Financial Management

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CHAPTER 14 FINANCIAL AND OPERATING LEVERAGE Q.1. A.1. Explain the concept of financial leverage. Show the impact of financial leverage on the earnings per share. The use of fixed-charges sources of funds, such as debt and preference capital, along with owners’ equity in the capital structure is known as financial leverage (or gearing or trading on equity). The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus will increase the return on the owners’ equity. The role of financial leverage in magnifying the return of the shareholders’ is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and other sources or debentures or…show more content…
EPS 0.60 0.80 0.40 Above example indicates that at the same level of debt–equity ratio in the capital structure of the firm, the EPS rises by increases in EBIT, and falls by decreases in EBIT. Q.4. A.4. If the use of financial leverage magnifies the earnings per share under favorable economic conditions, why companies do not employ very large amount of debt in their capital structures? Financial leverage works both ways. It accelerates EPS (and ROE) under favorable economic conditions, but depresses EPS (and ROE) when the going are not good for the firm. The favorable effect of the increasing financial leverage during normal and good years is on account of the fact that the rates of return on assets exceed the cost of debt. From, the table explained in A.3. above, it is clear that favorable economic condition (i.e., increase in EBIT in situation 2) accelerated EPS, while unfavorable economic condition (i.e., decrease in EBIT in situation 3) depressed EPS. Generally, companies do not employ very large amount of debt on account of business risk i.e., variability in sales and expenses, which is unpredictable with accuracy. What is an EBIT-EPS analysis? Illustrate your answer. In practice, EBIT for any firm is subject to various influences on account of fluctuations in the economic conditions, sales, expenses, etc. The EBIT-EPS analysis helps to find out the impact of financial leverage on EPS (and ROE) for possible fluctuations in EBIT. Example: (A) Debt 60%,

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