This research paper dwells on the effects of leverage in a competitive market. As such, the paper seeks to establish whether or not the practice of leverage impacts on the level of competitiveness of a firm relative to its competitors in the market. Besides, this research paper explores the different types of leverages that a firm may experience in a competitive market.In only 3 hours we’ll deliver a custom The Effect of Leverage in a Competitive Market essay written 100% from scratch Get help
Also, this research paper assesses the connection between pricing competition and the theory of financial leveraging.
Further to this, the tying theory, and the accompanying evidence in various firms is addressed. Several other theories (the theory of the pecking order, and the trade-off theory), as they relate to the issue of leveraging in competitive markets, are also explored. Furthermore, the leverage-profitability relationship is evaluated, as well as the role of core competencies in competing markets for strategic leverage. The Porter’s five forces are explored separately, along with how they impact on leveraging in a competitive market
According to some quantitative results, leveraging has been shown to bear a negative correlation with both growth and ‘non-double tax shields’. Size, asset tangibility, uniqueness, and profitability are on the other hand linked to leveraging in a positive manner (Zingales 1998).
Zingales (1998) and Liu (2001) separately seek to remind us that the “essence of a firm in the new economy is its ability to create, transfer, assemble, integrate, protect, and exploit knowledge capital”. In this particular regard, knowledge capital could be identified as one that buttresses competences.
In addition, competencies buttress the offering of the products and services into a market. This statement bears significant implications; in as far as the decision making by the management is concerned.
Growth options are often exploited thanks to the existence of knowledge capital within an organization. In turn, the growth and expansion of a firm shall have an impact on its cash flow. Also, the volatility and cash flow levels of a firm have also received massive empirical and theoretical attention, as well as the role that intangible assets play with regard to optimal leverage (for instance, Zingales 1998).Academic experts
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Operating leverage refers to the sensitivity of a given firm’s EBIT (Earnings Before Interest and Taxes) to sales fluctuations. This phenomenon comes about at a time when the cost structure of a firm includes its fixed operating cost as well. How an operating leverage impacts on a firm is that at a given point above the break-even point, the operating level degree appears to reduce. The operating level degree of a given firms is usually associated with the business risk that such a rim have to grapple with.
In financial terms, leverage, otherwise refereed to as gearing, describe the act of borrowing money with a view to augmenting existing funds for purposes of investing in such a manner as magnify the potential negative or positive consequences. Leverage typically expresses debt, or borrowed funds, in an endeavor to enhance equity returns. On the other hand, deleveraging refers to that action seeking to reduce borrowings.
Financial leverage often assumes the form of either a loan, or even debt (borrowings), with the ensuing proceeds being ploughed back into the business entity with the aim of bringing in a higher return, greater than even the interest cost.
In a case whereby the return in assets (ROA) of a certain firm appear to exceed the interest on loan return rate for such a firm, then it follows that its equity return shall also be higher than would have been the case had such a firm not borrowed money in the first place. This is because the assets of any one given firm equal the sum of its equity and debt. Conversely, should a firm’s ROA be lower than its rate of interest, the Return on Interest (ROE) of such a firm shall be less than would have been the case had the firm not assumed any loan to start with.
Through leveraging, this act enables organizations to attain greater return potentials, at least to the investors of such a firm, than would normally have been the case. Nevertheless, the loss potential at the same time also appear to be augmented by this act of firms leveraging since should such an investment lose its worthiness, the principal loan as well as the interests that may have accrued on it shall have to be repaid after all.
One of the most common methods of using leverage concepts from the context of investing is what if known as margin busting. Here, a firm that is not leveraged may be viewed as ‘an all-equity firm’ while a firm that is leveraged consists of debt and ownership equity.
The debt to equity ration of a firm is thus its leverage index. This ration of debt to equity impacts on a firm’s value, and this has been emphasized by the theorem by Modigliani-Miller (1963). The extent of financial leverage, as is also the case with operating leverage, estimates the impact of a change that one variable has over another. Financial leverage degree thus could be regarded as the earning for every share (that is a percent change in the earnings) that takes place due to a percentage change in the earnings of a firm prior to deductions of the taxes and interests.15% OFF Get your very first custom-written academic paper with 15% off Get discount
Financial leverage measures
This is generally estimated as the overall liabilities of a firm, which is then divided by the equity of the shareholders.
Ratio of debt-to-equity = D/E
Where D refers to a firm’s liability
E refers to equity
On the other hand, the interest coverage ratio of a firm is arrived at by dividing a firm’s earnings prior to the payment of interest and taxes (EBIT)
Therefore, interest ratio of coverage= EBIT/interest
Financial leverage degree (DFL)Get your customised and 100% plagiarism-free paper on any subject done for only $16.00 $11/page Let us help you
The financial leverage degree of a certain firm impacts on the earnings per share (EPS) of such a firm. In this regard, financial leverage assumes the role of a ‘double-edged sword’. In case of favorable economic conditions, then an elevated financial leverage shall impacts in a positive manner with regard to the earnings per share of the firm in question.
Financial leverage and market share macroeconomics
The debate as to whether or not decisions on finances cause real impact on the daily operations of a firm has received immense attention in literature, ever since the time of Modigliani and Miller (1963). A majority of the work within this field for the last thirty years has tended to emphasize more on the topic of evidence friction amongst the various firm investors (for instance, bondholders versus shareholders), as well as between the managers and investors, especially within the setting of a single firm.
On the other hand, recent research shows that the association between firms, competitions, as well as their customers, could be the much sought after key that would facilitate in a gauging of the broad, yet real consequences of a decision to finance a firm. Product markets in themselves prove to be quiet a natural nexus for an assessment of impact of financial decisions on the real performance of firms, as well as the welfare of the market.
Definitely, the way in which the market investments of products of a firm, and the consumer welfare are impacted on by the finances of a firm is linked to the competition within such an industry, as well as the characteristics of the products in the offing.
For example, in those industries in which consumers have a better chance of switching their pattern of consumption say, from a certain product brand to yet another (this may happen across various producers), binding economic handicaps may result into competitive results that are in agreement with reduced investments by the firm, in as far as share building in the market is concerned, for instance, elevated prices (Chevalier1995; Phillips1995) and losses in the market share (Campello (2003).
With regard to finances however, the interplay in performance could assume a different angle in those markets in which consumers are not in a position to switch to other brands without incurring an added cost. In these kinds of markets, there is a high likelihood that the consumers may get penalized extra via a way of losses in welfare, in those world states where products suppliers run out of business (Campello (2003).
Alternatively, consumers may be forced to opt for brands that are less preferred, especially in a case whereby a switching cost is imminent, and therefore is anticipated in the industry in question. As such, the responses offered by consumers have the potential to amplify the unfavorable financial consequences on the performance of competing firms within a market, and which are characterized by switching costs that are quite high.
