Lesson 5 of 7
Leverage and the equity cushion
Debt is fixed while the business it is borrowed against is not, so the same fall in a company's value takes a much larger share of a leveraged equity.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Debt is a fixed amount owed and equity is what is left, so a change in the business's value lands on equity first.
- The same 20 percent fall in a company's total value can be a 20 percent, a 50 percent, or a complete loss for equity, depending only on how much debt sits ahead of it.
- The more debt ahead of it, the more equity behaves like a bet with a capped loss and an uncapped gain, rather than a steady share of a steady business.
A company's enterprise value is what its whole business, debt and equity together, is worth. Debt is a fixed claim on that value. Equity is whatever is left, so a change in enterprise value lands entirely on the equity, however small the equity is.
A 20% fall in enterprise value, at three debt levels
- No debt · equity 1,000 to 80020%
- 600 of debt · equity 400 to 20050%
- 800 of debt · equity 200 to 0100%
Fall in enterprise value: 20%
Debt is fixed, equity is the remainder
The amount owed does not change when the business does better or worse; it is a stated amount, due on a stated schedule. Equity is defined as everything left after that fixed amount is subtracted. That is why every dollar the business gains or loses lands on equity, and the smaller the equity, the bigger that dollar is as a percentage.
The same fall, three different equities
Modigliani and Miller showed in 1958 that, under their assumptions, including no taxes and no cost of distress, a company's total value does not depend on how it is split. The split still changes the risk: the more debt, the riskier each dollar of equity. Real distress costs make it worse by shrinking the pie itself.
Why equity near distress trades like an option
Limited liability means an equity holder can never owe more than was paid in; the most a share can lose is everything, never a negative number. Combine that floor at zero with an uncapped upside, and a heavily leveraged equity starts to behave less like a steady share of a steady business and more like a bet: the share price swings far more than the business does. That is also why equity holders and lenders can want different things from the same company once it is under strain. A lender mainly wants its fixed claim protected, while an equity holder with little left to lose has more reason to prefer a risky bet that could restore its value. This is one reason lenders write covenants into a loan agreement in the first place. A covenant limits how much a heavily leveraged equity holder can gamble with a lender's own fixed claim.
Check yourself
Enterprise value falls from 1,000 to 800. A company carries 600 of debt. What happens to its equity?
- It falls from 1,000 to 800
- It falls from 400 to 200, a 50 percent fall
- It falls from 600 to 400
Show the answer
Answer: B.
Equity is enterprise value minus debt: 1,000 − 600 = 400 before, 800 − 600 = 200 after. The 20 percent fall in the business is a 50 percent fall in the equity.Why does the same percentage fall in enterprise value hit a leveraged equity harder than an unleveraged one?
- Leveraged companies always have worse businesses
- Debt is a fixed claim, so all of the change in value lands on the smaller residual claim, equity
- Lenders absorb losses before equity does
Show the answer
Answer: B.
Debt does not shrink when the business does. Equity, the amount left over, absorbs the whole change, and that change is a bigger share of a smaller equity.A business is sold for exactly what it owes. What do the shareholders receive?
- Half of the sale price
- Nothing
- The sale price cannot be calculated
Show the answer
Answer: B.
Equity is enterprise value minus net debt. At a sale, nothing is left once the debt is paid. While the company still trades, the market may pay something for the chance of recovery, which is the option described in the next section.Sources
- Modigliani and Miller, 1958: capital structure irrelevance under their assumptions, including no cost of financial distress.
What this leaves out
- The 1,000-and-800 figures and the three debt levels are round invented inputs, chosen to make the arithmetic exact.
- Enterprise value itself is an estimate, not a filed number, so the "fall" in every row is a scenario, not a measured event.
- Nothing here says any company is leveraged, distressed, or a bet worth taking. It is not advice about any security.