Yesterday, I wrote about return on equity, as it applies to a company that uses only this form of capital, i.e., has no long-term borrowings, no financial leverage.
In most places, companies are allowed to employ debt capital in their long-term operating plans as well as equity.
Opinions differ as to whether this is a good idea or not. Americans tend to approve, on the idea that debt is a cheaper form of capital than equity; investors in the UK and Europe tend to disapprove–arguing that debt is a more expensive form of capital than equity. In the Islamic world straight debt is not allowed.
My chief comment is old saw that “leverage works both ways;” that is, during an economic expansion it’s most often a return booster, while in bad times it can be an albatross around the firm’s neck.
Let’s say a company goes public by selling 1000 shares at $10 each.
Once it’s public, it issues $10,000 worth of ten-year bonds with a 5% coupon.
Now it has $10,000 in equity and $10,000 in debt.
Let’s say it invests all the money in projects that produce a $2000 annual return. (For simplicity’s sake, let’s make the (unrealistic) assumption that the money is all raised and invested in projects that are instantly up and running on January 1st). Let’s also ignore taxes.)
At the end of year 1, the firm has earned $2000.
return on capital
Its return on capital is: $2000 ÷ ($10,000 debt + $10,000 equity = $20,000), or 10%.
return on equity
Its return on equity is: ($2000 – $500 in interest = $1500) ÷ $10,000 equity = 15%.
return on leverage
Let’s define another term, return on leverage, as the return on equity minus the return on capital. In this case, the return (to equityholders) on (or from) leverage is +5%.
Why do so? Why in the form of a simple subtraction?
As to the form, the sole reason is because it is a simple thing to figure out.
I think it’s important to break down the returns a management is producing for shareholders into two components to quqntify how good it is at two different management skills–how company operations are being run (return on capital) and how those returns are being supplemented by shrewd use of debt financing (return on leverage).
I say “supplemented” because in a well-managed business the lion’s share of the returns will come from operations. Returns from leverage will be the icing on the cake.
Looked at in a different way, what conclusion should we draw if most of the returns come from leverage? One worry is that the firm’s management doesn’t have the necessary operating skills to be successful and is substituting aggressive risk taking with company financing to cover up for this deficiency.
Suppose the company described above earns $1200 in year 1.
That’s a 6% return on capital.
The return on equity is ($1200 – $500) ÷ $10,000 = 7%.
The return on leverage = 1%! This is trouble, because the company is barely covering the cost of its borrowing.
A worse case:
The company earns $400.
The return on capital is 2.5%.
The return on equity is ($400 -$500) ÷ $10,000 = -1%
The return on leverage is -1% -2.5% = -3.5%. This is a disaster.