Question

Discuss how financial leverage is a device used to increase owners’ expected return and create greater risk.

Answer 1

Financial leverage if used in an appropriate manner would provide impetus to the firm by providing better expected return to the owner. However , on the one hand while the expected returns could be improved the risks of distress and probability of default increases as financial leverage increases risk. This is due to the statutory payment pattern of interest which have to be paid irrespective of the profits made.

For example, if a company with an all equity capital structure has assets of $ 100. If the company makes $ 20 in net profits, the ROE is 20%. Now, if the company replaces $ 50 of the asset funding with debt at 10% interest, then EBIT=20 and Net profit = 20-10%*50= $ 15(assuming no taxes). Now ROE = 15/50 = 30%.The ROE improves as a result of debt taking.