Diagnose the financial leverage effect and debt load - Effective CFO

5.3. Diagnose the financial leverage effect and debt load

44% of managers claim that their company has a clear or sufficiently clear debt ratio (debt/equity). 37% said they adhere to a flexible ratio. 19% of managers said that their companies do not have a target debt ratio. The larger the company, the sooner it adheres to the target ratio.

From the results of a survey of financial directors conducted by professors from the Fukua Business School at the University of Luke (USA)

J. Graham and K. Harvey in 2000-2001

Work on borrowed capital is manifested in various ways in the company's traditionally fixed financial indicators. We introduce the notation and stipulate the terminology. The ratio of own and borrowed funds was called financial leverage. Denote the amount of equity through E (equity), debt capital through D (debt), of the total capital by the balance valuation through CE (capital employed). Recall that we are talking about the constantly used sources of financing the company's assets, spontaneous, once-attracted sources in the analysis do not participate. All capital, fixed by market valuation, is often denoted by V. The quantification of the lever can be fixed in different ways: CE/E, D/E, D/CE, D/V. which operates on borrowed capital or, as they say in the professional financial language, is "leverage", the following features are observed.

First, in those companies where there is a financial lever, the return on equity (ROE) exceeds the return on assets (ROA) . For any amount of financial leverage and any rate of interest on loans. The ratio will be satisfied and mislead the owner. The trap is that in fact, not any borrowed capital is beneficial to the owner. Its benefits arise only with certain ratios between the profitability of an activity and the interest rate on loans. However, the comparison of the traditionally fixed coefficients ROE and ROA does not reveal the conditions for the inexpediency of working on borrowed capital. You will need a return on invested (or invested) capital - ROCE. Recall that ROCE is calculated based on the post-tax operating profit, i.e. the amount of net interest (N1), interest on borrowed capital (INT) and the effects of a tax shield on borrowed capital (& iexcl; NTx T, where T-rate of the canopy):

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The dependence of the return on equity and operating profit on invested capital expresses the following formula:

where k & iquest; - is the after-tax borrowing rate, which is the product of the required return on the loan captain to the expression (1 - The rate of income tax).

It is this ratio that in the first approximation answers the question whether borrowed capital is profitable for the owner.

The second term of the expression of the return on equity ({ROCE-- kf & iexcl;) D/E) was called the financial leverage effect.

From this key expression ROE it is obvious that the owners will benefit from higher returns only if they manage to attract borrowed capital at a rate not higher than the operating yield on the invested capital, i. if ROCE & gt; k ^. The value of the required yield on loans and the fixed borrowing rate can be equal to or even higher than the return on the company's invested capital (ROCE). The tax benefits of borrowing can offset these excesses. It is important that, taking into account the tax bill, the average interest rate on loans the company operates does not exceed ROCE. This is the condition for creating additional profitability from owners. This is the first test that should be done to diagnose the quality of financial work in the company.

From the key expression it follows that if the owners are interested in the growth of ROE, , then they have three levers of influence, two of which are financial.

The non-financial, or operational, lever is the ROCE metric. Its value depends on the chosen marketing policy and asset management policy (stocks, accounts receivable) and costs, i.e. The value of ROCE depends on the effectiveness of the investment decisions of the company - what assets the company uses and how effectively they are used. DuPont's classical formula derives key operational levers of influence on ROCE:

ROCE = Turnover x Profitability.

Financial mechanisms are: the ratio between own and borrowed funds, i.e. the actual financial leverage or, as sometimes it is possible to find in the literature an expression borrowed from mechanics, is the lever arm; The difference between the operating return on invested capital and the cost of borrowed capital. Sometimes you can find an expression for this difference - the "lever differential". The cheaper the CFO will be able to attract borrowed capital, the things, other things being equal, will be more differential and higher the value ROE. The more a company will be able to attract borrowed capital at the same rate of interest, the higher will be the effect of the financial leverage.

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However, as in the Dupont model (the existence of a stable dependence of profitability and turnover), there is a limitation in the growth of the effect of the financial leverage. The more a company attracts borrowed capital, the riskier the creditor's position becomes (because the probability is higher that the company will not be able to pay off) and the more profitability it will require for its capital. Thus, with the growth of the financial lever, the value of k (& iexcl ;. grows. Note that this growth is non-linear and it is important for the CFO to understand how the creditors' requirements change when the financial leverage changes.

