Trading On Equity Or Financial Leverage

Leverages

The Term ‘leverage’ is used to describe the firm’s ability to use fixed cost assets or funds to increase the return to its owners; i.e. equity shareholder.

Two types of leverages-

1. Financial Leverage

2. Operating Leverage

Financial Leverage

Meaning-Trading on equity is when a company incurs new debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a return greater than the interest cost of the debt.

The use of long-term fixed interest bearing debt and preference share along with equity share capital is called financial leverage or trading on equity.

Impact Of Financial Leverage

The financial leverage is used to magnify the shareholders earning. The impact of financial leverage can be analyzed while looking at earnings per share and return on equity capital.

This can be analyzed with the help following questions-

A firm is considering two financial plans with a view to examining their impact on Earning Per

Share (EPS). The total funds required for investment in assets are Rs.500000

PLAN I PLAN II

Debt(Interest @ 10% p.a.) 400000 100000

Equity Shares(Rs. 10 each) 100000 400000

Total finances required 500000 500000

No. of equity shares 10000 40000

The earnings before interest and tax are assumed as Rs.50000,Rs.75000 and Rs.125000.The rate of tax be taken at 50%.Comment .

(1) When Earnings Before Interest and Tax (EBIT) are Rs.50000

PLAN I PLAN II

Earning before interest and tax(EBIT) 50000 50000

Less: Interest on Debt 40000 10000

Earnings before tax(EBT) 10000 40000

Less: Tax @ 50% 5000 20000

Earnings after interest and tax 5000 20000

No. Equity Shares 10000 40000

Earning Per Share (EPS) 5000/10000=.50 P

20000/40000=.50 P

(2)When EBIT is Rs.75000

PLAN I PLAN II

EBIT 75000 75000

Less: Interest on debts 40000 10000

EBT 35000 65000

Less: Tax @ 50% 17500 32500

Earnings after interest and tax 17500 32500

No. of equity shares 10000 40000

Earning per share (EPS) 1.75 0.81

(3)When EBIT is Rs. 125000

PLAN I PLAN II

EBIT 125000 125000

Less: Interest on debts 40000 40000

EBT 85000 115000

Less: Tax @ 50% 42500 57500

Earning after interest and tax 42500 57500

No. of Equity shares 10000 40000

Earnings per share EPS 4.25 1.438

(1)Plan I is a leveraged plan because it has 80% debt financing and has only 20% equity financing. Plan II is a conservative financial plan where fixed cost funds are

only 20% of total funds and the rest is financed through equity capital

(2)The EPS is increasing in Plan I with the increase in profits (EBIT).In situation (1) the earnings per share is same in both the plans i.e, Re.0.50.As the EBIT has increased from Rs.50K to 75K (situation 2)the EPS in plan I is Rs. 1.75 while it is Rs.0.81 in plan II.EPS is Rs.4.25 in Plan I and Rs.1.438 in Plan in Plan II when EBIT increases to Rs. 125000.

(3)It is a clear from from the analysis that EPS is increasing with the increase in profits in plan I as compared to that of Plan II. This is possible with the use of more fixed cost cost funds in Plan I ads compared to Plan II.

(4)The increase in EPS in Plan I is due to the financial leverage because earnings before interests and tax are same in all the situation.

A Ltd. Company has equity share capital of Rs. 500000 divided into shares of Rs. 100 each. It wishes

to raise further Rs. 300000 for expansion cum modernisation plans. The company olans the following

financing schemes.All common stock

Rs. One lakh in common stock and Rs. Two lakh in 10% debentures

All debt at 10% p.a.

Rs. One lakh in common stock and Rs. Two lakhs in preference capital with the rate of dividend at 8%

The company’s existing earning before interest and tax (EBIT) are Rs.150000. The corporate rate of tax is 50%.

You are required to determine the EPS in each plan and comment.

Significance Of Financial Leverage

Planning Of Capital Structure

Profit Planning

Limitation Of Financial Leverage

Double-edged Weapon

Beneficial only to companies having stability of earnings

Increase risk and rate of interest

Restrictions from financial institutions

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