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Financial Leverage

Financial Leverage Assignment / Homework Help
Financial leverage is related to the financing activities of the firm. It is caused due to fixed financial costs in the firm. The sources of such types of funds carrying a fixed interest cost are long-term bonds and debentures. These financial fixed charges do not vary with the earnings before interest and taxes or sales. They have to be paid irrespective of the profits available. Financial leverage is concerned with the effects of changes in EBIT on the earnings available to the equity shareholders. It can be defined as "the ability of the firm to use the fixed financial charges to magnify the effects of changes in EBIT on the firm's earnings per share (EPS)". In other words, financial leverage involves the use of funds obtained at a fixed cost with a hope of increasing the returns available to the equity shareholders.

A favorable financial leverage occurs when the firm earns more on the assets purchased with the funds, than the fixed cost of their use. Unfavorable leverage occurs in the reverse scenario. In a way, use of fixed cost source of funds generates increased returns for the equity shareholders without an additional requirement of finance from them. Therefore, financial leverage is alternatively also called as 'Trading on equity'.

Degree of Financial leverage

The degree of financial leverage can be expressed as the percentage change in Earnings per share divided by the percentage change in the firm's earnings before interest and taxes.

Financial Leverage

If DFL > 1, financial leverage exists.

The greater the DFL, higher is the financial leverage for the firm.

Example:

A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed operating costs are $50,000 per year. The fixed interest expenses (non-operating) are $25,000 and the firm has 10,000 shares outstanding. Let us evaluate the EBIT/EPS resulting from sale of 1) 2000 units & 2) 3000 units. Tax rate = 35%.
    Financial Leverage

A financial leverage of 2 indicates that for every $1 change in EBIT, there would be a $2 change in EPS in the same direction.

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