Question

Explain the term financial leverage. Describe how it changes the cost of capital for a corporation, as well as the firm’s perceived riskiness to investors.

Answer 1

Financial Leverage refers to the presence of debt and preference capital in the capital structure of a Company to raise capital for long term usage. Generally, the financial leverage of a Company is measured via its debt to equity ratio.

The cost of debt is usually lower than the cost of equity and hence increasing debt financing usually will reduce the WACC (assuming the debt portion in capital structure is not too high).

Higher the financial leverage, higher is the perceived level of financial risk of a Company. This is because, unlike equity share capital whose dividend distribution to shareholders is not mandatory , debt and preference share capital attract fixed obligations on part of the Company in the form of interest and preference dividend respectively. Hence, even though the Company does not make adequate profits in a year, it is still obligated to pay the interest and prefernce dividend owing to their fixed nature.