Why leverage has limits

Chapter 10 said distress costs limit leverage. This is what that means in numbers.

The magnification

Work the problem. ₹100 crore of capital, two structures.

All equity. Equity ₹100 crore, no interest.

EBIT	Profit before tax	Return on equity
₹30 cr	₹30 cr	30%
₹20 cr	₹20 cr	20%
₹5 cr	₹5 cr	5%

60% debt at 10%. Debt ₹60 crore, equity ₹40 crore, interest ₹6 crore.

EBIT	Less interest	Return on ₹40 cr equity
₹30 cr	₹24 cr	60%
₹20 cr	₹14 cr	35%
₹5 cr	−₹1 cr	−2.5%

In the good year leverage doubles the return. In the bad year it turns a modest profit into a loss.

The asymmetry is the whole chapter. A 30% return becoming 60% is pleasant. A 5% return becoming negative is the start of a different kind of problem, because the ₹6 crore of interest is owed whether or not it was earned.

Interest cover is the number lenders watch

$\text{Interest cover} = \frac{\text{EBIT}}{\text{Interest}}$

In the three cases: 5.0×, 3.3×, and 0.83×.

Below 1.0 the business is not earning its interest. It is not yet insolvent — it may have cash, or assets to sell — but it is consuming its own balance sheet to stay current, and lenders know it before anyone else.

That is why covenants are usually written on cover and leverage ratios rather than on profit: they trip early, while something can still be done.

What distress costs before insolvency

The important idea in this chapter is that the costs start long before the event. A company known to be stretched finds:

• Suppliers tighten terms — shorter credit, advance payment, exactly when cash is scarcest
• Customers hesitate on anything requiring the company to exist in three years: long contracts, warranties, bespoke work
• Good staff leave, and they leave first, because they have options
• Management time redirects from running the business to negotiating with lenders
• Investment stops, which damages the business precisely when it needs to compete
• Refinancing is priced punitively, or declined

None of this appears in a WACC calculation, and all of it reduces the cash flows the business was being valued on. Distress is not a point event; it is a tax on operations that rises with leverage.

The debt overhang problem

A subtler cost, and a real one. A heavily indebted firm can face a positive-NPV project it rationally declines.

The reason: if a large part of the gain accrues to lenders — who are owed more than the firm is worth — then shareholders funding the project capture too little to justify their outlay. The project is good for the firm and bad for the people who must fund it.

So high leverage does not merely risk failure. It can cause a solvent company to stop investing, which is how a liquidity problem becomes a competitive one.

Who sets the ceiling

Rarely the theory.

Lenders set it through covenants and the willingness to extend the next rupee, typically on leverage and interest cover.

Regulators set limits in specific actions — SEBI's buyback regulations require that aggregate secured and unsecured debt after a buyback be no more than twice paid-up capital and free reserves, with the Central Government able to notify a higher ratio for a class of companies.

Rating agencies set it indirectly: a downgrade raises the cost of debt and can trigger covenants, so the rating boundary is a practical ceiling well before the economic one.

The sensible position

Leverage is a tool with a known shape: it raises expected returns and raises the variance more. From chapter 5 of the Quantitative methods subject, scaling a position by $a$ scales the mean by $a$ and the variance by $a^2$.

What follows:

• Match debt to cash flow stability. Predictable cash flows carry debt; volatile ones do not.
• Keep headroom. Capacity is only useful unused.
• Watch cover through a downturn, not at today's earnings.
• Remember the fixed charge is fixed. That is the entire difference between debt and equity, and it is the reason the bad-year row above exists.

The point

Leverage magnifies returns in both directions, and the directions are not symmetric: a good year is a multiple and a bad year can be an ending, because interest is owed whether or not it is earned. Distress costs begin long before insolvency, as suppliers, customers and staff respond to known weakness, and debt overhang can make a solvent firm decline good projects. Lenders, regulators and rating agencies set the ceiling before any theory does.