Question

What is positive use of financial leverage? How would you determine if a firm has a positive use of financial leverage?

Answer 1

Financial leverage refers to use of debt to acquire the assets of the firm for the benefits of the common stockholders. Interest payment on debt or leverage is considered as tax exempt expense which increase the net profit of the company and results in increase in shareholders wealth. A financial leverage is called positive when rate of returns generated by assets which are financed from leverage is greater than cost of equity. Positive financial leverage is beneficial for the company as it increases the shareholders wealth by increasing the net profit available to common stockholders.

Positive use of financial leverage can be identified if rate of return generated by assets which are financed from debt is greater than the the rate of interest or dividend payable to the providers of funds and vice versa.