Unit 6 The financial sector: Debt, money, and financial markets

6.10 Businesses: Capital and the magic (and risks) of leverage

In Section 5.12, we analysed the decision of a firm considering an investment in productive capital. Here we examine how the firm chooses to fund the investment. Economists refer to this as the choice between debt and equity. It could borrow the funds required (from the bank, by issuing bonds). Or it could raise funds by issuing new shares (new equity), or reinvest some of its own profits. Both the second and third options are forms of equity investment; since all the firm’s profits legally belong to its shareholders. Reinvested profits are effectively a new investment of shareholder’s funds, and in practice most equity investment takes this form.

Borrowing to invest: The power of leverage

When a firm borrows to invest, it will have to pay interest on its loan. But if it can achieve a higher rate of return on its investment project than the interest rate it pays on any new borrowing, the difference can enable the shareholders of the firm to make higher—sometimes much higher—rates of return on the equity invested.

leverage, gearing, leverage ratio

Leverage (or gearing) refers to the process of increasing investments or asset purchases by borrowing. There are several different, but closely related, measures of leverage of a household, a firm, or a bank. CORE uses the proportion of the investment financed by borrowing; in other words, the leverage ratio is the ratio of debt to assets.

This strategy is known as leverage, or gearing. But the apparent miracle of leverage brings with it very significant risks.

Work through the steps in Figure 6.14a to understand the positive aspects—the apparently miraculous powers of leverage.

If the firm does not borrow at all, it cannot invest in a project that costs more than $100 million. But since every dollar’s worth of capital earns more than the interest cost of borrowing a dollar, the more the firm borrows—the higher its leverage—the higher is the return on equity for the shareholders. This is the apparent miracle of leverage.

Figure 6.14b illustrates the risks. The firm may expect a return of 10% on capital. But its forecasts may prove too optimistic. If its revenues from the new capital are equal to its operating costs, so that it makes no operating profits (in the fifth column), this implies that the actual rate of return on capital will be zero. And if it has borrowed, it will still have to pay interest on the debt and so will make a loss overall. Although the investment itself has not made a loss, the shareholders have lost some of their equity. In the bottom row, they lose almost the whole of their initial equity of $100 million.

Therefore, the higher a firm’s leverage, the more its losses are magnified in bad times—just as the potential gains are magnified in good times. In the most highly leveraged case in Figure 6.14b, shareholders lose almost the entire value of their initial investment of equity.

So the miracle of leverage is a distinctly qualified miracle. But that does not detract from its power or its importance in a modern economy. Even small differences between the return on capital and the cost of borrowing can result in high returns to shareholders; and so the firm’s owners have a very strong incentive to find the most profitable combination of debt and equity to fund its investments in fixed capital.

Limited liability

In the example in Figure 6.14b, even in the worst case, equity holders made a rate of return on equity of –95%, which meant they were left with 5% of their initial equity investment. But what if the $100 million invested was the entire value of the firm’s initial net worth? With sufficiently high leverage, even a modest negative return would mean that, after paying interest, the firm’s net worth could easily be negative. In that case, the company would owe more than it owned.

Under limited liability, the most that shareholders can lose is their initial investment. It means that the shareholders do not have to use their own personal assets to pay their debts. They do not, for example, have to use other wealth (such as their home) to pay back lenders. So, for a company with limited liability, negative net worth triggers bankruptcy, which in turn means at least partial default on debt. So lenders to the company may not get back everything they are owed—their rate of return will be less than the agreed interest rate on the loan.

Why are shareholders given this form of legal protection from risk? Proponents of limited liability would argue that the benefit is that firms will then not be deterred from risky investments with high expected returns, which can potentially increase aggregate wealth through innovation and more efficient use of capital. They might also point to the growth in GDP per capita that accompanied the growth in debt shown in Figure 6.5.

The counterargument is that it may lead shareholders to take excessive risks, because the potential losses will be borne by others. While limited liability is largely taken for granted in modern economies, it was quite controversial when first introduced in the nineteenth century and was vehemently opposed by some economists and legal scholars.

Does leverage benefit society?

In our example above, where the firm borrows to invest directly in productive capital, it generates future income for the shareholders, and increases the wealth of society as a whole. But the prospective benefits of leverage to the firm apply to any asset with a rate of return above the interest rate it pays on borrowing.

A firm has strong incentives to invest in any activity that yields the same high rate of return, whether or not that investment is in productive capital. It might, for example, use leverage to buy a franchise that gives it access to monopoly profits, or to engage in lobbying activities, or to fund a takeover of a competitor that will allow it to increase its market power.

None of these activities necessarily increases the aggregate wealth of the economy. When firms invest to increase or maintain their own market power, profits come at the expense of losses for others. From the perspective of society as a whole, the gains from channelling investment to its most profitable use depend on effective product market competition.

Banks and other financial intermediaries as highly leveraged companies

The examples in Figures 6.14a and 6.14b illustrate that leverage has potential benefits, but also risks. In principle, companies outside the financial sector always have the safer option of not borrowing. An ‘equity-only company’ could raise initial funds by a new issue, and fund further investments by retained profits, which is also a form of equity.

But for banks and other companies in the financial sector, the fundamental business model relies on leverage. For example, hedge funds are investment firms that make extensive use of leverage to boost their returns from investing in financial assets.

A bank that does not borrow is a contradiction in terms: it can only engage in the business of banking by borrowing. So compared to other companies, banks are typically highly leveraged: their net worth is very small relative to their liabilities. Figure 6.15 compares the leverage of Barclays Bank and Honda.

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https://www.core-econ.org/macroeconomics/06-financial-sector-10-businesses-capital-and-leverage.html#figure-6-15

Figure 6.15 Comparing the leverage of a bank with a non-financial company: Barclays and Honda.

As explained in Section 6.4, a bank only makes profits if it earns a higher return on its assets than it pays on its liabilities. But because banks are so highly leveraged and offer a guaranteed return on liabilities, the risk of an unexpectedly low return on assets has serious implications. Suppose, for example, that a bank has leverage of 95%; then its net worth is only 5% of the value of its assets. A fall of 5% or more in the value of its assets will entirely wipe out the bank’s net worth. In the run-up to the global financial crisis of 2007–2009, the leverage of many banks was even higher than this and small falls in the value of their assets made them insolvent. Reforms introduced since then have required banks either to raise more funds from their shareholders to boost net worth or to shrink their lending, thereby reducing leverage. (Unit 8 covers this topic.)