Question

why capital structure debt is called leverage ? compare debt leverage and earning per share

Answer 1

Debt in capital structure is called financial leverage.

Financial leverage is the use of cheaper fixed cost bearing sources of funds like debt or preferred stock to magnify the return on equity.

Debt has two advantages over equity.

1) Debt has lower cost due to the following two reasons:

*Debt suppliers demand lower return as they have preference over equity for payment of interest and repayment of principal.

*Interest of debt is tax deductible, which makes the cost of debt even lower,

2) The cost of debt is fixed and does not depend on income.

The aforesaid advantages of debt will help in magnifying the return to equity when debt proportion is increased, though up to a particular level of debt only, beyond which, return to equity will start declining.

The positive effect of leverage is subject to the condition that the Basic earning power of the firm (Before tax return on assets) is more than the cost of debt.

When the proportion of debt is increased keeping the total capital the same, the net income available to equity will go up and as the number of shares will get reduced the EPS will increase, though only up to a point of leverage. Beyond a level of leverage, the cost of debt and equity will start going up and the EPS will start declining. EPS will thus be highest at the optimum level of debt.