AcademicResearch on Corporate LeverageCorporate leverage is the degree to which acompany uses fixed-return securities such as debt and preferred equity. Themore debt financing a company uses, the higher its financial leverage. A highdegree of financial leverage means high interest payments, which negativelyaffect the company’s bottom-line earnings per share.
Modigliani and MillerThismodel states that, in an environment of no taxes the capital structure of acorporate does not matter but the risk of underlying assets and revenuegenerating ability matters.The tradeoff theory assumes that there arebenefits to leverage within a capital structure up until the optimal capitalstructure is reached. The theory recognizes the tax benefit from interest payments- that is, because interest paid on debt is tax deductible, issuing bondseffectively reduces a company’s tax liability. Paying dividends on equity,however, does not. Thought of another way, the actual rate of interestcompanies’ pay on the bonds they issue is less than the nominal rate ofinterest because of the tax savings. Studies suggest, however, that mostcompanies have less leverage than this theory would suggest is optimal.
firmshave to make a tradeoff betweenthebenefits of cheap debt finance on the one hand and the costsassociatedwith high levels of gearing (such as the risk of bankruptcy) ontheother. If the correct balance can be achieved, the cost of finance willfall to aminimum point, maximizing NPVs and hence the value of thefirm.Key Practical Aurgumentsagainst M theoryBankruptcyriskAs gearing increases so does the possibility ofbankruptcy.
Ifshareholders become concerned, this will reduce theshare price andincrease the WACC of the company.Agencycosts: restrictive conditionsIn order to safeguard their investmentslenders/debentures holders oftenimpose restrictive conditions in the loan agreementsthat constrainsmanagement’s freedom of action.E.
g. restrictions:TaxexhaustionAfter a certain level of gearing companies willdiscover that they have notax liability left against which to offset interestcharges.Kd(1 – t) simply becomes Kd.Borrowing/debtcapacityHigh levels of gearing are unusual because companiesrun out ofsuitable assets to offer as security against loans.Companies withassets, which have an active secondhandmarket, and low levels ofdepreciation such as property companies, have a highborrowingcapacity.
Differencerisk tolerance levels between shareholders andDirectorsBusiness failure can have a far greater impact ondirectors than on awelldiversifiedinvestor. It may be argued that directors have anatural tendency to be cautious about borrowing.The Traditional Viewthetraditional view has no theoretical basisbut commonsense.
It concludes that a firm should have an optimal level ofgearing,where WACC is minimised, BUT it does not tell us where thatoptimal point is. The only way of finding the optimal point is bytrial and error. At low levels of gearing:Equityholders see risk increases as marginal as gearing rises, sothecheapness of debt issue dominates resulting in a lower WACC.At higher levels of gearing:Equityholders become increasingly concerned with the increasedvolatilityof their returns (debt interest paid first). This dominates thecheapnessof the extra debt so the WACC starts to rise as gearingincreases.With the following from Goldman’sRobert Boroujerdi, we can finally close the book on whether US corporateleverage is at all time highs.
It is… and it’s even higher on a”normalized” basis.As the Goldman strategist writes, even as corporate defaultsremain near historically low levels, froth (there’s that word again) “hasbeen building in the form of corporate leverage. While this may not present a near-term risk, thewidespread increase in debt resulting in stretched leverage metrics bearswatching, in our opinion.”Goldman adds that while the pullback in Energy earnings in recentyears has stressed aggregated Net Debt/EBITDA, even excluding thatsector, the ratio is at the highestpoint since the financial crisisInspired from Zerohedge.
com Dealingwith ‘gearing drift’Profitable companies will tend to find that theirgearing level graduallyreduces over time as accumulated profits help toincrease the value ofequity. This is known as “gearing drift”.Gearing drift can cause a firm to move away from itsoptimal gearingposition. The firm might have to occasionally increasegearing (byissuing debt, or paying a large dividend or buyingback shares) to returnto its optimal gearingposition.Research at BehavioralFinance.
Behaviouralfinance combines, social and psychological human perception about prices ofcommodities.Forexample.Ifa price of a commodity Rise by 10%. It will be perception that there will be aprice drop after that. So the investor start selling off and the price drops.Andif a of a commodity drops by 10%. It will be perception that there will be aprice up after that.
