Modelling Changes in Financial Leverage and Firm Value in South Africa
Date
2012-11-14
Authors
de Villiers, Shane Adrian
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Abstract
This study was based on the static trade-off theory for the determination of the optimal amount of leverage within firm capital structure. This theory suggests that the optimal capital structure involves balancing leverage-related costs, such as the present value of bankruptcy costs and agency costs, with the tax advantage of debt. The research has adopted an empirical approach by using historical financial data from the Top 20 industrial sector firms (by market capitalisation) listed on the main board of the JSE Securities Exchange. These companies have been grouped into related industry sectors by trade, allowing for sector related correlations to be easily distinguished.
A mathematical model, namely a discounted cash flow valuation model, constituted the methodology for the research. The valuation model used historical financial data for each of the firms and future market assumptions to calibrate the model to the market values of the firms over the longitudinal study (2006-2010). The financial data was downloaded from selected online financial databases, and any missing data was sourced from company annual reports.
The valuation model was used to determine the impact of increased leverage on firm value and risk profile. The re-levering process assumed that the firms‟ total capital employed remained the same and the increased leverage was used to buy-back shares at their related market value. The Altman Z” score was used as a measure for financial distress, which correlated to a Bond Rating Equivalent credit rating and risk profile. The analysis concluded that the inter-industry sector firms could potentially have realised a 1.1% to 15.6% increase in firm value through increased leverage over this longitudinal study. This leverage optimisation was possible without any inter-industry sectors dropping into a financial distress risk profile. The maximum value creation seemed to occur at debt to total value ratios of between 19.0% and 53.0%.it was also evident that in recent years that firms are capable of taking on more debt and have higher optimal debt to total value ratios. The research concluded that the increase in firm value and tax reduction would be highly beneficial to the remaining shareholders. This would also indicate that firms in the industrial sector that announce share buy-backs could be excellent investment opportunities. It was recommended that this research be extended to cover the separate industry sectors on the JSE Securities Exchange main board.
Description
MBA thesis - WBS
Keywords
Discounted cash flow valuation models, Leverage of capital, Company valuation