Question

What are the two reasons why financial leverage improves the rate of returns to stockholders or owners, kindly explain. Thank you.

Answer 1

Financial leverage represents the quantum to which a company sources funds from fixed-income securities which includes debt, bonds and preferred stock.

Following reasons can be ruled out to justify why financial leverage improves the rate of returns to stockholders:

• Financing done through debt is generally seen as leverage for a company. Financial Leverage provides companies with an opportunity to grow with funds available at a lower cost. Which increases revenues and have a spiral growth effect on net Return on Equity (RoE) for the stockholders.
• Another benefit is that the higher revenue which will return in higher profits will result in higher dividends and profits being shared by the same number of shareholders which increases their EPS and RoE.
• Interest expense also provides tax benefit on such expense and reduces the tax burden on the company. This also helps in increasing Return on Equity.