In a bid to formalize the assertion about the connection between on the one hand, the performance of a firm and on the other hand, it’s financing, perhaps it would be prudent if a model could be developed, as regards competition, consumption, and financial contracting (Klemperer 1995; Chevalier 1995). When a given consumer decides to make a choice about a certain brand, he/she may form a “habit” of buying an identical brand repeatedly, given that switching brands could prove to be quite a costly undertaking.
Seeing that consumers are often faced with such costs, it is for this reason then that firms are often at a willing position to make investments (long-term) in the building of their market share through reduced prices that necessarily do not require a maximization of profits in the short-term, to the extent that firms are not undergoing a period of financial constraint.
One could then take the assumption that in many instances, customers always tend to be quite forward looking, and they at the same time also appear to comprehend the frictions that occur in the capital market, and the fact that these may lead to their supplier of their products to go out of business.
In addition, it should also be appreciated here that indeed, customers consider the welfare loss often imposed upon them once firms go into a state of bankruptcy. A theory could thus be developed to the effect that the market share of a firm tends to vary throughout the entire business cycle phase, based on the firm’s structure capital, the assets liquidation value of such a firm, the formation of the consumer habit, as well as on the competitors’ financial structure.
One of the new elements of this theory could be that the anticipation by consumers as regards the failure of businesses tends to impact negatively on the investment decisions by firms that are constrained financially in as far as their product market is concerned.
Due to this therefore, the sales performance of the firm that is constrained financially, especially during a recession period, is apt to diminish in a more sharp manner, in comparison to that observed from its competitors who are not constrained financially, at a time when the costs of switching brands appears to be extremely high. In an attempt to sanctify this model, Massey-Ferguson Ltd case that took places during the recession period in 1980 is worth considering.
The period between the 1960 and onto the 1970 were years in which Massey Ferguson became a leading producer of a durable good, yet one that was characterized by elevated switching costs; tractors (Costa & Healy 2006). For almost the entire time during which the firm was prominent in its market, the firm utilized considerably extra debt financing in comparison to its rivals in the industry, International Harvesters and John Deere.
On the other hand, once the recession period in the 1980s had started, the financial constraint of the firm quickly became binding: the waning cash flow of the firm was not adequate to help service its debt that amounted to $ 2.5 billion (Costa & Healy 2006). As such, Massey had no choice but to reduce two thirds of its capital expenditure, leading to a close down of more than 300 percent of the firm’s plants in 1980.
In contrast, its rival, John Deere (which happened to have been a low leveraged firm) increased its capital expenditure two folds, at a rate of 200 percent. Following this massive debacle, Massey reduced its investment plans, in a bid to maintain its market share (this included a reduction on price promotions, customer financing, and advertising), the firm’s loyal customers were increasingly getting concerned about the firm being declared insolvent, as well as the related costs of not having a firm to service their equipments (Costa & Healy 2006).
Questions regarding Massey-Ferguson’s future within the business of tractors steadily led to the firm’s plummeted sales, as well as a weakened network of distribution. In 1980, the dealerships affiliated to Massey-Ferguson reduced to 1,800, down from 3,600 in the North American region alone (Costa & Healy 2006).
In addition, consumers also had no choice but to switch to the firm’s competitor, Deere, in order to facilitate a purchase of their new farm equipments (Costa & Healy 2006). At the point of the recession ending, 20 percent of the market share held by Massey had already been lost to competition, with Deere taking the lion’s share, evidently increasing its overall tractors market share to 49 percent, up from 38 percent.
Pricing competition and financial leverage theory
Of late, there has been witnessed a rapid rise in the body of literature which seeks to examine a connection between on the one hand, the financial arrangement of a given firm in relation to its pricing behavior. For instance, Opler and Titman (1994) talks of a case of exceedingly leveraged firms located in industries that are quite distressed, and the way these tends to lose their share of the market to their competitors who almost always are less leveraged.
In addition, Dasgupta and Titman (1998) opines that such a phenomenon emanates from strategic associations among ‘imperfectly competitive firms in concentrated industries’ (Dasgupta & Titman1998).
Philips (1995) has also provided detailed evidence that illustrates that there is almost always an increase in the price of products within an industry that is distressed, following a leveraged buyout (LBO) initiative by one of the key firms, and that competition in terms of price heightens after a similar event in an industry that is not distressed. In a study that involved supermarkets, Chevalier (1995) was able to document an increase in prices by the supermarkets that were in a position to initiate LBO, with a further illustration that such supermarkets saw their market share shrinking.
In contrast, the pricing behavior of firms in an industry that is experiencing an imperfect competition has over the years been of central interest to market researchers, with the result that various theories have thus far been proposed to clarify the phenomenon that is price dealing, and which often occurs on a regular basis amongst the retail industries.
Additionally, micro-economists too have also attempted to connect this kind of behavior with the search for consumers (Shleifer & Vishny 1992). Nevertheless, this latter form of literature has taken into consideration a whole range of equity firms, and cannot therefore provide its hypothetical results for purposes of rationalizing the experiential regularities within the perspective of a rise in the financial leverage of a major firm, coupled with the ensuing product price stability.
If we were to consider retailer firms here, those among these that are quite financially levered have a tendency to compete with regard to pricing within a related environment (each and every firm possess its own loyal following of customers, and these firms are endorsed with switchers that are quiet sensitive to price) to that which has been highlighted by Varian (1980) and Narasimhan (1988). In this case therefore, the financial and business risks would probably require to be assessed simultaneously.
The reason why this could occur is that with a limited consumer segments number, there may not exist a strategic equilibrium pricing that is pure. In the event that this happens, risks to the business could come about solely as a result of mixed equilibrium pricing strategy, in a case whereby exogenous uncertainty is not in existence.
Time and again, firms become endowed with financial leverages at a time when they are involved in competitive pricing. As such, the arrangement of finances at a prior stage endogenously impacts on pricing strategy equilibrium, as well as the magnitudes and frequencies of the equilibrium dealing.
Conversely, in the event that firms generates funds within the financial market from creditors that are competitive, the latter logically supposes the impacts of debt face value so chosen, on the ensuing equilibrium in pricing, and which internally establishes the default risk of debt and business risk of a firm. As can be seen, equilibrium on pricing with regard to product market impact on the debt face-value equilibrium determination.
Moreover, a rise in the financial leverage of one retailer seeks to establish two opposing outcomes on the ensuing competition in price, known as ‘asset substitution effect’ and ‘the lower bound effect’. In an attempt at clarifying the former effect, it would be prudent if one could observe the fact that by the act of establishing low prices in a market with a view to grappling for the segment of market switchers, such an action could be seen as being risky, at least from the perspective of a firm, seeing that the profits that come about as a result of this action are determined by draws of random prices that are established by the competition.
