Page 151 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 8: Concept of Leverages

Notes

Notes The financial leverage is favourable when the firm earns more on the investments/
assets financed by the sources having fixed charges. It is obvious that shareholders gain in
a situation where a company earns a higher rate of return and pays a low rate to the
supplier of long term funds. Financial leverage in such cases is also called “trading in
equity.”

The degree of financial leverage is the nursical measure of the firms’ financial leverage and is
calculated as:

Percentage change in EPS
Financial leverage =
Percentage change in EBIT

Example: C Company Ltd. a small food company expects EBIT of 10,000 in the current
year. It has 20,000 bond with 10% (annual) coupon rate of interest and 600 shares of 4 (annual
dividend on share) preferred stock outstanding. It has also 1000 equity shares outstanding. The
firm is in the 40% tax bracket. Two situations are shown:
Case 1: A 40% increase in EBIT from 10,000 – 14,000

Case 2: A 40% decrease in EBIT from 10,000 – 6,000
The corresponding change in EPS is shown below:

Case 2 – 40% Base data Case 1 + 40%
EBIT 6000 10,000 14,000
Less interest 2000 2,000 2,000
Net profit before tax 4000 8,000 12,000
Less tax @ 40% 1600 3,200 4,800
Net profit after tax 2400 4,800 7,200
Less preferred stock dividend 2400 2,400 2,400
Earnings available to equity shares 0 2,400 4,800
No. of shares 1000 1,000 1,000
Earnings per share (EPS) 0 2.40 4.8
- 100% +100%

It is seen that in:
Case No. I – A 40% increase in EBIT has resulted in a 100% increase in earnings per share (from
2.40 to 4.80).
Case No. II – A 40% decrease in EBIT has results in a 100% decrease in earning per share (from
2.40 to 0).

100%
i.e., financial leverage is: = 2.5
40%
The effect of financial leverage is such that an increase in the firm’s EBIT results in a more than
proportional increase in the firms earnings per share, whereas a decrease in the firms EBIT
results in a more than proportional decrease in EPS.

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