set level of compensation, whereas shareholders
would rather extract a high level of effort from the managers with lower level of
compensation. Agency costs also arise between shareholders and debt holders (i.e.
creditors). Shareholders, through the managers they hire, can have incentives to
engage in asset substitution by taking the risk which beyond the preferred level of
debt holders. This happens since shareholders will benefit the net profit after taxation
and have unlimited upward monetary incentive from risk-taking. However, the firm’s
repayment obligation to debt holder is fixed (including the principal and interest cost).
Shareholders have incentive to turn down positive-NPV projects (underinvestment)
since the financial return on positive NPV projects will be used to honour the
repayment obligation to the creditors first and therefore the net profit after taxation
and interest expense has little left for shareholders. Some time, shareholders might
transfer the wealth from creditors to shareholders by paying out excess cash in the
form of dividends rather than investing excess cash into the business operation.
 Despite the conflicting interest between the shareholders and debt holders, the
financial leverage can be used by shareholders as the tool to mitigate the manager-
shareholder agency conflict. When a firm has excess cash available for managers to
waste—which is bad for shareholders—then an increase in debt (i.e. higher financial
leverage), and consequently the level of interest service required of that debt, will
make less cash available for the manager to waste. Also, if the firm’s financial
leverage generates a very small probability of bankrupting the firm, then increasing
the proportion of debt in the capital structure would increase the probability of the
firm falling into bankruptcy. This increased probability of bankruptcy, and therefore
the increased chance that the manager will lose his job, would then incentivize the
managers to work harder and help to align the interests of the manager with that of
shareholders. If financial leverage does carry the positive impact on reducing the
manager-shareholder agency conflict, and encouraging the investment of management
to the higher NPV projects and extracting higher level of effort from management,
higher financial leverage will lead to higher return on business assets.
4. If a firm increases its debt to a very high level, then the positive effect of debt in

aligning the interests of management with those of shareholders tends to become

negative. Explain why this occurs.

Whereas increasing the debt level for a firm tends to catch management’s attention

and force them to work harder, a very high level of debt can be detrimental. That is, at

very high levels of debt, risk-averse managers begin to minimise the risks that a firm

takes on for the managers’ own job preservation needs. This risk minimisation can

deter managers from taking risky, but positive-NPV projects, which are needed to

help the firm meet the very debt obligations. In addition, the financially risky firm (i.e.

the increasing likelihood of financial distress and bankruptcy associated with higher

level financial leverage) may also result in costs not previously borne in relationships

with employees, suppliers and customers. As the result, the financial leverage, if

passing the optimal level, will result in the lower profitability of the firm (i.e. ROA).

5. How can financial leverage affect the risk associated with net income?

The more debt a firm carries, the more risk will be associated with the firm’s net

income. This occurs because, given a certain level of fluctuating operating income, a

larger fixed debt payments will magnify the effects of the fluctuations on net income.