How Share Repurchase increases Leverage

Let's understand it through an example.

A company X has debt outstanding of 30m and Equity has market value 70m. The company plans to repurchase 7m of its shares from the market. The company can either use its excess cash or issue debt to repurchase its shares. The current debt to asset ratio is 30% (30/100)

1) Repurchasing shares through excess cash

Equity after repurchase = 70 - 7 = 63m
Debt = 30m
Total Assets = 30 + 63 = 93m
Debt to Assets Ratio = 30/93 = 32% (Approx.)

2) Repurchasing shares through issuing debt

Equity after repurchase = 70 - 7 = 63m
Debt = 37m (7m new + 30m existing)
Total Assets = 37 + 63 = 100m
Debt to Asset Ratio = 37/100 = 37%

Through repurchase the debt to asset ratio has increased from 30% to 32% in case of excess cash and if the firm opts to finance repurchase through debt then the ratio increases from 30% to 37%. In this way share repurchase increases financial leverage.

It can also be understood in a way that share repurchase decrease equity value and through balance sheet equation where Assets = Liability + Equity, either the decrease in equity is covered by incurring liability (debt)or through decreasing assets. The debt weight as percentage to assets increases in either way thus increasing leverage.