Financial Leverage

Financial leverage is the relationship between total assets and equity or shareholder investment. It measures the amount of equity that is used to acquire assets. If leverage is high, then a limited amount of equity is used to buy assets. This means that the primary source of financing is debt. If the financial leverage is low, then more equity is used to buy assets. What are the implications from a shareholder value perspective? Risk to shareholders increase as they invest more in a business. Hence investors will demand a larger return for the increase in risk. This will tend to increase the cost of capital that will be used to adjust cash flows to arrive at an intrinsic value.

On the other hand, the use of debt can have a significant impact on value. Debt gives rise to interest charges that will reduce cash flow. Excessive amounts of debt can offset cash flow gains if interest payments exceed the benefits generated by the Strategic Alternative. Increases in leverage can be a leading indicator of erosion of value, if debt is managed improperly.

How does this help evaluate SAs? A quick look at leverage can tell us if the risk profile is changing. If leverage is the driver in increasing ROE, then the change in value is not due to the SA, but how it is being financed.