Question

Explain in detail what would happen in bank’s leverage, (optimal) capital structure and lending (credit crunches) if the government of the country that the bank is located decides to increase the taxes by 5%.

Answer 1

A degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. The degree of financial leverage (DFL) measures the percentage change in EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT).

This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.

The Formula for DFL Is

\text{DFL}=\frac{\%\text{change in EPS}}{\%\text{change in EBIT}}DFL=%change in EBIT%change in EPS​

DFL can also be represented by the equation below:

\text{DFL}=\frac{\text{EBIT}}{\text{EBIT }-\text{ Interest}}DFL=EBIT − InterestEBIT​