An elevated price and one that seeks to attract market switchers’ superior returns, in a case whereby the price of competitors is even dearer. Nevertheless, this could be an event that may in the long-run prove non-viable. Due to this, an increase of product prices in that segment or region that has come to be accepted by the switchers depicts a very risky action.
Available literature on corporate finance indicates that this sector has for a long time now been awake to the realization that a firm that is financially leveraged is endowed with an incentive of ‘over-engaging in high-risk projects’. In addition, should such a firm resolve to borrow more, this incentive seeks to become even stronger. This phenomenon is generally termed asset substitution effect.
With this kind of substitution effect, it follows that should a firm seek to exceedingly borrow more funds, the incentive is also higher, and such a firm will seek to price its products at a higher price, in an attempt at competing for possible market switchers, in the event that the pricing strategy of the competition were to stay unaltered, thereby inducing the competition to assume a reduced equilibrium price.
Then again, the ‘lower bound effect’ states that the action of establishing exceedingly reduced prices are ‘dominated strategies for highly levered firms’, seeing that the generated revenues by these kinds of low prices are never sufficient to offset obligations of debt. As a result, with regard to debt face value, a lower bound is evident in the case of prices that are not dominated, and this lowered bound appear to rise as the debt face value rises too. This is what has come to be known as ‘the lowered bound effect’.
This effect means that in the event that a single firm seeks to borrow more, such an action shall often induce competitors to increase the price of their products, and because prices complements are strategically placed (Narasimhan 1988), the price equilibrium thus increases.
It has been illustrated that a lower bound effect seek to take control of the substitution effect of assets in an industry that is quite distressed (Shleifer, & Vishny 1992) and in which at a time when an equilibrium has been established, one firm, for instance a retailer (say, R1), may seek to default on the debt that they have incurred at a probability level of one.
What this means then is that should this firm (R1) increase the price of their products above that in the competition, and at the same time also only resolve to serves the customers that are loyal to it, then chances are extremely high that the firm (R1) might not in the long-term remain solvent.
In this kind of industry that is quite distressed, the firm (R1) shall never be able to price its products below a certain level, say p, a level that would enable the firm to realize a profit that matches the debt face value of such a firm, assuming there are no competitors to the company. In this regard, another firm that could be less-leveraged than the form in question (say, R2), may opt to fix their price at p, and at the same time also ensure that R1 is not in a position to bid in a price range that is less than their own. In this case, this new price range then becomes the equilibrium pricing strategy of R2.
As a result of the second firm (R2) equilibrium price rising in tandem with the financial leverage of R1, and seeing also that R2 commands a larger share of the market, the standard price of products within a distressed industry have a inclination to rise, as a result of a rise in the utilization of debt by either of the two firms.
What this tries to depict is that should a given firm decide to increase their borrowing power, in relation to the competitors within an industry that is quite distressed, then such a firm often tends to cede a portion of its market share, which is effectively acquired by their rival who are in possession of a lesser leverage (Shleifer, & Vishny 1992)
These are findings that bear a correlation with experimental evidence. In an industry that is not quite distressed, and in which each of the firms is in a position to honor their debts within the confines of a positive and strict probability, at the very least, one of the firms may be in a position to honor its debts simply by way of being of services to the firm’s loyal customers (Shleifer, & Vishny 1992)
From the scenario depicted above, and in keeping with the definition provided of a non-distressed industry, it becomes quiet apparent that p is extremely independent of the debt face value that the first firm in this case (R1) seeks to issue. What this then implies is that the ‘low-bound effect’ becomes totally considered in an industry that is not distressed. As such, it is just the asset substitution effect that seems to be at play here.
The standard price equilibrium that calls to be identified by the various firms in this case is quite independent of the debt face values. As such, a decision by one of the firms to borrow may not necessarily lead to the firm in question altering its behavior of pricing. Rather, such a firm seeks to induce the competition to price their products in equilibrium.
The argument about competition in pricing becoming increasingly aggressive as a result of a rise in leverage in an industry that in not distressed appear to be quiet consistent with experimental results, as provided by Phillips (1995).
There is quiet a number of theoretical papers that have attempted to elucidate the abovementioned experiential regularities. For instance, Sharpe (1995) indicates that enhanced leverages could either result in a fall in price, or a rise in the same, based on whether the firms in question are grappling with demand or cost uncertainties.
On the other hand, Klemperer’s (1995) argues of a tendency by the highly leveraged firms to utilize high rates of discount, in effect translating into elevated product prices, since such firms have a higher chance of declaring a state of bankruptcy in the recent future, meaning that future shares of the market become quiet less significant.
Dasgupta and Titman (1998), have talked of ‘more long-term debt’, and this thus implies an elevated rate of discount for a firm that is leveraged courtesy of a problem of over-hanging debt (Myers 1977), and in the event that such firms are given an option of discount rate, they instead opt to go for an elevated price, which, as per the arguments of Klemperer’s (1995) switching theory of consumers, ends up benefiting the short-term proceeds of a firm to the detriment of a market share that is long-term (and thus the firm enjoys profits for longer).
The tying leverage theory
Tying requirements takes place at a time when the tying market (that is a firm whose operations are restricted in one market) specifies that the consumers of the products that such a company produces (in this case referred to as the tying good), should also buy their stipulated second good (in this case referred to as the tied good) from the retailer of the first good (Dasgupta & Titman 1998).
The evidence of the tying concept of leverage appears to be quite common in a wide range of firms, and they include those that enjoy a monopoly, to those that are quite competitive (Slade 1998). For instance, a majority of the franchisers, whose point of operations are characterized by retail markets that are quite competitive; require their franchisees to buy from the parent company the business format, as well as a part of the parent company inputs as well.
In addition, tying had also been shown to trade place at the opposing end of the spectrum of a market structure (Dasgupta & Titman 1998). For instance, it was a requirement previously by companies dealing with telephone services to demand telephone services purchases is accompanied by a purchase of telephone equipments by the same company as well.
Nevertheless, in other markets, a mere casual observation indicates the presence of a constructive relationship between on the one hand, the monopoly power and tying, on the other hand (Slade 1998). For instance, reflect on the advertising sector, in which the tying product is viewed as the printed media space (such as magazines) or in the case of the visual media, time (such as television), and the product being tied is both the administrative and creative services of the advertising.
Those advertising media with a local scope, as a general rule, tends to enjoy a greater deal of the power of monopoly, as opposed to the advertising media whose audiences are scatted far and wide nationally. Besides, local media are more inclined towards the practice of tying, and the mainstream media are less-prone to this practice.
As an illustration to this, in Canada, those firms that have an affiliation to the telephone organizations enjoy a virtual monopoly on advertising space of the yellow pages directory. In addition, all the publishing companies of the directory are obliged to tie the advertising services provision to the space of advertising that is allocated in such directories (Slade 1998).
