Financial leverage refers to debt a firm’s capital structure. Firms with debt in the capital structure is called levered firms. The inter firm’s irrespective of the firm’s earnings. Hence, interest charges are fixed costs of debt financing. The fixed financial costs result in financial leverage and cause profit after tax to vary with change in EBIT.
Hence, the degree of financial leverage defined as the change in the company’s profit after tax due to change in the EBIT. Since financial leverage increases the firm’s (financial) risk. It will increase the equity beta of the firm.
USE OF FIXED CHARGE FUND
The use of the source of the fixed charge funds.Such as debt and preference capital along with the owners’ equity in the capital structure financial leverage or gearing or trading on equity. The use of term trading on equity derived from the fact that is the owner’s equity that is used as a basis to raise debt.
Every time firm makes an investment decision. It is at the same time making a financial decision also. A decision to build a new plant or to buy a new machine implies a specific way of financing that project. A company finances its investment by debt and equity. The rate of return an asset.The company has a legal binding to pay interest on the debt.
The use of the fixed charges source of funds such as debt and preference share capital with the owner’s equity in the capital structure. Describe as financial leverage employed by a company intended to earn more return on the fixed charge funds than their cost.
Financial leverage at once provides the potential of increasing the shareholder earning as well as creating the risk of loss to them.
IMPACT OF FINANCIAL LEVERAGE ON SHAREHOLDER RETURN
Financial leverage is managing the shareholder return fixed charge funds (loan from financial market institutional bank and debenture can be obtained at a cost lower than the firm’s rate of return on net assets (RONA &ROI).
Based on assumption EPS or return on equity (ROE) increases EPS ROE will fall. The company obtains the fixed charge fund at a cost higher than the rate of return.
MEASURES OF FINANCIAL LEVERAGE
The most commonly used measures of financial leverage.
1) Debt Ratio:-The ratio of debt to total capital.
E=value of share holder’s equity
V=Value of capital
2)The debt-equity ratio-The ratio of debt to equity.
3)Interest coverage ratio= The ratio of net operating income(or EBIT) to interest charges.
The firm two measures of financial leverage expressed either in terms of book value reflects. The current attitude of an investor.
Role of financial leverage
->The financial leverage or trading on equity is derived from the fact that it is the owner’s equity that is used as a basis to raise debt.
->The supplier of debt has limited participation in the company’s profit and therefore.it will insist on protection in earnings and protection in values represented by ownership equity.
->The surplus or deficit will increase for a decrease in the return on the owners’ equity is levered above or below the rate of return in total assets for example if a company borrows Rs.100 at 8 percent interest.(that is rs.8 per annum).
The balance of 4 percent (rs.4 per annum ) after payment of interest will belong to the shareholder. It constitutes the profit from financial leverage. On the other hand, if the company could earn only a return of 6 percent on Rs.100(rs.6 per annum). The loss to the shareholders would be rs. 2 per annum.
Thus financial leverage at once provides the potentials of increasing the shareholder’s earning as well as creating the risk of loss of to them.