Financial Leverage

Trading On Equity /Financial Leverage

How are the shareholders of a company likely to gain with a debt component in the capital employed?

Explain with the help of an example.

What do you mean by Trading on equity/financial leverage?

Financial leverage = proportion of debt in the overall capital structure. Also called - Trading on Equity or

Capital Gearing.

• Cost of funds = cost of debt + cost of equity.
• As financial leverage increases, the cost of funds declines as debt is a cheaper source of funds.

The reasons for higher EPS with debt are:

• Rate of return on investment  is more than the cost of debt
• Interest paid on debt is tax-deductible and so there is a saving on the amount of income tax that the company will be required to pay.
• Number of shares is lesser when funds are raised as debt and so divisible profits (EAT) will have to be distributed among a lesser number of shares.

Use of Financial Leverage, however, involves a risk to equity holders because even a small change in EBIT will cause a great change in EPS and return on Equity as we can see in example II. Thus, the benefits of trading on Equity are available only when the following conditions are satisfied:

• The rate of earning is higher than the rate of interest on the debt.
• The company‘s earnings are stable and are regular to pay at least the interest on debentures.
• There are sufficient fixed assets to offer as security to lenders.