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T
The company example uses a 40 percent combined federal and state income tax
rate, which is realistic. However, the taxation of business income varies considerably
from state to state. Also, under the current federal income tax law, corporate taxable
income from $335,000 to $10 million is taxed at a 34 percent rate. Annual taxable
incomes below $335,000 are taxed at lower rates and above $10 million at a slightly
higher rate. The example assumes that the business is a corporation and is taxed as a
domestic C (or regular) corporation.
A corporation with 75 or fewer stockholders may elect to be treated as an S cor-
poration. An S corporation pays no income tax itself; its annual taxable income is
passed through to its individual stockholders in proportion to their ownership share.
Sole proprietorships, partnerships, and limited liability companies are also tax con-
duits; they are not subject to income tax as separate entities but pass their taxable
income through to their owner or owners who have to include their shares of the
entity™s taxable income in their personal income tax returns. Individual situations
vary widely, as you know.
Corporations may have net loss carryforwards that reduce or eliminate taxable
income in one year. There is also the alternative minimum tax (AMT) to consider, to
say nothing of a myriad of other provisions and options (loopholes) in the tax law. It™s
very difficult to generalize. The main point is that in a given year in a given situation
the taxable income of the business may not result in a normal amount of income tax.


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million EBIT. The business would have to have earned a
20.0 percent ROA rate in this situation. But since interest is
deductible, the business needed to earn only 18.0 percent
ROA to pay interest and to generate 15.0 percent ROE for its
shareowners.


RETURN ON EQUITY (ROE)
The example business is organized as a corporation. The
company™s shareowners invested money in the business for
which they received shares of capital stock issued by the busi-
ness. Keep in mind that the stockholders could have invested
this money elsewhere. The business over the years retained a
good amount of its annual net income instead of distributing
all its annual net income as cash dividends to its stockholders.
The total owners™ equity capital of the business from both
sources is $6.0 million. This amount includes the paid-in capi-
tal invested in the business by its stockholders and the cumu-
lative amount of retained earnings.
Stockholders™ equity capital is at risk; the business may or
DANGER!
may not be able to earn an adequate net income for its
stockholders every year. For that matter, the company could
go belly-up and into bankruptcy. In bankruptcy proceedings,
stockholders are paid last, after all debts and liabilities are set-
tled. There™s no promise that cash dividends will be paid to
stockholders even if the business earns net income. The ROE
ratio does not consider what portion (if any) of the business™s
annual net income was distributed as cash dividends. The
entire net income figure is used to compute the ROE ratio.
In the example (see Figure 6.2), the company™s ROE was
15.0 percent for the year, which is not terrific but not too bad.
This comment raises a larger question regarding which yard-
stick is most relevant. Theoretically, the $6 million owners™
equity in the business could be pulled out and invested some-
where else to earn a return on the best alternative investment.
Should the company™s ROE be compared with the rate of
return that could be earned on a riskless and highly liquid
investment such as short-term U.S. government securities?
Surely not. Everyone agrees that a company™s ROE should be
compared with comparable investment alternatives that have
the same risk and liquidity characteristics as stockholders™
equity.

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The rate of return on the most relevant alternative
(the next best investment alternative) is called the
opportunity cost of capital. To avoid a prolonged discussion,
simply assume that the stockholders want the business to
improve on its 15.0 percent ROE performance. This implies
that their opportunity cost of capital is higher than 15.0 per-
cent, at least in the minds of the stockholders. Of course, the
company should maintain its ROE and do even better if possi-
ble. One reason for the business™s ROE being as good as it is
that the company had a nice gain from financial leverage.


FINANCIAL LEVERAGE
Piling debt on top of equity capital is called financial
leverage. As stated at the beginning of the chapter, if you visu-
alize equity capital as the fulcrum, then debt may be seen as
the lever that serves to expand the total capital of a business.
For this reason, using debt is also called trading on the equity.
The main advantage of debt is that a business has more capi-
tal to work with and is not limited to the amount of equity
capital that a business can muster. The larger capital base can
be used to crank out more sales, which should yield more
profit. Of course, this assumes that the business can actually
make profit from using its capital.

Using debt also has another important potential advantage. If
a business borrows money at an interest rate that is lower
than its ROA rate, it makes a financial leverage gain. The idea
is to borrow at a relatively low rate, earn a relatively high
rate, and keep the difference. In Figure 6.2, note that the
company earns 18.0 percent ROA but paid only 7.5 percent
interest on its borrowed capital. (The business has several
loans and pays different interest rates on each loan; the 7.5
percent is its composite average interest rate.) You don™t have
to be a rocket scientist to figure out that paying 7.5 percent
for money and earning 18.0 percent on it is a good deal.
In the example, debt provides 40 percent of the capital
invested in assets ($4 million of the total $10 million). Thus,
40 percent of the company™s EBIT is attributable to its debt
capital ($1.8 million EBIT — 40% = $720,000). But the busi-
ness paid only $300,000 interest expense for the use of the