So the investor start purchasing and the price rises.Whyis behavioral finance necessary?When using the labels “conventional” or”modern” to describe finance, we are talking about the type offinance that is based on rational and logical theories, such as the capital asset pricingmodel (CAPM) and the efficientmarket hypothesis (EMH). Thesetheories assume that people, for the most part, behave rationally andpredictably. (For more insight, see TheCapital Asset Pricing Model: An Overview, What Is MarketEfficiency? and Working Through The Efficient Market Hypothesis.
)For a while, theoretical and empirical evidencesuggested that CAPM, EMH and other rational financial theories did arespectable job of predicting and explaining certain events. However, as timewent on, academics in both finance and economics started to find anomalies andbehaviors that couldn’t be explained by theories available at the time. Whilethese theories could explain certain “idealized” events, the realworld proved to be a very messy place in which market participants oftenbehaved very unpredictably. Homo EconomicusOne of the most rudimentary assumptions thatconventional economics and finance makes is that people are rational”wealth maximizers” who seek to increase their own well-being.
According to conventional economics, emotions and other extraneous factors donot influence people when it comes to making economic choices. In most cases, however, this assumption doesn’treflect how people behave in the real world. The fact is people frequentlybehave irrationally. Consider how many people purchase lottery tickets in thehope of hitting the big jackpot. From a purely logical standpoint, it does notmake sense to buy a lottery ticket when the odds of winning are overwhelmingagainst the ticket holder (roughly 1 in 146 million, or 0.
0000006849%, for thefamous Powerball jackpot). Despite this, millions of people spend countlessdollars on this activity.These anomalies prompted academics to look tocognitive psychology to account for the irrational and illogical behaviors thatmodern finance had failed to explain. Behavioral finance seeks to explain ouractions, whereas modern finance seeks to explain the actions of the”economic man” (Homoeconomicus).AnomaliesThe presence of regularly occurring anomalies in conventionaleconomic theory was a big contributor to the formation of behavioral finance.These so-called anomalies, and their continued existence, directly violatemodern financial and economic theories, which assume rational and logicalbehavior.
The following is a quick summary of some of the anomalies found inthe financial literature.January EffectThe January effect is named after the phenomenon in which the averagemonthly return for small firms is consistently higher in January than any othermonth of the year. This is at odds with the efficient market hypothesis, whichpredicts that stocks should move at a “random walk”. The Winner’s CurseOne assumption found in finance andeconomics is that investors and traders are rational enough to be aware of thetrue value of some asset and will bid or pay accordingly.Equity Premium PuzzleAn anomaly that has left academics in finance and economics scratchingtheir heads is the equity premium puzzle.
According to the capital assetpricing model (CAPM), investors that hold riskier financial assets should becompensated with higher rates of returns.Inspired from InvestopediaOn The Impossibility of Perfect Capital Markets.Thegeneral equilibrium theory developed by Walras, Arrow, Debreu, Radner andothers, and expounded in Arrow and Hahn (1971), involves linear budgetconstraints and market clearing prices. For intertemporal environments, this iswhat is required for “perfect” capital markets, in which agents are free toborrow and lend at the same market rate of interest for all loans of the samematurity, and the rates of interest adjust to match the plans of borrowers andlenders. This theory is for an economy of honorable agents, who always satisfytheir intertemporal budget constraints.
Agents never expose themselvesdeliberately to the risk of default. With perfect foresight, no default wouldever occur. Without perfect foresight, of course, some agents may be unable toavoid bankruptcy ex post, as was realized by Green (1974) and Bliss (1976),amongst others. 1 Yet in the theory of temporary equilibrium, as surveyedrecently by Grandmont (1982, 1988), agents still arrange their affairs so that,according to their own expectations, they can fulfill their budget constraintswith probability one. As Milne (1980) has pointed out, this is consistent withtwo traders making a contingent contract which each is sure that he himself canhonor, and yet is sure that the other cannot! By contrast, the world is full ofless honorable agents who, to the extent that they find it profitable, willknowingly incur debts which they may find themselves unable to honor.There are also other Factors which have to be considered The Need for Credit Rationing Feasible Allocation Mechanisms Additional Incentive Constraints.Inspired from Stanford