II.

Financial leverage
2.1 Definition
Whereras operating leverage influences the mix of plant and equipment, financial
leverage determines how the operation is to be financed.

Financial leverage reflects to the amount of debt used in the capital structure of the
firm. In other words, financial leverage refers to the extent to which fixed-income securities (debt and
preferred stock) used in a firm’s capital structure.

2.2 Pros and cons of financial leverage

2.2.1 Pros of financial leverage

When a firm expands, it needs capital, and that capital can come from debt
or equity. Debt has two important advantages. First, interest paid is tax deductible, which lowers
debt’s effective cost. Second, debtholders get a fixed return, so stockholders do not have to share
their profits in case of the business is thriving. Generally, financial leverage gives possitive
impacts on equity if the expected interest ratio is higher than the debt ratio.

Kroger, the nation’s largest supermarket chain, is a good example of a

firm that has used debt wisely. Like many food stores, Kroger has a heavy debt burden, but the
assets purchased with that debt have earned more than the cost of the debt, so the “debt leverage”
has increased the company’s profit. As a result, its EPS have a good growth, and in recent years
Kroger’s stock has an A-level rating.

2.2.2 Cons of financial leverage (The risk factors)

However, debt also has disadvantages. First, when the company abuses too much
debt, the higher the debt ratio, the riskier the company, so the higher its interest rate will be. As a
result, the investors will buy company’s stocks with the lower price, so it results eranings per
share is not high too.

* For example, company A and B have the same EBIT is $100,000. Company A does not use
debt while company B has issued $250,000 bonds at an interest rate of 15%. Company B has to
pay $37,500 in interest. If EBIT of both companies dropped to $25,000, Company B loses the
interest payment ability when company A is not

Second, if a company’s health is not effective, and operating income is not

sufficient for covering interest charges, its stockholders will have to make up the shortfall, and if
they cannot, bankruptcy will not be avoidable. In other words, risks will place on the common
stockholders.
 There is a “trade-off” in the use of financial leverage. Companies with uncertain
earings and operating cash flows may limit their use of debt. On the contrary, companies with
less business risk and more stable operating cash flows can take on more debt. In other words,
substantial uses of debt will place a great burden on the firm at low levels of profitability, but it
also will help to magnify earinings per share (EPS) as volume or operating income increases.

* For example, if the company was capitalized entirely by equity, and if each investor buys 10%
of shares, they will share the same business risk. But assume that the company is capitalized at a
rate of 50% debt and 50% equity, with five investors to contribute capital in the form of debt and
five investors to contribute capital in the form of equity. Creditors will receive fixed payments
and benefits to be received before the shareholders. If the company goes bankrupt, creditors are
paid before shareholders. In this case, five investors to contribute capital in the form of equity
will bear the entire business risk. Therefore, the use of debt (financial leverage) focuses the
entire business risk on shareholders.

2.3 Impact in earnings

To study the impact of a financial leverage, we will examine two financial plans
for a firm, where $200,000 is required to carry the assets. Each plan has a different amount of
debt in the capital structure.

Total Assets = $200,000

Plan A (leveraged) Plan B (conservative)

Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest)

Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25)

Total financing $200,000 $200,000

In plan A (leveraged), company will borrow $150,000 and sell 8,000 shares of stock at $6.25,
while plan B (conservative) borrows only $50,000 and sell 24,000 shares of stock at $6.25. We
assume operating income (EBIT) levels of the firm is $0, $12000, $16000, $36000, $60000. The
tax rate is 50% for ease computation.

( Look at table below)

Although both plans assume the same operating income (EBIT), the earnings per share (EPS) is
clearly different. With an EBIT of $16000, company are earnings 8% on total assets of $200000-
exactly the percent cost of borrowed debts to the firm. The use or nonuse of debt does not
influence the answer. Therefore, earnings per share of both plans are the same amount $0.25.
Table shows that the conservative plan will produce better results at low income levels, but the
leverage plan will get much better earning per shares as operating income (EBIT) increases.
 2.4 Degree of Financial Leverage (DFL)
DFL measures the effect of a change in one variable on another variable. DFL
may be defined as the percentage change in earnings (EPS) that occurs as a result of a percentage
change in earnings before interest and taxes (EBIT).

Percentcha ngeinEPS
DFL =
Percentcha ngeinEBIT

For the purpose of computation, the formular for DFL may be conveniently restated as:
 EBIT
Or DFL =
EBIT − I

With: EBIT – earnings before interest and tax / I: interset

Let’s compute the degrees of financial leverage for Plan A and Plan B

Company A Company B
1. EBIT: 16,000
Earnings before interest & taxes(EBIT) $16,000 $16,000

-Interest (I) 12.000 4,000

Earnings before taxes 4,000 12,000

-Taxes (T) 2,000 6,000

Earnings after taxes 2,000 $6,000

Shares 8,000 24,000

Earnings per share (EPS) $0,25 $0,25

EBIT: 36,000
Earnings before interest & taxes(EBIT) $36,000 $36,000

-Interest (I) 12,000 4,000

Earnings before taxes 24,000 32,000

-Taxes (T) 12,000 16,000

Earnings after taxes $12,000 $16,000

Shares 8,000 24,000

Earnings per share (EPS) $1,50 $0,67

=> We can compare the percentage change in EPS and EBIT at the EBIT

level of $16,000 and percentage change in EPS and EBIT at the EBIT level of

$36,000 between Plan A ( the company use financial leverage) and PlanB

( without using debt in the capital’s structure) . The percentage change in

EPS is calculated by dividing the increase in EPS by the current EPS, and the

percentage change in EBIT is calculated by dividing the increase in EBIT by

the current EBIT.

Plan A ( leverage firm) Plan B

1,50 − 0,25
(conservative firm) DFL =
changeperc entageinEB IT
=
1,50
= 1.5
changeperc entageinEP S 36 ,000 −16 ,000
36 ,000

0,67 − 0,25
changeperc entageinEB IT 0,67
DFL = = = 1.1
changeperc entageinEP S 36 ,000 −16 ,000
36 ,000

EBIT
Another way: DFL =
EBIT − I

We calculate the degree of financial leverage for Company A and

company B at an EBIT level of 36,000. Assume that Plan A requires $
12000 of interest at all levels of financing, and Plan B requires $ 4000

Company A (Leverage)

EBIT 36 ,000
DFL = = =1.5
EBIT − I 36 ,000 −12 ,000

Company B (Conservative)

EBIT 36 ,000
DFL = = =1.1
EBIT − I 36 ,000 − 4,000

Let’s take a look at 2 results; Plan A has much higher DFL than plan B. At an EBIT level
of $36,000, a 1% increase in earnings will produce 1.5% increase in EPS for plan A, but only
1.1% increase for plan B.

 DFL can be calculated for any level of operation, and it will change from point to
point, but company A will always exceed company B.
• Conclusion
All in all, leverage is a two-edged sword. When investors can predict exactly the
market’s situations in long-term in order to analysis and invest effectively, financial
leverage will make a considerable increase of profit. On contrast, a wrong forecast
will result more seriously failure for companies. Therefore, the use of financial
leverage is just for expert invetors, it’s not suitable for entreprenuers who lack of
experience and capital.