Financial Leverage is the ability to gain an advantage over potential competitors by taking advantage of existing financial resources at the lowest cost. It is also known as the ability of a firm to leverage its assets to purchase other firms. However, leverage may also be the result of financial leverage (using market size to obtain financial benefits) or positive cash flow leverage (using positive cash flow to secure financial benefits). Financial leverage also refers to a difference in the value of accounts payable and accounts receivable, with the capitalization of accounts receivable being greater than the value of accounts payable. Financial leverage thus refers to the ability of a firm to buy or sell financial assets at a price less than the price of the underlying shares. This paper seeks to show how financial leverage impacts firm investment, particularly the extent to which it is dependent on the rate of return and the degree to which information asymmetry can affect an investment decision.
We begin by examining the relationship between firm value and capital. We argue that firms should not be judged by their current asset value (i.e., net present value), but instead by prospective capital gains over their lifetimes. We use the concept of long-term value extraction (LTVE) to specify and measure capital across firms. The concept of potential growth in earnings per share (EPS) is then introduced to quantify potential growth in firm value. We also introduce the concept of a multiple-firm valuation (MFSV) to qualitatively assess the profitability of new investments.
Accounting measures the control of financial risk by measuring book value and non-financial cost of capital over the term of the financial instrument. Therefore, accounting measures the extent to which external costs exceed the value of the firm value. The relation between internal funds and firm investment therefore is determined by the correlation between internal funds and the characteristics of external funds. We use the log of internal funds as our main measure of internal equity and beta distribution to identify the liquidity of equity.
A key result of this paper is that firms with greater levels of external financing tend to maximize the productivity of capital and limit internal resource allocation. Specifically, firms with greater levels of external financing are more efficient at identifying the location of additional funds and capitalizing on them. They are also more efficient in harnessing and using external finance to achieve the most optimal rates of interest and capitalization. Finally, they are also more likely to take advantage of new opportunities in foreign markets. Thus, it is claimed, firms that have greater levels of domestic credit freedom and economic freedom are more likely to maximize economic growth through investment through external sources.
This is a valuable input into the macroeconomic debate. It shows how firms with greater levels of economic freedom are able to take advantage of new opportunities that may arise through global economic competition. It also demonstrates how domestic constraints do not affect firm investment decisions. This allows firms to maximize their profits and at the same time minimize their exposure to risks.
This research is useful for understanding the link between domestic credit constraints and firm investment decisions. I would like to thank G. H. Druckemek for his comments on an earlier paper on the subject. I would like to thank C. Williame and J. P. van Essen for their suggestions on this topic. The research was supported by a grant from the National Research Council. The views expressed are my own.