One of the main tasks of the CFO is to monitor changes and identify trends in the capital markets and, depending on this, refinance loans in order to reduce the payment for the used capital. One of the most frequently used tools for United States companies is the combination of borrowings in United States and foreign markets, bank and bond issues. For example, the gradual strengthening of the ruble made borrowing in foreign currency in 2005-2007. more profitable. In addition, over the past few years, interest rates on eurobonds have decreased on average from 12 to 6% - on annual placements and from 10 to 7% - for three years. For the largest 15 United States borrowers, the average long-term foreign borrowing rate was 8%, in the United States market - 12%. However, an effective admission ticket on the Eurobond market is quite high - when placing an amount of at least 40-70 million dollars. The borrowing of capital from United States exchanges is usually advisable starting from 150 million rubles. We also note that not always placement in the European market is successful, it is important not to lose out in choosing the moment of entering the borrowing market, to take into account the availability of free money from potential lenders, folding rates. For example, the September 2006 exit to the Eurobond market "EvrazHolding" was not very successful. In fact, the bond was forced to be redeemed by the underwriter.

Since borrowing rates in foreign and United States markets vary, tracking their dynamics is an important part of the company's financial work. Large companies can raise money in developed markets with little or no intermediaries and large commission payments, so differences in interest rates on ruble and foreign currency borrowing often become the determining factor in their choice. For example, the management of NK Rosneft gathered in the autumn of 2007 to refinance existing loans to issue eurobonds worth about $ 4-5 billion with a maturity of up to 30 years. The issue of refinancing in the company is very acute, as from the total debt of $ 27.3 billion to the middle of 2008, about $ 17 billion is to be paid. However, due to the liquidity crisis on the world market and the rise in the cost of borrowed money, management is forced was to review the plans and abandon the currency borrowing. In October 2007, the Board of Directors approved the issue of ruble bonds worth 45 billion rubles.

If you choose between ruble and foreign currency borrowings, you should not focus solely on the ratio of interest rates. A sound financial policy is primarily a balancing of income and liabilities on risks, including both terms of circulation and currency risks. For example, if a company plans and receives all revenues in rubles, the presence of foreign exchange liabilities requires hedging foreign exchange risks, which is a costly operation and should be taken into account when making a decision.

An example of United States telecom operators shows the choice of a policy of avoiding currency risks. By 2007, 98% of the debt obligations of MTS (in the amount of more than $ 3 billion) were nominated in dollars. This was permissible due to the fact that until June 2006, tariffs were tied to the dollar. Since January 2007, the proceeds of "MTS and other telecoms operators are nominated in rubles. In 2007, MTS placed a ruble bond loan, brought to the market in several tranches with different maturities, which was sent to refinance foreign currency obligations. A similar refinancing policy is implemented by VimpelCom. However, despite the convergence of interest rates on currency and ruble bonds, which occurred in 2006, for 2007 ruble borrowings by 30-50 basis points are more expensive than foreign exchange.

The longest bond loans will be attracted to "Gazprom". Their maturity dates back to 2034. The corporation VimpelCom and TNK-BP attract money with maturity in 2016, "Alrosa" - in 2015, MTS - in 2014

An interesting form of attracting borrowed capital through bonds with an offer was realized in February 2004 by the group of companies Inteko E. Baturina. In 2002-2007 years. The company actively used borrowed capital to implement the growth strategy in all areas, including construction. The traditional form of lending was bank loans (the largest creditor is the Bank of Moscow). At that time, almost all construction companies were moving along the path of bank or promissory note financing. By early 2004, Inteko largely exhausted the possibility of increasing bank liabilities and made an attempt to enter the bond market. At that time, the main competing companies in the construction industry attracted borrowed capital in rubles at 16-20% per annum. Required Yield by Inteko was estimated at 14-15%, taking into account the volume of activity and credit risks. The company went on the way of forming a coupon rate for three-year ruble bonds at an auction. I presenters on payments of bonds made a construction plant and two cement plants. The company intended to attract 1.5 billion rubles. To participate in the bidding 74 applications were submitted, the authors of which tried to raise the bar of profitability to the required 14%. This made the general director E. Baturin behave quite harshly, fixing the amount involved in 290 million rubles. with a coupon yield of 10.95%. It could be said that the auction did not take place, if it were not for the creditors to purchase additional bonds on the MICEX in the negotiated deals mode. This additional amount allowed the company as a result to attract about 1.2 billion rubles. for the coupon yield of 10.95%. We note that, given the three-year maturity of the bond, the yield to maturity for them was 11.25% for 2004, and the yield to the annual offer, under which the company undertook to redeem at 102% of the nominal value, was 13.31%.

When considering the benefits of borrowing, one should keep in mind one more trap that is not diagnosed within the accounting (accounting) model of analysis. The increase in the financial leverage also changes the risk of the owner of own capital. The more financial leverage, the more unstable the net profit of the owner, because interest on loans are fixed and do not depend on the revenue. A loan on borrowed capital can be viewed as an additional kind of fixed costs that make residual income more risky. In this regard, the share of borrowed capital in the total capital of the company is often called debt burden to the owners. The ROE for account of financial decisions,

Therefore, the answer to the question whether the owner has won from the growth of the financial leverage and the corresponding growth of ROE, is not obvious.

A possible analysis algorithm, taking into account the benefits and risks for all owners of financial capital, is to examine the behavior of the WACC value when the financial leverage changes (see Section 5.3).

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