LEVERAGED FINANCEThe assets of a business must be financed somehow, and when a business is growing, the additional assets must be financed by additional capital.Leverage refers to the way in which an organization is financed by a combination of equity capital and debt. A highly geared or levered company is one that is financed with more of debt relative to equity. The level of leverage has a considerable effect on the earnings attributable to the ordinary shareholders.
A highly levered company must generate enough profits to cover its interest charges before anything is available for equity. On the other hand, if borrowed funds are invested in projects which provide returns in excess of the cost of debt then the ordinary shareholders will benefit (this is called favorable effect of leverage). Leveraged Finance DefinedLeveraged finance is funding a company or business unit with more debt than would be considered normal for that company or industry. More-than-normal debt implies that the funding is riskier, and therefore more costly, than normal borrowing. As a result, levered finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self-sustaining cash-generating asset. Although different banks mean different things when they talk leveraged finance, it generally includes two main products – leveraged loans and high-yield bonds. Leveraged loans, which are often defined as credits priced 125 basis points or more over the London inter-bank offered rate, are essentially loans with a high rate of interest to reflect a higher risk posed by the borrower. High-yield or junk bonds are those that are rated below “investment grade,” i.
e. less than triple-B.A key instrument is much leveraged finance, particularly in leveraged buy-outs, is mezzanine or “in between” debt. Mezzanine debt has long been used by mid-cap companies in Europe and the US as a funding alternative to high yield bonds or bank debt. The product ranks between senior bank debt and equity in a company’s capital structure, and mezzanine investors take higher risks than bond buyers but are rewarded with equity-like returns averaging between 15 and 20 per cent.
Companies that are too small to tap the bond market have been the traditional users of mezzanine debt, but it is increasingly being used as part of the financing package for larger leveraged acquisition deals. Although mezzanine has been more expensive for companies to use than junk bonds, the low coupons coupled with high returns often makes some sort of mezzanine or hybrid debt an essential buffer between senior lenders and the equity investors.Leveraged Acquisition FinanceLeveraged Acquisition Finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by an existing internal management team (a management buy-out), an external management team (a management buy-in) or a third party (an acquisition).The leverage of a transaction refers to the ratio of debt capital (bank loans and bonds) to equity capital (money invested in the shares of the target company). In a leveraged financing, this ratio is unusually high. As a result, the level of debt service (payment of interest and repayment of principal) absorbs a very large part of the cashflow produced by the business.
Consequently, the risk of the company not being able to service the debt is higher and thus the position of the lenders is riskier than in a conventional acquisition. The interest rate on the debt will be high.Leveraged RecapitalizationsA technique whereby a public company takes on significant additional debt with the purpose of either paying an extraordinary dividend or repurchasing shares, leaving the public shareholders with a continuing interest in a more financially-leveraged company. This is often used as a “shark repellant” to ward off a hostile takeover.;Leveraged Corporate CreditLeveraged corporate credit involves the provision and managment of credit products, including bank loans, bridge loans and high-yield debt, for below investment grade companies that rely heavily on debt financing.Leveraged Asset-Based FinanceLeveraged asset-based finance entails raising debt capital for companies where the physical assets or a defined, contractual cash flow form the basis for highly levered non- or limited-recourse funding of assets or projects.
Leasing, project financing and whole business securitization are examples of these techniques.;Leveraged finance, like other parts of structured finance, primarily involves identifying, analyzing and solving risks. These risks can be arranged into the following groups:Credit risks and financial risksCredit risks are concerned with the business and its market. Financial risks which lie within the economy as a whole, for instance, interest rates, foreign exchange rates and tax rates.Structural risksThese are risks created by the actual provision of finance including legal, documentation and settlement risks.;There are often different layers of finance involved in leveraged financing.
These range from a senior secured bank loan or bond to a subordinated loan or bond. A large part of the role of leveraged financiers is to calculate how each type of finance should be raised. If they overestimate the ability of the company to service its debt, they may lend too much at a low margin and be left holding loans or bonds they cannot sell to the market. If the value of the company is underestimated, the deal may be lost.Debt-Equity RatioJust as it is sufficient to measure current assets against current liabilities and establish the current ratio for assessing the short-term financial soundness of a company, the debt-equity ratio is by itself sufficient to assess the soundness of long-term financial policies. Debt means the long-term loans, i.
e., preference share capital, equity share capital, reserves less losses and fictitious assets like preliminary expenses. The ratio is ascertained in two ways:Debt/EquityDebt/Debt + equity (or total long-term funds)*Method 2 is more popular and meaningful as it shows the proportion of long-term funds that have been raised by way of loans.The main purpose of the ratio is to determine the relative stakes of outsiders and shareholders.
