13-7-2013

13-7-2013

FINANCIAL LEVERAGE
The various means used to raise funds
represent the financial structure of an
enterprise
The term capital structure is used to
represent the proportionate
relationship between debt and equity

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Capital budgeting
decision
Need to raise funds
Capital structure
decision
Existing capital
structure

Debt- equity mix

Effect on EPS

Dividend decision

Effect on risk
Effect on cost of
capital

Value of the firm

Optimum
capital
structure

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Questions to any financing decision

How should the investment projects be
financed
Does the pattern of finance matter
Effect on shareholders risk, return and
value
What is an optimum financing mix ensuring
wealth maximization
Is it for real
Factors in considering a financing policy

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Meaning of financial leverage

The use of fixed charge sources of
funds, such as debt(and preference
capital) along with the owners equity in
the capital structure is described as
financial leverage or trading on equity

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MEASURES OF FINANCIAL
LEVERAGE
RATIO OF DEBT TO TOTAL CAPITAL
L1=D/(D+S)

RATIO OF DEBT TO EQUITY

L2=D/S

RATIO OF EBIT TO INTEREST CHARGES

L3=EBIT/INT
FIXED CHARGES MAY ALSO INCLUDE SIJNKING FUNDS
THEN, L3=EBIT/[INT+{SINKING FUND/(1-TAX RATE)}]

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LIMITATIONS OF THE FORMULA

To determine the solvency the cash flow

information is more relevant

Calculated on past earnings gives no idea of the
future of the company
Is only a measure of short term liquidity than of
leverage

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Financial leverage: effect on

shareholders return
EPS and ROE are important figures for

analyzing the impact of financial leverage

EPS=[(EBIT-INT)(1-T)]/N
EPS=EBIT*(1-T)/N

FOR A FIRM WITH DEBT CAP

FOR A FIRM WITHOUT

DEBT CAP

EPS=[(EBIT-INT)(1-T)-DIVP]/N
ROE=[(EBIT-INT)(1-T)]/S

FOR A FIRM WITH

PREFERENCE CAP

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ANALYZING ALTERNATIVE
FINANCIAL PLANS: CONSTANT EBIT
The financial leverage will have a favorable impact
on EPS and ROE only when the firms return on

assets exceeds the interest cost of debt.

The impact will be unfavorable if the return on

assets is less than the interest cost.

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Analyzing alternative financial plans:

Varying EBIT
ECONOMIC CONDITIONS
0.1
0.15
0.35
0.3
0.1
0.15
0.24
0.32

0.05 PROBABILITY
0.6 BEFORE-TAX ROA

PROBABILITY
0.05
BEFORE-TAX ROA
-0.05
FINANCIAL PLAN I: NO
DEBT
EBIT
-25000 50000 75000 120000 160000 300000
LESS INTEREST
NIL
NIL
NIL
NIL
NIL
NIL
PBT
-25000 50000 75000 120000 160000 300000
LESS TAXES AT 60%
-15000 30000 45000 72000 96000 180000
PAT
-10000 20000 30000 48000 64000 120000
NO. OF SHARES
EPS
ROE(%)

FINANCIAL PLAN I:
50% DEBT
EBIT
LESS INTEREST
PBT
LESS TAXES AT 60%
PAT
NO. OF SHARES

50000 50000 50000 50000 50000 50000

EPS
-0.2
0.4
0.6
0.96
1.28
2.4
ROE(%)
-2
4
6
9.6
12.8
24

FINANCIAL PLAN II: 25%DEBT

EBIT
-25000
LESS INTEREST
-18750
PBT
-43750
LESS TAXES @ 60%
-26250
PAT
-17500
NO. OF SHARES
37500
EPS
-0.47
ROE(%)
-4.7

50000
18750
31250
18750
12500
37500
0.33
3.3

75000
18750
56250
33750
22500
37500
0.6
6

120000
18750
101250
60750
40500
37500
1.08
10.08

160000
18750
141250
84750
56500
37500
1.51
15.1

300000
18750
281250
168750
112500
37500
3
30

FINANCIAL PLAN II:

75%DEBT
EBIT
LESS INTEREST
PBT
LESS TAXES @ 60%
PAT
NO. OF SHARES
EPS
ROE(%)

0.05
-0.05

ECONOMIC CONDITIONS
0.1
0.15
0.35
0.3
0.1
0.15
0.24
0.32

0.05
0.6

-25000 50000 75000 120000 160000 300000

37500 37500 37500 37500 37500 37500
-62500 12500 37500 82500 122500 262500
-37500 7500 22500 49500 73500 157500
-25000 5000 15000 33000 49000 105000
25000 25000 25000 25000 25000 25000
-1
0.2
0.6
1.32
1.96
4.2
-10
2
6
13.2
19.6
42

-25000 50000 75000 120000 160000 300000

56250 56250 56250 56250 56250 56250
-81250 -6250 18750 63750 103750 243750
-48750 -3750 11250 38250 62250 146250
-32500 -2500 7500 25500 41500 97500
12500 12500 12500 12500 12500 12500
-2.6
-0.2
0.6
2.04
3.32
7.8
-2.6
-2
6
20.4
33.2
78

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Behavior of EPS/ROE with fluctuating EBIT/ROA

Financial plan (debt inclusion)
ECONOMIC
CONDITIONS

Financial plan (debt inclusion)

ECONOMIC
CONDITIONS

ROA
-0.05

0
25%
ROE ROE
-0.02 -0.047

50%
ROE
-0.01

75%
ROE
-0.26

poor

0.1
0.15

0.04
0.06

0.033
0.06

0.02
0.06

0.02
0.06

poor

normal

0.24
0.32

0.096 0.108
0.128 0.151

0.132
0.196

0.204
0.332

normal

0.6

0.24

0.42

0.78

good

very poor

good

0.3

very poor

0
EBIT
EPS
-25000 -0.2

25%
EPS
-0.47

50%
EPS
-1

75%
EPS
-2.6

50000
75000

0.4
0.6

0.33
0.6

0.2
0.6

0.2
0.6

120000 0.96
160000 1.28
300000 2.4

1.08
1.51
3

1.32
1.96
4.2

2.04
3.32
7.8

Favorable effect of increasing financial leverage during normal

and good years is on account of the fact that rate of return on
the assets exceed the cost of debt
Financial leverage works both ways. It increases EPS and ROE
under favorable economic conditions and worsens the same
during unfavorable conditions

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