Question

What is financial Leverage; explain with an example how leverage creates larger returns in both directions.

Answer 1

The answer is as follows:

Financial Leverage : This ratio is the lever the leverage in true sense. financial leverage is measure of conwen's ability to recover fixed financial charges. This & a link between EBIT & EBT so that % change in EBIT would be followed by l change in EBT in accordance with financial leverage. High financial Leverage indicates that aggressive debt policy is being followed. Low financial Leverage indicates that a cautious debt policy is being pwested. Now, it is very sure that if the firm is highly levered and the fund procured from debentureholders and preference shareholders is invested yielding a lower return than the fixed cost obligation on them, we will say that unfavourable or negative leverage has occurred. In general debentures

pure lower cost seeweities and if the amount prowied 110m dibentere holders € invested af a netwen which is more than or even equal to the rate of interest, the investor's rate of retwen. (shareholder's rate of retwen) will be increased because of the tax saving on the interest element. This can be said as positive or favoweable leverage Degree of financel Leverage =% Change in EPS/Roofit fuailable for egleit, Sharehobeleza) I Earnings after Taxe (EAT) PAT/ Earnings Before Tar C'EST % Change in Earnings Before Interest & Tanes (EBIT) financial Leverage = EBIT EBT

Assum posame, Combo No Capital Storture equity Capital pany to consisting of 100% Equity Shave Cafarital ($10 each) = 600000 12% Debenture Total Capital Employed : 600000 Coming Earnings I earnings before Expected Earnings expected Less 30% Interest d'Torxes(EBIT) 126000 180000 Expected Eamings plus 30% | 234000 - 180000 Less : Interest evenings before Tere (BT) 126000 Taxes @40% (50400) Tone Ceat L 75600 | Return on Equity (ROE) 12.6% ( 75600 234000 (72000) (93600) 108000 140400 181 1 23-40%. (108000) (140400 (500000) 600000) 1 (756000) Now, let us assume Company X's capital structure consisting of 50% Equity Capital and 50% Debt Capital

Equity Shave Capital ($ 10 each) 300000 12% Debenture 300000 Total Capital Employed: 600000 Expected coming Expected ezbeetedecorings Les 20% Garnings bekore Interest Earnings Add 30% cind Taxes CEBIT) 126000 180000 234000 hexs: Interest@19% (36000) (36000) (36000) Cornings Before Tom TEBTS 90000 144000 198000 Taxes@40% (36000) (57600) (79200) Teornings After Taxe CEAT) 54000 86400 1 18800 Retwen on Equity (ROC) 1867 - 28.8% 39.6% (54000 186400 i (11800 ) (300000) (300000) (300000 Percentage Point Increase in ROE due to use of 5.4%. 10.84% 16.2./. Debt Capital (18-12.6) (28.8 -18) (18-12.6) lion (3916- 23.4) Percentage Increase ese 42.86% in Rot due to ! 60% 69.23% use of Debt /18-12.6 /28.8-18) 39.6-23, capital ( 12.6 ( 23.4

Indere 100% Equit, Capital Structure, the company's ROE is projected to fall between range of 12.6% to 23.4% depending on the level of the company's pre-tax earnings. But Under 50% Equity and 50% Debt Cafarital Stoucture, the company a ROE increases dramatically to a range that I falls between 18% to 39.6%