Leverage and Default Risk in a Business: Problems and Solutions | Accounting

Here is a list of top three problems on leverage and default risk in a business with its relevant solutions.

Problem 1:

A company needs to deploy Rs.80 million.

It may be financed in different combination of D/E, namely:

(i) D/E = 0, fully equity financed,

(ii) D/E = 2, and

(iii) D/E = 3.

Two issues the company encountered are:

(1) At D/E = 2, banks are offering it Prime Lending Rate of 11% but at D/E = 3 banks intend to charge 12.5% interest. This is because banks’ perception is that higher D/E ratio increases the probability of default.

(2) Risk perception of the equity shareholders has also increased.

The finance director of the company has collected information about Beta of a similar company which is unlevered (i.e. having no debt in the capital structure). Comparable unlevered beta is 0.75.

Market return is 14% and risk free rate is 6.5%.

The company may encounter three different business situations under which its net operating cash flow may be as follows:

The Board of Directors wants to know see after operating cash flow of the company and interest impact thereupon in different business situa­tions.

Solution:

Comment:

The company may clearly face default risk with moderate and bad cash flow at D/E = 2 and 3, and likelihood of default is more at D/E = 3.

You are convinced that although K_d< K_e there are other issues which a company needs to analyse thoroughly before deciding the D/E ratio.

Now let us progress with the discussion. An important issue is how to compute cost of equity commensurate with the degree of financial leverage. Risk perception of the equity shareholders will be of higher degree than it has been envisaged for the unlevered company in which there is no default risk.

Levered Cost of Equity:

Hamada’s equation is very popular which helps to derive theoreti­cally cost of levered equity from unlevered one and vice versa.

bL = bU(1 + (1 – T)(D/E)

b_L = Levered beta, T = tax rate, D/E = Debt Equity ratio,

b_U = beta of a firm when it has no debt (the unlevered beta)

Given b_U = 0.75, Tax rate 36.75%, D/E = 0.25,

b_L = 0.87

Problem 2:

In continuation of Illustration 1, the Board of Directors want to know WACC at different level of D/E ratio.

The Finance Director has collected the following information:

Find out WACC and identify the optimum level of D/E mix.

Solution:

Comment:

The company may choose D/E = 1 at which level WACC is minimum

Problem 3:

The Finance Director of a company has collected the following information relating capital structure planning:

Unlevered beta 0.80, market return 12% and risk free rate 6%.

You are required to find out optimum capital structure for the company.

Solution:

Optimum Debt Equity Ratio: 1.5, WACC 10.22%.