Normally, for industrial or trading concerns the ratio should be 0.67:1, indicating that two-thirds of the total requirements of long-term funds could be raised by way of loans. A higher proportion would be risky since loans carry with them the obligation to pay interest at a fixed rate which may become difficult if profit is reduced.
A proportion of loans to total long-terms funds very much less than 2/3rds would indicate an undue conservatism and an unwillingness to take even normal risk. Both these affect the image of the company and the value placed by the market on the company’s shares.One should note that for assessing the financial soundness of a company one should establish both the current ratio and the debt-equity ratio. Some other aspects or offshoots of the debt-equity ratio are stated below:If on a certain date the proprietors want to know what their share is in the business on that date, the ratioShareholder’ funds/Total tangible assets would be helpful.
This is known as the “proprietary ratio”. The ratio is expressed normally as a percentage. It would indicate an alarming state of affairs if the above ratio is less than 50% since that would mean that the proprietors’ own funds and are less than those of others. A big loss will mean that probably outsiders will have to bear a part of it.;;;Capital Gearing Ratio (Leverage)The main idea behind this ratio is to compare the composition of the capital employed by classifying the components into two groups, i.
e., funds bearing fixed interest or fixed dividends and other funds which constitute equity shareholders’ funds which do not bear fixed dividends. The gearing ratio can be ascertained as:Funds bearing fixed interest or fixed dividends/Total capital employedOrFunds bearing fixed interest or fixed dividends/Equity shareholders’ funds;If fixed interest or fixed dividends bearing funds are more than the equity shareholders’ funds, the company is said to be highly geared or levered. If the equity shareholders’ funds are more than the fixed interest and dividend bearing funds, then the gearing is low.
If the two components are equal then the company is said to be evenly geared.There is a close similarity between the debt-equity ratio (as a long-term ratio) nd the capital gearing ratio. But a basic difference should be noted. In the former case, the classification was outsiders against members. In the latter case, the classification is based on the return for the funds.The utility of the gearing ratio lies in indicating the extra residual benefit accruing to the equity shareholders. This benefit accrues because the company earns a certain percentage on total funds employed, but pays only a fixed return against loans and preference capital.
This would result in a higher percentage return, even higher than the percentage earned by the company. Thus, if the company earns a 20% rate of return, the equity shareholders may get a 30% rate. Such a situation is known as “Trading on equity” or ‘leverage”.What is the link between capital gearing and leverage? A company though evenly geared may still have leverage because such situation can arise as a consequence of:i) the overall profitability,ii) the rate of fixed interest and fixed dividend, andiii) tax burden.-the leverage, however, is further influenced by the gearing also. A high gearing would mean a low equity base with the result, the return to the equity shareholders would increase.
Trading on equity or leverage is a necessary reward for the risk taken by the equity shareholders. This reward is also uncertain as it is dependent upon the higher profitability and the tax burden. Moreover, in case of lower profitability, the equity shareholders run the risk of not only denying the dividends for themselves but also forgo out of thair capital, the return payable to the fixed interest and fixed dividend bearing funds. Thus, leverage by itself is not an evil but it has potential for making the shares highly speculative which can be considered as an undesirable feature.;TYPES OF LEVERAGEFinancial leverage – Financial leverage takes the form of loan or other borrowing (debt), the proceeds of which are reinvested with the intent to earn a greater rate of return rather than the cost of interest. If the firm’s return on assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm’s ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential return to the investor than otherwise would have been available.
The potential for loss is also greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid.;Operating Leverage – This reflects the extent to which fixed assets and associated fixed costs are utilized in the business. Degree of operating leverage (DOL) may be defined as the percentage change in operating income that occurs as a result of a percentage change in units sold. To the extent that one goes with a heavy commitment to fixed costs in the operation of a firm, the firm has operating leverage.;The Role of the main providers of Leverage finance.The following are the main providers of leveraged finance in most parts of the world; including Australia: They arei.
Banksii. Insurance companiesiii. Finance companiesiv. Unit trustv.
Pension fundsvi. Individuals, andvii. Institutional investorsPreferred stock – This is a hybrid security having some characteristics of debt and some of equity. Equity holders view preferred stock as being similar to debt because it has a claim on the firm’s earnings ahead of the claim of the common stockholders. Bondholders view preferred stock as equity because debt holders have a prior claim on the firm’s income.Advantages of preferred stock to the issuer are:Preferred stock dividends are limited;The failure to pay preferred stock holders will not bankrupt the firm.
