The impact of financial leverage on return on

total business assets and cost of debt

Learning Objectives

1. The impact of financial leverage on return on total

business assets

2. The impact of financial leverage on required rate of return

on debt

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The decomposition of ROE using the DuPont
analysis
• ROE= Return on Business Assets (ROA) + Spread * Financial leverage

• Spread = Return on business assets – effective interest rate

• The higher level of financial leverage (debt/equity)) will lead to higher ROE, if the spread
>0, keeping other factors constant

• Does the change in financial leverage affect return on business assets?

• Does the change in financial leverage affect the required rate of return by creditors?

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The Benefits of Debt
• Agency costs result from conflicts of interest between principals and
agents where the principal and the have different sets of information and
have conflicting interest.

• The principals delegate the decision-making to the agents, and the

agents are expected to act in the interest of the principals, but agents
sometimes have interests that conflict with those of the principal

• Stockholder-manager agency costs occur when the incentives of the

managers are not perfectly identical to those of the stockholders, and
managers will make some decisions that benefit themselves at the
expense of the stockholders
• Periodic payment of interest expense and the repayment of the principal to creditors
act as the governance instrument to mitigate the principal-agent problem between
stockholder-manager

• Since interest and principal payments must be made when they are due, debt provides
managers with incentives to focus on maximizing the cash flows that the firm produces

• Debt can be used to limit the ability of bad managers to waste the stockholder’s money
on things such as fancy jet aircraft, plush offices, and other negative-NPV projects that
benefit the managers personally

• If managers do this, managers face the likelihood of failing to honour the payments’
obligation and the prospect of bankruptcy, which can destroy a manager’s career

• If debt does reduce the principal-agent problem between shareholders and mangers as
such, the higher financial leverage would increase the return on total business assets
The Costs of Debt: Bankruptcy costs
• Bankruptcy costs

• Also referred to costs of financial distress, i.e. costs associated with financial
difficulties that a firm might get into because it uses too much debt financing

• Costs incurred when a firm gets into financial distress (direct costs)
• Direct bankruptcy costs are out-of-pocket costs that a firm incurs as a result of financial
distress

• They include things such as fees paid to lawyers, accountants, and consultants

• Firms can incur bankruptcy costs even if they never actually file for
bankruptcy (indirect costs)
The Costs of Debt: Bankruptcy costs (2)
• Indirect bankruptcy costs are costs associated with changes in the behaviour
of people who deal with a firm in financial distress

• Some of the firm’s potential customer’s will decide to purchase a competitor’s products
because of concerns the firm will not be able to honor its warranties, or that parts or
service will not be available in the future

• Some customers will demand a lower price to compensate them for these risks

• Thus, if the higher financial leverage leads to a higher likelihood of

bankruptcy cost as such, it leads to lower return on total business assets.
The Costs of Debt: Agency costs
• While the use of debt financing is expected to reduce agency costs
between shareholders and managers, and thus the positive impact of
financial leverage on the return on total business assets

• However, higher bankruptcy risk due to higher financial leverage

could also cause managers to make more conservative decisions, and
avoid risky investment which might have higher return

• If so, the impact of higher financial leverage on the return on total

business assets could be negative.
The Costs of Debt: Agency costs (2)
• Stockholder-Lender Agency Costs – occur when creditors lend money to a
firm and delegate authority to the stockholders to decide how that money
will be used

• Creditors expect that the stockholders, through the managers they appoint,
will invest the money in a way that enables the firm to make all of the interest
and principal payments that have been promised (fixed in the nature)

• However, stockholders may have incentives to use the money in ways that are
not in the best interests of the creditors (default risk faced by the creditors)
The Costs of Debt: Agency costs (4)
• Creditors are concerned about the possibility that stockholders have incentives to distribute some or
all of the funds that they borrow as dividends

• There exists the asset substitution problem, where once a loan has been made to a firm, the
stockholders have an incentive to substitute less risky assets for more risky assets (this increases the
default risk facing the creditors)

• There is also concern over underinvestment problem

• It occurs in a financially distressed firm when the value that is created by investing in a positive-NPV project is likely to
go to the lenders instead of the stockholders, the firm therefore becomes reluctant to undertake the project with
positive return
• It could lead to lower return on total business assets for firms with higher financial leverage

• The higher debt increases the volatility of a firm’s earnings and the probability that the firm will get
into financial difficulty (i.e. the default risk facing the creditors)

• All of these will result in higher risk premium asked by the creditors in the required rate of return on
investment to the firm with higher financial leverage.
The Costs of Debt
• Financial managers limit the amount of debt in their firms’ capital structures in part
because there are costs that can become quite substantial at high levels of debt

• At low levels of debt, the benefits are greater than the costs, and adding additional
debt increases the ROE of the firm (positively affects ROA and have little impact on cost
of debt)

• At some point, the costs begin to exceed the benefits, and adding more debt financing
destroys ROE (negatively affects ROA and also leads to a higher required rate of return
by creditors)

• Put differently, the higher level of financial leverage will reduce return on assets,
increase the required rate of return of debt, and eventually lead to a negative spread.
After the optimal level of financial leverage, the further increase in financial leverage
will decrease the return on equity (ROE)
Summary
• The DuPont analysis shows how we could develop our understanding of
the impact of financial leverage on Return on Equity

• The impact of financial leverage on Return on Equity can be either

positive or negative, depending on the detailed analysis of the impact
of debt on the return on total business assets and that on the required
rate of return by the debt holders (i.e. the impact on spread).

• The increase in the financial leverage will positively contribute to the

return on equity but the impact will be diminishing and eventually
become negative when the financial leverage passes the optimal level
Reading
• Parrino, R., Kidwell, D. S., Bates, T. W., & Moles, P. (2015).
Fundamentals of Corporate Finance, International Student Version
(3rd ed.). John Wiley & Sons. Chapter 16

• Additional reading

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