In contrast, the advertising industry of the newspapers is armed with a transitional market structure. Without a doubt, there are a number of daily news papers in competition that are to be found in one city, while at the same time, some other cities only posses a single daily news paper.
In addition, some newspapers have been known to engage in the practice of tying, whereas others do not opt to prescribe to such a practice. Lastly, such advertising media that have a national reach as television and magazines tends to be face by a direct competition, meaning that the practice of tying is not all that common.
Several reasons have been proposed as to why a firm that is considered to be quite a power in the market may wish to be associated with tied sales, with a majority of these pointing at efficiency motives (Grimes 1994). These entails cost savings, price discrimination, as well as the control of quality. In contrast, the leverage theory holds that a monopolist is in a position to utilize the power that they posses within a tying market in order to dig out added surpluses from such a tied market, even in a case whereby such a tied market is quite competitive.
Distinct from efficiency justification, the leveraging option from a single market to yet another has for a long time now been a hot topic, at least from the perspective of economists and lawyers alike. For instance, Dasgupta and Titman (1998), disregards the idea that assert that this “theory of tying arrangements is merely another example of the discredited transfer of power theory, and perhaps no other variety of that theory has been so thoroughly and repeatedly demolished in the legal and economic literature.”
Conversely, Grimes (1994) supports this idea by noting that;” If the tying seller can foreclose a substantial percentage of the tied-product market, competing sellers of the tied product may face increased costs and be driven from the market.” Based on the nature of such a controversy then, it becomes to some extent, astonishing that minimal experiential analysis has been dedicated to the field of tied sales.
Nevertheless, the leverage theory appears to be quiet steady with the limited observed regularities which have hitherto been unearthed. For instance, Hass-Wilson (1987) discovered that the process of contact lens tended to be exceedingly higher in those states where the sales of these had been tied to both optometrist and ophthalmologists’ services.
Additionally, Slade (1998) undertook a comparative study of the prices of beer in the United Kingdom that were sold in both free as well as tied public houses, and arrived at a conclusion that such tied products (in this case, beer) tended to exhibit higher prices in comparison to the beers that were sold in the free public houses.
Lastly, other authors (Grimm, Winston, and Evans 1992) discovered that in contradiction of the leverage theory, the action of monopolizing a single segment of the route of a railroad proved to be inadequate to dig out the entire surpluses of monopoly. What such findings appear to suggest is that leveraging may in fact prove to be quite a profitable venture
Theory of Pecking Order
Myers (2002) talk about the Pecking Order theory. This theory begins with an organization with both growth opportunity and assets in –place. Such a firm then is often in a dire need for extra equity financing.
Myers (2002)) presume ‘perfect financial markets’, but for asymmetrical information, investors are usually not aware of the ‘true value’ of either a new opportunity or the current assets, and as such, they may not exactly place value on those shares that have been issued for purposes of funding new investments. An announcement for the issue of stock would be a welcome respite for investors in case this reveals opportunities for growth
This theory holds that often times, a firm makes a choice as to how the amount of debt finances it requires, and also the amount of equity finance that it shall utilize, through a balancing act of benefits and costs. The conventional edition of the theory revert to Kraus and Litzenberger (1973) , who measured the balance between the cost of dead-weight as regards the bankruptcy of a firm, and how debt is quite beneficial in terms of assisting a firm to save on the remitted taxes.
Usually, agency costs get included in this kind of a balance as well. This is a theory that is usually established to offer competition to the “Pecking Order Theory of Capital Structure”, and whose literature reviews has been undertaken by Harris, M. & Raviv (1991). This theory serves a significant purpose, by way of offering an explanation to the fact that corporations often gets financed partly with equity, and partly with debt.
The theory asserts that it is quite beneficial for a firm to be partially financed through debt, the benefits that a firm gets by assuming a debt finances, by saving on taxes submitted, financial distress costs (includes bankruptcy debt costs as well as non-bankruptcy costs- for instance, the leaving of staff, a demand by suppliers on payments terms that are disadvantageous, infighting between stockbrokers and bind-brokers, et cetera).
As the debt of a firm rises, so does its marginal benefit. At the same time, the marginal cost of a firm rises, meaning that now, a firm that seeks to optimize its entire value opt to concentrate on this kind of a trade-off, at a time when they are arriving at a choice regarding how much of both equity and debt should be utilized with regard to a firm’s financing exercise.
The theoretical significance that surrounds the Trade-Off Theory has often times been faced by sharp oppositions. For example, Miller (1977) likened this form of balancing as of the same kind to “the balance between horse and rabbit content in a stew of one horse and one rabbit”, in this particular case, taxes seems both sure and large, while on the other hand, bankruptcy seems quite a rarity and, as viewed the observation by Miller, “it has low dead-weight costs.
For that reason, Miller offers a suggestion that if at all the Trade-Off Theory holds any waters, then it should be expected that firms in reality, should exhibit massive debt levels, than is normally the case. Myers (2002), happened to have been a predominantly harsh critic of this theory, while Fama and French (2002) offered a criticism not just of the Trade-Off Theory alone, but to the Pecking Order Theory as well, albeit in various ways. Separately, (Phillips 1995) has offered the opinion that firms often fail to undo the consequences ‘stock price shock’ as they ought to be based on the fundamental tenets of the Trade-Off Theory.
What this then implies is that the asset prices mechanical change that mainly contributes to the observable variation happens to be capital structure (Myers 2002). Such criticisms notwithstanding, the Trade-Off Theory is still a leading theory within the realm of the capital structure of corporate organizations.
Trade-off theory evidence
The ‘trade-off theory’ may be cross-sectionally tested via tax status proxies as well as financial distress potential costs. For instance, the following proxies ought to be linked with ‘reduced debt ratios carry-forwards’; business risk, estimated using the volatility of market value or earnings; intangible assets, estimated via elevated expenditures on research and development and marketing (relative to tangible capital investment), as well as valuable growth opportunities in the future.
These kinds of proxies function relatively well with regard to cross-sectional tests. Significant prior publications in this area have also been documented (Auerback 1985; Long and Malitz 1985). Smith and Watts (1992) have also stressed on the empirical significance of “investment opportunity set”.
As in the investment opportunities of a certain firm into the future becomes more valuable, the borrowing tendency of such a firm at the present time, appears to reduce. This theoretical statement is backed by two reasons. To start with, opportunities for growth are by nature, intangible assets, and which are highly susceptible to bankruptcy, or damaged in distress. Then, the act of issuing debts that are risky today undermines the incentive of a form to make future investments.
