There are three issues with this calculation. First, Total Debt includes operating debt…operating liabilities generated in the course of business…which are not financing debt. Second, Total Debt is not reduced by debt assets (negative debt) to yield Net Debt. Third, Equity can include preferred equity which is effectively debt from the common shareholders’ perspective.

The same criticism applies to

The correct calculation for financing leverage is:

This is appropriate measure for equity analysis. The standard measure is appropriate for credit analysis where the issue is coverage of all debts.

ROOA, Return on Operating Assets, is the return without operating liabilities.

Operating Liability Leverage, is the amount of operating liabilities as a component of net operating assets.
Financing leverage levers ROE according to the financing leverage equation:

The two leverage effects can be combined into one equation:

The drivers of the two leverage effects are in the respective leverage equations.

A professional sports team gains revenue from stadium ticket sales, broadcasting rights, food and drink concession sales, and sales of sports attire. Expenses include player and staff salaries, concession supplies, and depreciation on stadium and training facilities. The team plays to booked out crowds but, with escalation in players’ salaries, the operation just breaks even.

In 2005, a consultant advises on strategy to enhance profits: Sell multiple-year season tickets to enthusiastic fans, payment upfront. Modify the stadium to incorporate luxury boxes sold to corporations on multiple-year contracts, cash up front. Sell concession rights to franchisees, cash up front. Require longer payment terms from suppliers of sports and other equipment. Modify player contracts with a deferred payment element in the form of a pension.

The consultant presents a pro forma balance sheet to the team owners who balk at the increase in liabilities with deferred revenues, accounts payable, and player retirement liabilities. But the consultant points to the increase in cash from the upfront payments and longer-term payables, cash that the owners can invest, not only in securities but also in the stadium modifications. Indeed, the consultant advises the construction of a new stadium with more capacity for season ticket revenue and up-market concession franchises. Sensibly, the owners also ask for a pro forma income statement. That forecasts higher revenue with fan participation and higher concession revenue. Expenses increase because of higher stadium depreciation, but bottom-line income increases.

The increase in cash comes without additional investment by the owners. They are using cash from customers and suppliers; operating liability leverage finances the business with added value. Perhaps the consultant should demonstrate the value added with increased RNOA and residual income.

The Modigliani and Miller theorem assumes debt and equity can be traded costlessly in so-called perfect capital markets, so explanations for capital structure are often based on relative costs associated with debt and equity. For example, interest on debt is tax deductible whereas dividends are not, favoring debt. Or debt incurs bankruptcy costs, favoring equities. Or debt financing is not available for start-ups, so they must be all equity financed.

However, there is a value investing view of capital structure. The value investor buys equities when they are cheap and sells them when they are deemed overpriced. Similarly, he or she buys bonds when they are underpriced and sells them when they are overpriced. Following the principle that trading in mispriced securities adds value for shareholders, the CFO or Treasurer of a firm can be a value investor when financing the firm: If debt is overpriced, issue debt rather than equity; if the firm’s shares are overpriced, issue equity rather than debt. That determines the capital structure. The capital structure is also affected if the CFO repurchases underpriced shares or underpriced debt. The CFO, of course, has privy to information about the pricing of the firm’s debt and equity (although must be aware of laws on trading on private information).

        Levered P/B = Unlevered P/B + [Book Leverage x (Unlevered P/B – 1)]

The equation can be expressed in terms of B/P rather than P/B:

In the P/B equation, leverage is book leverage =In the B/P version, leverage is market leverage =

So, ROCE is a weighted return to operating activities and financing activities:

or,

RNOA &nbsp= OI (After tax) / NOA                   (Return on Net Operating Assets)

FLEV &nbsp &nbsp= NFO / CSE                         (Financial Leverage)

NBC&nbsp&nbsp= NFE (after tax) / NFO        (Net Borrowing Cost)

SPREAD&nbsp= RNOA – NBC                           (Operating Spread)

The balance sheet is reformulated into net operating assets and net debt with the balance sheet equation now

Common Shareholders’ Equity = NOA – ND

The income statement is reformulated as

Comprehensive Income = Operating Income – Net Financial Expense

The equations in the middle of the display show how net operating assets, net debt, and shareholders’ equity change over a period. NOA is increased by operating income but reduced by free cash flow (FCF), the net cash from the business. An example is Accounts Receivable that is increased by Revenue but reduced by cash that pays off the receivable. Net debt increases with net financial expense but is reduced by the amount of FCF left over after paying net dividends to shareholders. A reformulated cash flow statement (in Chapter 13) reports the FCF and net payout to shareholders.