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debt capital. Therefore its gain is the excess, or $420,000
($720,000 debt™s share of EBIT ’ $300,000 interest =
$420,000 financial leverage gain). Another way to compute
the gain from financial leverage is to multiply the 10.5 percent
spread between the 18.0 percent ROA earned by the business
and its 7.5 percent interest rate times the amount of its debt
(10.5% spread — $4 million debt = $420,000 financial leverage
gain before income tax).
A financial leverage gain adds to the share of EBIT avail-
able for equity capital. Figure 6.3 illustrates the importance of
the financial leverage gain in the company™s profit perform-
ance for the year. Using debt provides additional earnings for
the equity investors in the business. The shareowners earn
EBIT on their capital in the business and also get the overflow
of EBIT on debt capital after paying interest. In the example,
financial leverage gain contributes a good share of the earn-
ings for shareowners, as shown in Figure 6.3. The financial
leverage gain adds 39 percent on top of EBIT earned on
equity capital ($420,000 financial leverage gain · $1,080,000
EBIT on equity capital = 39%).

In analyzing profit performance, managers should separate
two components of earnings before income tax: (1) the finan-
cial leverage gain and (2) the EBIT earned on owners™ equity
capital. As shown in Figure 6.3, the company™s $1.5 million
earnings before income tax consists of $420,000 financial




debt percent debt share
$1,800,000 EBIT — 40% of total capital = $ 720,000 of EBIT
($ 300,000) interest
financial
$ 420,000 leverage gain
equity percent equity share
$1,800,000 EBIT — 60% of total capital = $1,080,000 of EBIT
earnings for equity
$1,500,000 before income tax
FIGURE 6.3 Components of earnings for equity.



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leverage gain plus the $1,080,000 pretax EBIT on equity capi-
tal. Therefore, a good part of the company™s pretax profit is
sensitive to the interest rate on its debt and its ratio of debt to
equity. If its interest rate had been 18.0 percent (an unreason-
ably high interest rate these days) the financial leverage gain
would have been zero.
The business, by using a moderate amount of debt capital,
enhanced the earnings for its owners. Professor Ron Melicher,
my longtime colleague at the University of Colorado, calls this
the earnings multiplier effect. I very much like this term to
describe the effects of financial leverage. The financial lever-
age multiplier effect cuts both ways, however. A percentage
drop in the company™s ROA causes earnings for equity to drop
by a larger percentage.
Why not borrow to the hilt in order to maximize financial
leverage gain? Well, for one thing, the amount of debt that can
be borrowed is limited. Lenders will loan only so much money
Y
to a business, relative to its assets and its sales revenue and
FL
profit history. Once a business hits its borrowing capacity,
more debt is either not available or interest rates and other
lending terms become prohibitive. Furthermore, there are
AM


several disadvantages of debt.
The deeper lenders are into the business the more restric-
DANGER!
tions they impose on the business, such as limiting cash
TE




dividends to shareowners and insisting that the business
maintain minimum cash balances. Lenders may demand
more collateral for their loans as the debt load of a business
increases. Also, there is the threat that the lender may not
renew the loans. Some businesses end up too top-heavy with
debt and can™t make their interest payments on time or pay
their loans at maturity and the lender is not willing to renew
the loan. These businesses may be forced into bankruptcy in
an attempt to work out their debt problems.
In short, using debt capital has many risks. Interest rates
change over time and the ROA rate earned by a business
could plunge, even below its interest rate. Even relatively
small changes in the ROA and interest rates can have a sub-
stantial impact on earnings. It™s no surprise that many busi-
nesses are quite debt-averse, opting for low levels of debt even
though they could carry more. The company in the example
uses a fair amount of debt; using either more or less debt
would have caused more or less financial leverage gain.

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s
END POINT
Every business must decide on a blend of debt and equity cap-
ital to invest in the assets it needs to make a profit. The total
capital invested in assets should be no more than necessary.
Interest has to be paid on debt capital, and the business
should earn at least a satisfactory return on equity capital in
order to survive and thrive. The starting point is to earn an
adequate return on assets (ROA), that is, an adequate amount
of earnings before interest and income tax (EBIT) relative to
the total capital invested in assets. Operating liabilities (mainly
accounts payable and accrued expenses payable) are deducted
from total assets to determine the amount of capital invested
in assets.
Using debt enlarges the total capital base of a business, and
with more capital a business can make more sales and gener-
ate more profit. Using debt for part of the total capital invested
in assets offers the opportunity to benefit from financial lever-
age”as well as the risk of suffering a financial leverage loss if
the business does not earn an ROA rate greater than the inter-
est rate on its debt. Managers should measure the financial
leverage gain or loss component of earnings for shareowners.
The financial leverage gain or loss component of earnings is
sensitive to changes in the interest rate, the debt level, and
the ROA of the business.




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7
CHAPTER




Capital Needs
of Growth

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