An estimation of future investments opportunities may be arrived at via an utilization of the market value to book value of a firm (market value entails growth opportunities value; on the other hand, book value refers to a firm’s assets value in place). A strong and inverse connection is apparent between debt rations and market-to-book ratio, in line with what could be termed “the casual observation that growth firms borrow less”. This type of an inverse relationship is today restricted to the United States (Zingeles 1998).
Research into the finances of firms seems to have settled on several common factors that appear to cross-sectionally explain debt ratios. According to Williams (1995), the agency cost could be estimated to approximate 4 percent of a debt face value.
Williams (1995) arrived at a conclusion that alterations in investment as a result of underinvestment and shifting are minimal. Several publications by Leland and others consider credit risk, taxes, agency financing costs, and default. Computed models have also evolved, with an observable disappearance of uninformed limiting assumptions in previous publications, and which seems to be disappearing gradually.
The connection between on the one hand, the leverages that exists within a given firm, and the profitability of such a firm on the other hand, has to a greater extent been explored, in a bid to offer support to capital structure theories. Of late, more attention has been directed at the influences that a competitive environment appear to have over the choice of the capital structure of a firm.
For instance, MacKay and Phillips (2003) discovered that leverage reacts in a different manner to the profitability of firms that are located within concentrated industries, in comparison with industries that are quite competitive.
Further, MacKay and Phillips offers the suggestion that the variations with regard to profitability persistence might as well add to the variations in the linkage between on the one hand, leverage and on the other hand, profitability, in a case whereby firms are often categorized on the basis of their concentration in the industry.
Pragmatically, the profitability of those firms that are located within concentrated environment often varies from that often exhibited by firms that are located in industries that are more competitive, with regard to their persistence levels.
Also, MacKay and Phillips (2003) have discovered that firms that are located in concentrated industries are also endowed with comparatively higher profits. Besides, higher levels of profits appear to be a characteristic of industry concentration. Other than elevated profits levels, there also exists evidence that support the claim that firms located in concentrated industries assume different behaviors with regard to profit margins preservations, relative to the competitive industries.
Other authors (Domowitz, Hubbard, and Petersen 1987) have discovered that markups tend to be countercyclical; at least from the perspective of the concentrated industries that handles durable goods. For the sectors that do not handles durable goods, their mark-ups are comparatively ‘more pro-cyclical’ in the industries that are concentrated, as opposed to the competitive industries.
Lev (1983) on the other hand discovers that the connection between entry barriers and autocorrelation with regard to a firm’s annual earnings is both significant and positive. The impact of persistence with regard to profitability (or alternatively, a mean reversion) on the “leverage-profitability relationship” has also been highlighted elsewhere (Domowitz, Hubbard, and Petersen 1987), with unstable forecasts.
The model by Raymar (1991) show that firms often tends to recapitalize at the close of a financial period, causing a positive correlation between profitability and leverage. MacKay and Phillips (2003) fail to model the process of earnings as a means of reverting sequentially discovering that the ratio of leverage is not in variance with profitability alterations.
The Sarkar and Zapatero model (MacKay & Phillips 2003) creates a converse connection between on the one hand, leverage, and a need for a firm’s profitability, on the other hand. This inverse relationship so created is apparently thought to emanate from an observable mean reversion with regard to a firm’s profitability. This model also attempt to tie ‘optimal long-term debts to long-term expected profitability’.
In view of the fact that sporadic profitability changes slips back to expectations in the long-term, it then follows that debt that is long-term is somewhat not sensitive to alterations in the prevailing profit levels. If the ratio of leverage is described as ‘long-term debt scaled by the market value of equity’, it then follows that the inverse connection between leverage and profitability functions via the productivity effect on the equity market value, a view that the models by Sarkar and Zapatero perceives as being increasingly sensitive to alterations in periodic profitability.
Leverage: the case of the Lehman Brothers
According to research findings, it has been indicated that competing firms stands a better chance enhance their organizational survival when they are lucky enough to enjoy a connection (political, economic, or in the same way, arguments have abounded to the effect that firms stands out to face sanctions out of the practice of following strategies that are quite nonconformist (Zuckerman 1999).
Such an influence and existence of firms that are capable of expressing authenticities that entails industry associations as well as property rights, up to and including the procedures of operation is many a times assumed by firms. Nevertheless, research also shows that firms could be leveraged by activities, thus accessing the conformity benefits just by outwardly complying with the demands of an institution.
Even then, leverage policies may not always be to the benefit of a firm in question. For example, the Lehman Brothers demise came about due to the firm’s ‘very aggressive leverage policy’ for the perspective of a key economic crisis. Bad regulation has been identified as the starting point of the financial crisis that bedeviled the Lehman Brothers, coupled with market complacency that came about as a result of a coupled of years that witnessed positive returns, and also a deficiency in transparently within the firm (The Economist, 2008).
In addition, an overextended phase of increased prices on real estate, and a relaxation on the lending security are other reasons attributed to the firm’s demise. To make matters even worse, Lehman, as has also been the cases with a number of other investment bankers, had to grapple with elevated leverage , as a well as an over-reliance on debt financing that were short-term.
Even as commercial banks finds in difficult to leverage their equity to a ratio exceeding 15 to 1, Lehman, on the other hand, had a leverage rate that was greater than 30 to 1. Given this kind of leverage then, an asset value drop of say, 3.3 percent would be adequate to wipe out, literary, the whole equity value of a firm, thereby leading to this insolvency (The Economist 2008).
Sequentially, the instability that came about as a result of the problem of leveraging became worse following the decision by the Lehman Brothers to utilize short-term debts. By virtue of relying on short-term debt, this compounded the “runs” risk analogous to those often faced by banks at such a time as when rumors abounds that they have been involved in a state of insolvency.
At the time when the Lehman went under, the firm had in its equity books 26 billion. Nevertheless, the doubts regarding the asset value of the firm, coupled with its leverage degree sought to cerate a massive level of uncertainty regarding the firm’s true equity value (The Economist 2008).
The paradigm of strategic leverage offers systematic advancement from the structural analysis of an industry to an assessment of the competitive position of a firm, as well as its consequences. Further, it also examines in details, such a firm’s leverage, the “game” of the industry and ultimately, narrows down to specific strategies, objectives and tactics.
Moreover, owing to its interactive nature, strategic paradigm leverage provides business managers with insights as regards the context of a competitive position and structure of an industry, coupled with a strategic leverage of an industry. A manger is thus at a better position to determine how and whether he/she may alter such an industry, to their advantage.
Core competence and strategic leverage
Core competencies of firms have been brought to the limelight by Prahalad and Hamel (1996). The authors describes a core competence as that which (1) offer possible access to a heterogeneous markets (2), provides a massive contribution to the “perceived customer benefits of the end product” , and (3) proves quite difficult to be duplicated by the competitors.
