Trading On Equity Or Financial Leverage

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

Two types of leverages1. 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 Debt(Interest @ 10% p.a.) Equity Shares(Rs. 10 each) Total finances required 400000 100000 500000 PLAN II 100000 400000 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 Earning before interest and tax(EBIT) Less: Interest on Debt 50000 40000 PLAN II 50000 10000

Earnings before tax(EBT)

Less: Tax @ 50% Earnings after interest and tax No. Equity Shares Earning Per Share (EPS)

10000
5000 5000 10000 5000/10000=.50 P

40000
20000 20000 40000 20000/40000=.50 P

(2)When EBIT is Rs.75000

PLAN I EBIT 75000

PLAN II 75000

Less: Interest on debts

EBT Less: Tax @ 50% Earnings after interest and tax No. of equity shares Earning per share (EPS)

40000
35000 17500 17500 10000 1.75

10000
65000 32500 32500 40000 0.81

(3)When EBIT is Rs. 125000

PLAN I

PLAN II

EBIT
Less: Interest on debts EBT

125000
40000 85000

125000
40000 115000

Less: Tax @ 50%

Earning after interest and tax No. of Equity shares Earnings per share EPS

42500
42500 10000 4.25

57500
57500 40000 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 companys 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

Thank You