Question

Excessive financial leverage can begin to reduce the economic performance of a business, explain which is an ideal level of debt for a firm.

Answer 1

Excessive financial leverage can begin to reduce the economic performance of a business, explain which is an ideal level of debt for a firm.

Company can have funds either through equity source or Debt source. An organisation always try to make balance between Debts and Equity. Where companys finds it difficult to raise funds through issue of capital will raise funds through Loans, and issue of debentures etc. As per the Startegist an ideal financial leverage is Always 0.5 i.e equal proportion of debt and Equity in the business.

It is seems an ideal ration becaus eexcess leverage may cause the arise of situatin where cost of debt will be excess of Return on equity, excessive leverage will never promise growth in the business, if the business is not able to gear up with those funds, then return will not be as per expectation of the shareholders.

Where EBIT remains Constant
	Situation 1	Situation 2	Situation 3
Cases	Stock @ 200000 for 10 FV	Stock @ 200000 for 10 FV Debt 2000000 @ 10%	Stock @ 200000 for 10 FV Debt at 8000000 for 10%
EBIT	1200000	1200000	1200000
Less: Interest Cost @ 10%	0	200000	800000
EBT	1200000	1000000	400000
Less: Incoem Tax @ 30%	360000	300000	120000
EAT	840000	700000	280000
Degree of Financial Leverage EBIT / EBT	1	1.2	3
Financial Leverage : Total Debt / Shareholders Equity	-	0.5	0.25
EPS: EAT / No. of Equity Shareholders	4.2	3.5	1.4
From Above as Increase in leverage will eventually decrease the Return on Equity
Secondly, here the Degree of Financila Leverage is increase it means volatility is higher
Marking the EBIT the Remain Constant
EBIT Increases with 10 % in Situation 2 and 25 % in Situation 3
	Situation 1	Situation 2	Situation 3
Cases	Stock @ 200000 for 10 FV	Stock @ 200000 for 10 FV Debt 2000000 @ 10%	Stock @ 200000 for 10 FV Debt at 8000000 for 10%
EBIT	1200000	1320000	1650000
Less: Interest Cost @ 10%	0	200000	800000
EBT	1200000	1120000	850000
Less: Incoem Tax @ 30%	360000	336000	255000
EAT	840000	784000	595000
Degree of Financial Leverage EBIT / EBT	1	1.18	1.94
Financial Leverage : Total Debt / Shareholders Equity	-	0.5	0.25
EPS: EAT / No. of Equity Shareholders	4.2	3.92	2.975
From above situation even with the increase in Earnings the Degree of Financial Leverage is still higher
Secondly, EPS is still higher in Situation 1 and Situation 2 as compared to situation 3