Prahalad and Hamel further opines “… in the long run, (a company’s ) competitiveness derives from an ability to build, at the lower cost and more speedily that competitors, the core competencies that spawn unanticipated products”. From such a perspective, strategy design thus becomes a process through which core competencies could be identified, exploited and investigated, with the aim of generating higher profits.
On the one hand, strategic leverage literary, identifies requirements, while core competencies on the other hand, and defines possibilities. As such, these two approaches appear to offer complement to each other. Managers are advised to desist from designing strategies entirely around the core competencies of an organization, while at the same time not paying any attention to strategic leverage.
Then again, it would be foolhardy for managers to exclusively focus on leverage, while not paying any attention to a firm’s core competencies. In the event that a certain firm is deficient in leverage, such a firm has a higher likelihood of making a mess of its core competencies (Prahalad & Hamel 1996).
At a minimum, there is very likelihood that firm’s resources could go to waste as a firm manager attempts to assess through trial and error, areas in which the competencies of their firms ought to be best applied. For instance, in might be argued that IBM possessed a majority of the core competencies that were vital to enable it compete adequately in the market of laptops.
IBM is not only a leading producer of large memory chips, but the form enjoys a highly recognized brand. Furthermore, IBM is endowed with enormous expertise in such sophisticated techniques as ‘surface mounting’ of various computer components (Prahalad & Hamel 1996).This notwithstanding, IBM seems not to have apparently comprehended areas in which the market provides strategic leverage, as evidenced by the firm’s action to introduce overpriced and under-powered products repeatedly, its responding strategy to price competition, as well as the firm’s reluctance to utilize channels of “discount”.
In addition, knowledge per se, may not be argued to be a sufficient leverage, until managers are in a position to comprehend their core competencies, they are not in a position to know the extent to which they could make use of available leverage. As a result, managers are inclined to either become complacent, or miss opportunities in a competitive market altogether, evidently falling short of responding to changes in leverage.
For example, during the 1970s, Amana, were in a position to retain the micro wave oven market leadership, only in the firm had opted to alter its pricing and sales tactics, as well as shifting towards mass merchandisers in the market (Prahalad & Hamel 1996).
Sadly, not even Raytheon, the parent company of Amana possessed expertise in low-cost production, or even the capability to work hand-in hand with channels in the mass market, essential core competencies fro an exploitation of such opportunities (Prahalad & Hamel 1996). Consequently, Amana was in a poor position to fully exploit on the available leverage. Leverage assist in core competencies identification.
Through the analysis of the strategic leverage of a firm in a certain market segment, one is in a position to distinguish what enabling competencies are necessary to facilitate leverage exploitation. An assessment of such enabling competencies in a wide range of groups enables us to unearth common themes, and consequently, such themes often point to the kinds of core competencies that firms ought to invest in, nurture, or acquire.
Leveraging of core competences
Synergy and leverage is the ‘common thread’ binding the old businesses to the new. From the context of product innovation, the capability to leverage prevailing ‘in-house’ competencies, strengths, capabilities and resources, enhances the success odds of novel product project. Conversely, what are referred to as ‘step-out’ projects shifts a firm’s focus into territories that are beyond the resource base and experience of a firm, thereby enhancing failure odds (Cooper 1999; Kavenock and Phillips 1997; Zingale 1998; Phillips (1995).
There are a number of reasons that have been provided as regards leverage impacts, and these are evidently clear:
- Resources are not available and when they are, they come at a certain added cost.
- The action of operating within a firm’s specialization field (could either be familiar technology or familiar market), avails profound ‘domain knowledge’ and which is often accessible to a project team
- The experience factor argues that an individual becomes more competent in an area as they seek to accomplish more of something. In the event that novel product projects have a close relationship with current businesses (leveraged form), there is a high likelihood that a profound experience has been in existence previously in such projects, thereby leading to reduced execution costs and ultimately, fewer misfires.
With regard to the innovation of a product, two kinds of leverage are vital:
- Technological leverage: the capability of a projects to enhance development technology in-house, make use of inside engineering skills, as well as utilize existing operations or manufacturing competencies and resources.
- Marketing leverage: a company blends well with regard to sales force, customer base, channels of distribution, advertising and promotions, customer service resources, skills, resources and knowledge, and market-intelligence.
These leverage dimensions- marketing and technical- along with their ingredients turns into obvious items of checklist in a rating or scoring model to assisting in giving preference to novel product projects.
In a case whereby leverage could be low while a project still remains attractive as a result of other reasons, there is a need in this case to initiate procedures meant to reinforce the internal competencies and resources. A score of low leverage depicts a need for partnering action with outside resources, or better still, a need to outsource some of the firm’s activities.
Nevertheless, none of these available solutions could be regarded as a panacea- both routes are not averse to costs and risks, as they attempt to secure the necessary competencies and resources.
Porter’s five forces
Other than impacting on the structure of an industry, the individual five forces of competition as discussed by Porter (1985) also tend to impact on one or several; target market elements. These are what are referred to as the 4Ps (product, price, place, and promotion). The presence of strong buyers in say, automobile ancilliaries, has a high likelihood of averting the consolidation of such an industry.
The presence of powerful buyers also means that the differentiation of products in question becomes either irrelevant, or difficult; usually, the buyers will often specify the product, as well as ‘base purchase decision’ on both the price of such a product, and its delivery as well. Such kinds of buyer shall often not be influenced by promotion, preferring also to maintain a bare minimum intermediary’s role.
Conversely, in the business of diamond, supplier power is regarded as to principal economic force. For example, De Beers could be said to run the cartel for diamond, with an iron hand’ (Grant 2005), eliminating diamond distribution consolidation, as well as having a controlling effect on wholesale (to a certain extent, they also impact on retail) prices to see to it that the conventional investment value of diamonds is retained.
Substitutes have the power to either end or limit the growth of an industry, as well as place massive constraints on both pricing and promotion in an industry. In a case whereby entry and exit barriers to an industry are quite low, such an industry may have to tendency towards a state of periodic upheaval, thereby remaining fragmented.
In this kind of an environment, the differentiation of a product becomes quite difficult, seeing that any emergency efforts at promoting such a product efforts gets “muffled” by the fragmented nature and period turmoil of the sector. Ultimately, following intense rivalry, product price and the promotion aspects of the same are often placed under tremendous pressure.
Buyers who are quite powerful in an industry6 have the capability t6o avert consolidation by way of maintaining the different industry participants in a fragmented nature, through a backward integration. Powerful buyers are capable of creating “poor” competitors, and who are both able and willing to go for ‘reduced returns’. Consequently, they impact on leverage be altering the emphasis toward price competition, away from product differentiation (Grant 2005).
By contrast, weak buyers tend to impact less on the structure of an industry, as well as on the 4Ps. The 4Ps-buyer power relationship appears to function in other directions as well. Powerful buyers with a potential could be neutralized with success, by way of utilizing tactics and strategies that are quite appropriate.
