Financial Leverage
Financial leverage is the use of debt to finance a company’s operations. This can increase the company’s return on equity (ROE), but it also increases the risk of the company.
The following is a summary of the text you provided:
- The capital structure of A Ltd is as follows:
- Authorized Issued and Paid-up capital: 500,000 equity shares of Rs. 10 each
- 15% Debentures: 500,000
- 10% Preference Shares: 5,000 Preference Shares @ Rs. 100
- The degree of financial leverage (DFL) of A Ltd can be calculated as follows:
- EBIT = Rs. 600,000
- Interest (I) = Rs. 75,000
- Preference dividend (Dp) = Rs. 50,000
- Corporate tax (T) = 50%
- DFL = 600,000/600,000 – 75,000 – (50,000/1 – 0.5) = 1.41
- Why do companies not resort to ever increasing amount of debt financing, even though increased financial leverage leads to increased return on equity?
- As the company becomes more financially leveraged, it becomes riskier.
- This increased risk can lead to:
- Increased fluctuations in the return on equity.
- Increase in the interest rate on debts.
The following are the questions and answers from the text:
Question 8
If increased financial leverage leads to increased return on equity, why do companies not resort to ever increasing amount of debt financing? Why do financial and other term lending institutions insist on norms for Debt-Equity ratio?
Answer
As the company becomes more financially leveraged, it becomes riskier. This increased risk can lead to:
- Increased fluctuations in the return on equity.
- Increase in the interest rate on debts.
Financial and other term lending institutions insist on norms for Debt-Equity ratio to mitigate this risk.
Question 9
Explain Total/ combined Leverage.
Answer
Total leverage is the combined effect of financial leverage and operating leverage. Operating leverage is the use of fixed costs to magnify the effects of changes in sales on profits.
Total leverage can be calculated as follows:
Total leverage = Financial leverage * Operating leverage