Financial leverage is the degree to which a company uses fixed-income

securities such as debt and preferred equity. The more debt financing a company
uses, the higher its financial leverage. A high degree of financial leverage means
high interest payments, which negatively affect the company's bottom-line
earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt
and preferred equities in a company's capital structure. As a company increases
debt and preferred equities, interest payments increase, reducing EPS. As a
result, risk to stockholder return is increased. A company should keep its optimal
capital structure in mind when making financing decisions to ensure any
increases in debt and preferred equity increase the value of the company.

Chapter One

1.
2.

Chapter Two

Chapter Three

Chapter Four

Chapter Five

5.1 Risk Management1.

5.3.1 Introduction To Financial Leverage And
And Options
Capital Structure Policy
5.2 Cost Of Capital

2.

5.3.2 Capital Structure

3.

5.3 Financial Leverage3.

5.3.3 Financial Leverage
And Capital Structure Policy
4.
5.3.4 Modigliani And Miller's Capital Structure
4.
5.4 Dividends
Theories
5.

5.5 Raising Capital

5.

5.3.5 Bankruptcy Costs And Optimal Capital

Structure

6.

5.3.6 Extended Pie Model, Observed Capital

Structures And Long-Term Financing

Financial Leverage And Capital

Structure Policy - Financial Leverage
Financial leverage is the degree to which a company uses fixed-income
securities such as debt and preferred equity. The more debt financing a company
uses, the higher its financial leverage. A high degree of financial leverage means
high interest payments, which negatively affect the company's bottom-line
earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt
and preferred equities in a company's capital structure. As a company increases
debt and preferred equities, interest payments increase, reducing EPS. As a
result, risk to stockholder return is increased. A company should keep its optimal
capital structure in mind when making financing decisions to ensure any
increases in debt and preferred equity increase the value of the company. (Learn
more about leverage in ETFs: Losing At Leverage and 5 Ways Debt Can Make
You Money.)
Degree of Financial Leverage
The formula for calculating a company's degree of financial leverage (DFL)
measures the percentage change in earnings per share over the percentage
change in EBIT. DFL is the measure of the sensitivity of EPS to changes in EBIT
as a result of changes in debt.

Formula:
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBIT-interest
A shortcut to keep in mind with DFL is that if interest is 0, then the DLF will be
equal to 1.
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's
variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The
company's annual interest expense is $100,000. If we increase Newco's EBIT by
20%, how much will the company's EPS increase?
Calculation and Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000$100,000)
DFL = $1,800,000/$1,700,000 = 1.058

MM Hypothesis
They theorized that the market value of a firm is determined by its earning power
and by the risk of its underlying assets, and that its value is independent of the
way it chooses to finance its investments or distribute dividends.

The basic M&M proposition is based on the following key assumptions:

No taxes
No transaction costs

 No bankruptcy costs
Equivalence in borrowing costs for both companies and investors
Symmetry of market information, meaning companies and investors have
the same information
No effect of debt on a company's earnings before interest and taxes

Modigliani and Miller's Capital-Structure Irrelevance Proposition

The M&M capital-structure irrelevance proposition assumes no taxes and
no bankruptcy costs. In this simplified view, the weighted average cost of
capital (WACC) should remain constant with changes in the company's
capital structure. For example, no matter how the firm borrows, there will
be no tax benefit from interest payments and thus no changes or benefits
to the WACC. Additionally, since there are no changes or benefits from
increases in debt, the capital structure does not influence a company's
stock price, and the capital structure is therefore irrelevant to a company's
stock price.
Modigliani and Miller's Tradeoff Theory of Leverage
The tradeoff theory assumes that there are benefits to leverage within a
capital structure up until the optimal capital structure is reached. The
theory recognizes the tax benefit from interest payments - that is, because
interest paid on debt is tax deductible, issuing bonds effectively reduces a
company's tax liability. Paying dividends on equity, however, does not.
Thought of another way, the actual rate of interest companies pay on the
bonds they issue is less than the nominal rate of interest because of the
tax savings. Studies suggest, however, that most companies have less
leverage than this theory would suggest is optimal.
In summary, the MM I theory without corporate taxes says that a firm's
relative proportions of debt and equity don't matter; MM I with corporate

taxes says that the firm with the greater proportion of debt is more valuable
because of the interest tax shield.
MM II deals with the WACC. It says that as the proportion of debt in the
company's capital structure increases, its return on equity to shareholders
increases in a linear fashion. The existence of higher debt levels makes investing
in the company more risky, so shareholders demand a higher risk premium on
the company's stock. However, because the company's capital structure is
irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with
corporate taxes acknowledges the corporate tax savings from the interest tax
deduction and thus concludes that changes in the debt-equity ratio do affect
WACC. Therefore, a greater proportion of debt lowers the company's WACC.