In addition, promotion of products seems to have minimal leverage since there are few buyers (else, how would they becomes powerful?), specify the design and functions of the product, are endowed with complete information in terms of the different products of a firm., and do onto allow decisions of purchase to be influenced by either promotional or advertising efforts, and whose aim is to have differentiated product.
It is for a similar reason that intermediaries use (place) provides reduced leverage; since buyers shall often opt to capture for themselves margins awarded to the intermediaries, the chief intermediaries function (Grant 2005).
Influencing leverage using supplier power
Suppliers whole are weak tends to have no impact on the structure of an industry. In case an industry seems like it is becoming quite lucrative, they could attempt to integrate forward in a bid to capture for them a portion of the profit, in the process assisting in the creation of ‘poor’ competitors (Hunger et al 2003). Alternatively, weak suppliers could also attempt to capitalize on the profitability of the industry, by way of raising prices.
Strong suppliers impact leverage in an indirect manner by raising the costs of a product, as well as restricting the flexibility of pricing. In this case therefore, the strategy ought to be one that seeks to neutralize the power of supplier, by way of industry testing, to evaluate whether or not customers may accept substitutes, as well as cooperation with the designers of a product to mitigate supplier inputs dependence.
For example, when the price of sugar skyrocketed, following a decision by sugar millers to raise its prices, both Pepsi and Coca-Cola altered their formula, thereby replacing sugar with the cheaper fructose (Hunger et al 2003). The two competitors first however had to undertake a test market, which leveraged that indeed, the customers were quite willing to accept the new products. In effect, both Pepsi and Coke had to later their formulations “(designs) to utilize the lower-cost alternative.
Impact of rivalry on leverage
Intense competition could result in a consolidated industry, with the stronger players in the sector either forcing out or buying out those players in the industry who are weak (Hunger et al 2003). This from of consolidation has a higher likelihood of taking place in cyclical or slow growth industries.
A good example is the farm equipment industry during the 1980s, in the United States, and also the recent merger waves that have been witnessed in the domestic airline industry in the United States as well, among several of the cases, intense rivalry has the potential to destabilize an entire industry, as the industry participants increasingly turn desperate in their quest to enhance their ‘competitive position’.
A stable competition and intense rivalry are typical characteristics of low-growth, mature industry, for instance, the farm equipment industry (McGahan 2004). Both intense rivalry and unstable competition, appears to be a common phenomenon in those industries that are experiencing profound structural changes, for example, home computer industry; an industry that is up to now evolving.
In other cases, for instance, the cereal industry, competition terms are quite stable, and the intensity of competition is low, an illustration of a tacit agreement that could be arrived at by the concerned industry players to maintain rivalry within the industry under control (McGahan 2004). In the local; travel agency sector, rivalry does not appear to be quite intense.
Nevertheless, unstable competition, and one that does not conform to any specific rules, seems to be in existence. Rivalry within an industry impacts on leverage chiefly via the limitation that is often placed on both price and promotion. Based on the stability and intensity of competition, price points could be alternatively set. Similarly, promotion shall also be limited.
Substitute’s impacts on leverage
Through limiting the flexibility of price as well as profitability, the substitutes existing within a certain markets sees to intensify the level of competition within such an industry. They are also capable of destroying such an industry, especially in a case whereby the production marginal costs of the substitutes appears to be quite low (McGahan 2004). Should this be the case then, such an industry is forced to adjust the price of its products to a level below its costs, in a bid to maintain its share of the market.
Another strategy would be for an industry to maintain its current prices and risk losing its market share. Whichever way an industry chooses to follow, a loss is imminent (McGahan 2004) A good example of this from of substitution is the jute industry, which had to endure the loss of their largest customers; the makers of carpets, at a time when they (carpet companies) replaced jute with polypropylene as a backing for carpet.
Polypropylene, which happens to be a petroleum refining by-product, became a jute competitor, once the carpet companies had started using it in pace of jute, owing to its reduced marginal costs. The results, as would have been expected, were quite inevitable. In under a decade, jute share in carpet backing had plummeted to negligible proportions.
Those substitutes which emerges into existence as a result of either buyer’s cost pressure for industry pricing could be competitive opportunities or threats, on the basis of whether or not they eliminate or limit the existing markets, or even enable an organization to widen its products and by extension, its markets.
Products markets and leverage
Leverage may also impact on the value of a firm by altering the competitive nature of the market in which the products and services of such an organization are trading at. If at all leverage could be viewed as competitive disadvantage, it then follows that the ‘feedback effect on leverage’ in as far as competitiveness is concerned become an added expense of financial distress.
Chevalier (1995) discovered that supermarket chains that were highly leveraged appeared to compete in a less aggressive manner, much to the benefit of those supermarket chains whose financing was rather more conservative. Following an announcement of a leveraged buyout (LBO) of a certain chain supermarket, this acted to enhance the competitor chain supermarket’s stock prices.
Later on, the conservative supermarket exhibited tendencies to expand, at the expense of the leveraged buyout chain. In addition, Zingales (1998) also discovered that trucking company that was quite highly leveraged had a tendency to ‘make reduced investments’.
Furthermore, such firms were also ‘less likely to survive in a de-regulated environment’ (Zingale 1998). Likewise, Phillips (1995) and later Kavenock and Phillips (1997) have observed that those firms that are highly-leveraged have a tendency to invest in a less-aggressive manner. Additionally, these studies appear to offer the opinion that those firms that are highly leveraged shall, whenever possible, seek to charge prices that are higher for their products and services.
Nevertheless, competitors who are endowed with “deeper pockets” could take the advantage of their competitors who are highly leveraged, by way of initiating intense and heightened competitive pricing. In such a scenario, highly-leveraged organizations could have no choice but to follow suit.
Evidently, there appears to be an association between, on the one hand products markets and finances, on the other hand. Thus far, available empirical literature provides that highly-leveraged firms are more of “softer” competitors, who are more inclined towards reducing expansion and investments. As such, a decision for a firm to leverage on its finances rests with the opportunities available to such a firm.
A firm at the growth stage whose future investment opportunities are quite valuable ought to be a “hard” competitor, thereby preferring equity financing. On the other hand, a firm whose future opportunities and investment are quite limited, and which faces an over-investment temptation ought to favor debt.
Leveraging and indirect costs of financial distress
A default threat in any one given firm could result in multivariate feedback impacts. Titman (1984) emphasizes the costs incurred by a state of liquidation on suppliers, consumers and employees, in a case whereby the products and/or services of an organization are dependent on its very existence. It then turns out that those organizations that are financed in a conservative manner end up having a competitive advantage.
