Question

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

Answer 1

Financial leverage

The term 'Capital structure' refers to the relationship between the various long-term forms of financing such as debenture, preference share capital and equity share capital. Financing the firm's assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing the firm's assets. The use of long-term fixed interest bearing debt and preference share capital along with equity shares is called financial leverage or trading on equity.

The management employs leverage principle, more often than not, to increase the company’s return on equity capital and more so when it is impossible to improve operating efficiency of the company and increasing the return on total investment.

From the firm's perspective, raising funds through loans and debentures have a greater risk attached, as interest has to be paid irrespective of profits earned. Preference shares are less risky, though dividend rates are fixed;they are payable out of profits alone. Equity shares bear no risk at all. It is thus clear that different sources have varying risk perception. Use of more debentures and preference shares would mean higher returns for equity shareholders.

Financial leverage is the use of fixed interest bearing sources of funds to enhance the return of equity shareholders. Thus, it is also called trading on equity or capital gearing.

In short,using more equity capital helps to increase the owners returns as well as the associated risk.