Question

Class, does leverage work in both directions? In other words, leverage increases the return to shareholders by taking on debt when times are good but does it leverage the losses when things turn sour? Can you provide an example?

Answer 1

Yes Financial Leverage works in both ways. For explaining the same, below i have provided 3 difference scenaior.

In Case 1, the company uses no leverage and earns 7% ROE, however with the EBIT, by using 40% leverage, the company's shareholders earn 8% ROE due to lower shareholder's fund and tax benefit on interest expense. However, in Case 3 where the company is makibg lesser of EBIT, due to the use of leverage, the company's shareholders are making lesser return of 6% on their funds.

	Case 1	Case 2	Case 3
Total Capital	$ 1,000,000	$ 1,000,000	$ 1,000,000
Debt	$                 -	$     400,000	$     400,000
Equity	$ 1,000,000	$     600,000	$     600,000
EBIT	$     100,000	$     100,000	80,000
Less - Interest @ 8%	$                 -	$     (32,000)	$     (32,000)
PBT	$     100,000	$        68,000	$        48,000
Less - Taxes @ 30%	$     (30,000)	$     (20,400)	$     (14,400)
PAT	$        70,000	$        47,600	$        33,600
ROE	7.0%	8%	6%