The disadvantage to the issuer is that the cost is higher than that of debt because preferred dividend payments are not tax deductible. To the investor, preferred stock offers the advantage of more dependable income than common stock. However, returns from preferred stock are limited and the investor has no legally enforceable right to a dividend.Finance gearing is the ratio between ordinary share capital and interest bearing plus fixed dividend bearing securities (including preference shares). Financial gearing might be important to a company becauseIt affects the income risk of shareholders and the providers of interest bearing and fixed dividend bearing finance. The higher the financial gearing the greater the interest payments a company must make before the ordinary shareholders and preference shareholders receive dividend payments.It affects the capital risk for providers of funds.
Increase financial gearing is likely to increase bankruptcy costs, agency costs and lead to a higher probability of a corporate failure as there is a greater chance of default on payments on interest and principalThe level of financial gearing influence a company’s ability to raise new finance, and the type of finance that might be available;Financial gearing affects the company’s cost of capitalThe following factors might limit the amount of debt finance:i. Security;ii. Limitation imposed in the company’s articles of association;iii. The existing level of financial gearingiv. Cash flow available to meet payments of interest and principal;v. Stability and growth of profits and salesvi.
The relative costs of debt and equityvii. Covenants on existing debt restructuring further debt financingviii. The attitude of the company’s managers towards risk and control.;Private BorrowingBusiness firms can use bond, preferred stock and common stock to secure capital directly from financial institutions such as commercial banks, insurance companies, pension funds, mutual funds, and non-financial organizations or even rich individuals. A private placement may be made to potential investors for direct financing.Direct financing offers speed, flexibility, and low issuance costs as it is not necessary to go through some rigorous registration exercise. Restrictive provisions are designed to protect long-term lenders.Advantages of Private sources to the borrower are:1.
Much seasonal short-term borrowing can be dispensed with, hereby reducing the danger of non-renewal of loans;2. The borrower avoids the expenses of issuing and registration and investment bankers’ distribution;3. Less time is required to complete arrangement for obtaining a loan than is involved in a bond issue;4. Since only one lender is involved in most cases, rather than many bondholders, it is possible to modify the loan indenture.The disadvantages include high interest rate due to long-term period; sinking fund requirement maybe incorporated in the agreement hence cash drain on the firm’s purse; attracts high credit standards, etc.;Public Borrowing: -This source consists of the investment bankers. Investment bankers are used to sell securities such as preferred stock, debenture or bonds, equity stock to a large number of investors such as the general public and institutional investors in the capital market.
Euity Capital: The capital owned by the shareholders of a company is known as euity or ordinary share capital. It is sum of capital stock, share premium, and accumulated retained earnings. The company may be a private company whose shares are traded on any recognized stock exchange or it may be a public company whose shares are traded on recognized stock exchange.The major advantages of common stock financing are that:i. There is no obligation to make fixed payments;ii. Common stock never maturesiii.
The use of common stock increases the credit worthiness of the firm and enhances firm’s borrowing capacity, etcThe major disadvantages include:i. It dilutes ownership control as it extends voting privileges to new stockholders;ii. It reduces dividend per share as new shareholders share in the firm’s profits;iii. Cost of common stock financing can be high due to fees and allied charges.
;Acquisitions of companies have been done in recent years by some interests using one or a combination of the following means.Management buy-outs: This is the purchase of all or part of a business from its owners by its managers. For example, the directors of a subsidiary company in a group might buy the company from the holding company, with the intention of running it as proprietors of a separate business entity. A well known company, Pfizer Limited has been transformed to Neimeth Limited through this way for a more efficient management and a good capital base.Management buy-ins: This is used when a team of outside managers, as opposed to managers who are already running the business, mount a takeover bid and then run the business themselves. A management buy-in might occur when a business venture is running into trouble, and a group of outside managers see an opportunity to take over the business and restore its profitability. Econet wireless International was into financial problem before it was bought over and changed to V-Mobile; more cash was injected into it by outside interest, i.
e. Celtel, who now controls about 65% of the capital base.Leveraged buy-outs: Going private can be a straight transaction, where the investor group simply buys out the public stockholders, or it can be a Leveraged Buy-out (LBO), where there are third and fourth party investors. As the name implies, a leveraged buy-out represents an ownership transfer consummated primarily with debt. Sometimes called asset-based financing, the debt is secured by the assets of the enterprise involved. While some leveraged buy-outs involve the acquisition of an entire company, many involve the purchase of a division of a company or some sub-unit.
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