Evaluating a Company’s Capital Investments and Structure

Sources and Uses of Capital

Companies invest capital that they acquire from debt and equity investors. Their primary goal is to earn returns that exceed the investors’ required rates of return. A significant part of company analysis involves assessing whether these required rates of return have been met or exceeded, thereby creating economic value for investors over time.

The company analysis also includes evaluating the risks and opportunities associated with the company’s capital structure, such as the use of financial leverage. The table provided below provides a snapshot of how businesses manage their financial resources, ensuring they have enough funds to operate smoothly while also making strategic investments for the future.

$$\begin{array}{l|l}
\textbf{Sources of Capital} & \textbf{Uses of Capital} \\
\textbf{(Where it comes from)} & \textbf{(Where it’s spent)} \\
\hline
\text{Operational profits} & \text{- Reserving cash and} \\
\text{including savings} & \text{making investments} \\
\text{from working capital} & \\
\hline
\text{Raising funds} & \text{- Allocating to working} \\
\text{through issuing debt} & \text{capital needs} \\
\hline
\text{Raising funds} & \text{- Investing in physical} \\
\text{through issuing equity} & \text{and intangible assets} \\
\hline
\text{Selling off assets} & \text{- Buying other businesses} \\
& \text{or assets (acquisitions)} \\
& \text{- Reducing outstanding} \\
& \text{debt} \\
& \text{- Distributing profits as} \\
& \text{dividends or buying back} \\
& \text{shares} \\
\end{array}
$$

Evaluation of Capital Investments

Assessing the efficiency of management in utilizing investor capital can be achieved by comparing long-term returns on invested capital to the required rates of return. Independent investment analysts, who lack the same information as management, utilize aggregated measures to gauge if there have been changes in value creation, whether positive or negative.

For example, if a company has consistently shown a high return on invested capital, it indicates effective management of investor’s capital.

Understanding and Assessing Risks Related to Capital Structure

Risks associated with the capital structure can be measured using leverage and coverage ratios, credit ratings by third-party rating agencies, and the degree of financial leverage.

The degree of financial leverage, which is the sensitivity of net income to changes in operating income, increases with higher interest expenses that are fixed with respect to operating income. It is similar to the degree of operating leverage but is determined by financing costs rather than fixed operating costs. For example, a company with a high degree of financial leverage may see a significant change in net income with a small change in operating income.

The Degree of Financial Leverage (DFL) is calculated as:

$$DFL = \frac{\% \Delta \text{Net income}}{\% \Delta \text{Operating income}}$$

Where:

DFL = Degree of Financial Leverage.

%Net income = Percentage change in net income.

%Operating income =  Percentage change in operating income.

Financial Leverage and Levered Returns

Unlevered returns, represented by Return on Invested Capital (ROIC) and return on assets (ROA), are enhanced by financial leverage to yield levered returns or return on equity (ROE).

Both Return on Invested Capital (ROIC) and Return on Equity (ROE) are fundamental metrics that provide insights into a company’s efficiency in generating returns. ROIC focuses on returns generated from the capital invested in the business, while ROE emphasizes returns to equity shareholders. Financial leverage can amplify the difference between these two metrics.

Let’s use an example of a company, TechFirm Inc., to illustrate this:

1. Starting Point: TechFirm Inc. has an initial investment (equity) of $100,000 and generates a profit of $10,000. Therefore, its ROE is 10% (10,000 / 100,000).
2. Introducing Debt: Now, imagine TechFirm Inc. borrows $100,000 at an interest rate of 5%. With this, it now has a total capital (equity + debt) of $200,000. Let’s assume that by effectively using this borrowed amount, it manages to double its profit to $20,000. After paying off the interest of $5,000 (5% of $100,000), it’s left with a profit of $15,000.
3. Calculating ROIC: ROIC would consider the returns generated by the entire capital. So, ROIC = $15,000 / $200,000 = 7.5%.
4. Calculating ROE: ROE focuses only on equity shareholders. Given that equity remains $100,000 and profit (after interest) is $15,000, ROE becomes 15% (15,000 / 100,000).

From this example, we see how TechFirm Inc., by using financial leverage (debt), increased its ROE from 10% to 15%, even though its ROIC went down from 10% to 7.5%. This amplification in returns due to leverage is precisely why companies like Google with high ROE are seen as highly profitable.

However, it’s essential to be cautious. While leverage can enhance returns, it also introduces additional risks. If TechFirm Inc. had not been able to utilize the borrowed funds effectively, it could have ended up with reduced profitability or even losses.

This example provides a clearer picture of how financial leverage can influence a company’s returns and the difference between ROIC and ROE.

Question

What is most likely the main benefit of using financial leverage?

1. Stabilizes the fluctuations in ROE.
2. Increases the available capital for new investments.
3. Enhances unlevered return to produce levered returns.

The correct answer is C.

The primary benefit of employing financial leverage is its potential to amplify unlevered returns, thereby generating higher levered returns. By leveraging, companies employ borrowed capital for investment and earn a return on it, which is hoped to exceed the interest expense. Financial leverage is the use of various financial instruments or borrowed capital to amplify the potential return of an investment.

A is incorrect. Financial leverage does not stabilize fluctuations in return on equity; in fact, it can increase the volatility of returns on equity because it adds fixed financing costs (interest expenses) that must be paid regardless of the company’s earnings performance. Hence, it can make returns on equity more volatile rather than stabilizing them.

B is incorrect. While financial leverage does indeed make more capital available for investment by allowing businesses to invest borrowed funds, this is a characteristic of leveraging and not the main benefit. The main benefit is the enhancement of returns on equity, provided the investments funded with borrowed funds generate returns above the cost of borrowing.