Possibly, one of the ‘most dramatic’ and recent example could be the consequences that the financial distress of Enron had on the ‘energy-trading business value’ of the firm. This is the business section of Enron that commanded the greatest market share as well as profound market strength. Nevertheless, the execution of trade may only take place in the face of counterparty risk is extremely low (Biermann 2008).
The trading volume of Enron deeply plummeted starting from that moment when the firm’s debt rating overshadowed the organization’s investment grade, leading to a loss of the trading business value, evidently as a ‘going concern’.
In addition, the financial strategy be Enron was in total violation of a principal normative ‘implication of trade-off theory’; in the event that a firm’s operations or assets value gets massively damaged following a case of financial distress, the available option was for the reduction of distress odd, through a reduction on financial leverage (Biermann 2008).
Leverage evidence on financial distress costs
It is quite difficult to differentiate between on the one hand, financial distress costs and on the other hand, business setback costs that often place a given firm into a state of distress. In a bid to attack this problem, Andrade and Kaplan (1998) assessed a sample of ‘highly leveraged transactions (that is, leveraged restructuring and buyouts).
A majority of the sample firms that the authors used might as well have been healthy financially, seeing that these firms started with a leverage that was quite high, it then follows that minor setbacks in business were enough to trigger a state of distress. Andrade and Kaplan have placed an estimate of financial distress costs at a standard figure of between 10 and 20 percent of the value of a firm.
The effects of this form of financial distress are apparently not quite large, at least not as one would have expected. This is primarily as a result of two reasons. To start with, there is a high likelihood that several costs could flow from those business setbacks that are responsible for triggering distress in the first place.
In the case of Andrade and Kaplan, there appeared to have been negligible estimated costs of distress, in a firm’s sub-sample based on ‘evident adverse economic shocks’. Secondly, for a firm that functions at average debt ratios, the main concern would evidently be the foreseen impacts of extra borrowing, and this would seek to multiply distress costs with a limited distress probability.
Generally, leverage buyouts and restructurings tend to be undertaken by renowned firms that are also endowed with adequate cash flows for operations, coupled with limited opportunities for growth and expansion. The assets of such a firm that are in place may overcome reorganization and distress- they have a higher chance of being liquidated or shut down, for instance.
The results by Andrade and Kaplan may not necessarily find application in firms endowed with growth opportunities and intangible assets. These assets tends to have a fragile value, especially in a case whereby this value hinges on specialized labor, and which has a high chance of departing under financial distress conditions.
Leveraging in the legal profession for enhanced profitability in a competitive market
As a majority of the professionals in the legal fraternity will attest, most of the cultural differences that have for a long time now placed a division between the business world and the law firms, if these could be assessed more closely, hinges on the myths of law practice, as apposed to the realities of its practice.
Amongst the most notable myths that have thus far been fronted is the fact that leverage does not in fact improve on the profitability of a law firm in a significant way. In addition, skeptics have also been quick to fuel this myth, by adding their opinion that indeed, there is no connection between, on the one hand, the profitability of a firm and on the other hand, its leverage (Gibson & Trautz 2006).
The conventional reasoning argues that since the experienced and most senior lawyers on a law firm gets to bill at reasonably high rates, it then follows that the profitability of such a firm get augmented by the creation of work at the level of the partners, as opposed to additional billing hours for the firm’s associates (Poll 2004).
This is a perspective that indicates significant differences from that model often utilized by the business world, and which attempts to create value from, divergent and large employees’ pools, while the managerial and executive positions are often reserved for a very small portion of a firm’s workforce.
Nevertheless, this is not reason enough to warrant the level of divergences that seems to be projected by these two models. If anything, laws firms ought to greatly benefits out of a realization that though their comparatively unleveraged approaches could not have proved quite profitable, nevertheless they are at a position to tremendously enhance their leverage.
Perhaps one of the questions that we ought to be asking ourselves is why is it that an increase in the rates of billing does not translate into an increase in the profitability of a firm? In a bid to answer such a question, it is important first to appreciate that whereas the practice of utilizing non-equity lawyers attempts to condense a firm’s overall revenues, the profits that each of the partners acquire at the end of the day are however, increased.
For a more profound comprehension of leverage power, the most general metric of measurement for a law firm, with regard to their lawyers who are non-equity ( this includes also the partners that are non-equity, in addition to counsels, as well as the associates), in relation to the equity partners). For instances, suppose we have a law firm that is characterize by a low leverage, and consists of a single non-equity lawyer for every partner.
If we then compare this firm with another that is characterized by high leverage of a total of three non-equity lawyers for every single partner, the latter firms could end up generating a reduced revenue, as well as profits compared with the other firms.
Another question that is worth pondering on the matter at hand is, if at all leverage impacts so greatly on the profitability of a firm, (in this case, a legal firm), why is it then that the entire legal industry bear minimal or at best, no relationship between profitability and leverage? In other words, what enables a majority of the most profitable firms on the globe to sustain average returns that are quite low?
A probable explanation to this could be based on the premise that there are other factors too, which seeks to obscure low leverage negative impacts, as well as the positive impacts of enhanced leverage (Wert et al 2006). For instance, by taking into account the utilization factor, an enhanced leverage only function at a time when a firm truly places both the non-equity lawyers as well as associates to work.
Other probable elements capable of obscuring leverage impacts include realization, pricing, specialty practices, and matter-type mix. The individuals responsible for seeing to it that the profitability of a firm is achieved ought to realize that the noise often generated by some or all of these factors could be responsible for their arriving at a conclusion that leverage, in itself, is insignificant.
Research findings indicates that leveraging- the act of borrowing funds with a view to enhancing the equity returns of a firm- bears a correlation with the growth of a firm and consequently, impacts on the competitive nature of such a firm in the market. In a case whereby a firm is endowed with knowledge on capital, then it is possible fro such a firm to exploit growth options.
In turn, the growth and expansion of a firm shall have an impact on its cash flow.
Furthermore, leveraging in affirm has been shown to bear a correlation with the market share of a firm. An association has been established between no the one hand, firms and their competitors, and on the other hand, firms and their customers, in as afar as the issue of leveraging is concerned. For example, firms that deals with products that are characterized by a high switching rate, stands to lose ground on their leverage.
Yet, there still exist a connection between the competition in prices between firms and the financial leverage theory. A leveraged buyout (LBO) initiative has been shown to enhance competition amongst firms in a distressed industry. Furthermore, Chevalier (1995), through a study of supermarkets, established that those supermarket chains that had initiated an LBO, also tended to have elevated prices for their products and consequently, had a reduced market share.
Moreover, those supermarket chains that were highly leveraged were also seen to compete in a less aggressive manner and this appeared to be of benefit to those firms with a conservative financing. Therefore, through leveraging, it is possible that this phenomenon may impact on the value of a firm, by altering the competitive nature of the market in which both the products and services of such a firm are trading in
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