FINANCIAL LEVERAGE AND SHAREHOLDERS RETURN

Primary motive of firm in using fin. Leverage is to magnify shareholders return under favorable economic condition.

• Its based in the assumption that fixed charges funds can be obtained at a lower cost than firms required rate of return.
• When difference between earnings generated by assets financed by the fixed-charges funds and cost of these funds is distributed to the shareholders by which EPS & ROE increases.
• EPS & ROE will fall if the company obtains fixed charges funs at a higher cost thane required rate of return. Thus EPS, ROE & ROI are influenced by financial leverage.

Interest tax shield:

The effect of debt is to see the impact of the interest charges on the firm’s tax liability. The interest charges are tax deductible and therefore, provided tax shield which increases the earnings of the shareholder.

Financial leverage magnifies the shareholders earnings. Variability of EBIT causes EPS to fluctuate within the wider ranges with debt in the capital structure. With more debt EPS raises and falls faster than the rise and fall in EBIT. Thus financial leverage not inly magnifies EPS but also increases its variability.Variability of EBIT and EPS distinguish between two types of risk

• Operating risk
• Financial Risk

Operating Risk

It can be defined as the variability of EBIT (return on total asset). The environment internal or external in which a firm operates determines the variability of EBIT. Operating risk is an unavoidable risk. A firm is better placed to face such risk if it can predit it with a fair degree of accuracy. Variability of EBIT has two components Variability in sales & Variability in expenses

Financial Risk

For a given degree of variability of EBIT, the variability of EPS( & ROE) increases with more financial leverage. The variability of EPS caused by the use of financial leverage is called financial risk

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