FINANCIAL LEVERAGE ( TRADING ON EQUITY)

• FINANCIAL LEVERAGE
  TRADING ON EQUITY
  FINANCIAL MANAGEMENT
  MEANING OF LEVERAGE
• IN SIMPLE WORDS IT MEANS AN INCREASED MEANS OF ACCOMPLISHING SOME PURPOSE.
• LEVERAGE IS USED TO DESCRIBE THE FIRM’S ABILITY TO USE FIXED COST ASSETS OR FUNDS TO INCREASE THE RETURN TO ITS OWNERS, I.E. EQUITY SHAREHOLDERS.
• TYPES OF LEVERAGE
• TWO TYPES OF LEVERAGE;-
• OPERATING LEVERAGE: CONCERNED WITH THE COST STRUCTURE OF A FIRM I.E THE EXISTENCE OF FIXED NATURE OF COST. THE OPERATING LEVERAGE OCCURS WHEN THE FIRM HAS FIXED COST WHICH CAN BE RECOVERED IRRESPECTIVE OF CHANGES IN SALE VOLUME. IT RESULT WHEN  CHANGES IN THE VALUES OF SALES PRODUCE A WIDE FLUCTUATIONS IN THE OPERATING PROFITS.
• FINANCIAL LEVERAGE: ABILITY OF THE FIRM TO USE FIXED FINANCIAL CHARGES TO MAGNIFY THE EFFECT OF CHANGES IN EBIT ON THE EARNING PER SHARE
• COMPOSITE LEVERAGE: COMBINED EFFECT OF LEVERAGES

• FINANCIAL LEVERAGE

1. THE USE OF  LONG-TERM FIXED INTEREST BEARING DEBT AND PREFERENCE SHARE CAPITAL ALONG WITH EQUITY SHARE IS CALLED FINANCIAL LEVERAGE OR TRADING ON EQUITY.
2. THE USE OF THE TERM TRADING ON EQUITY IS DERIVED FROM THE FACT THAT IT IS THE OWNER’S EQUITY THAT IS USED AS A BASIS TO RAISE DEBT THAT IS THE EQUITY TRADE ON.THE SUPPLIER OF DEBT HAS LIMITED PARTICIPATION IN THE COMPANY'S PROFIT AND THEY WILL INSIST N PROTECTION OF EARNING AND PROTECTION IN VALUE REPRESENTED BY OWNERSHIP EQUITY
3. THE AIM OF FINANCIAL LEVERAGE IS TO INCREASE REVENUE AVAILABLE FOR EQUITY SHAREHOLDERS USING FIXED COST FUNDS.

4. FINANCIAL LEVERAGE IS FAVORABLE WHEN THE FIRM IS ABLE TO EARN MORE IT IS PAYING FOR BORROWED FUNDS
5. FINANCIAL LEVERAGE WILL BE UNFAVORABLE IF PAYMENT ON BORROWED FUND IS MORE
6. JAMES C VANE HORN,” FINANCIAL LEVERAGE INVOLVES THE USE OF FUNDS OBTAINED FUNDS AT FIXED COST IN THE HOPE OF INCREASING RETURN TO COMMON STOCK HOLDER
7. IF THE RATE OF RETURN IS 8% AND COMPANY BORROWS 100 RS AND RATE OF RETURN IS 12 % THEN 4% AFTER PAYMENT OF THE INTEREST WILL BELONG TO SHAREHOLDER
8. IF THE RAET OF RETURN IS 8%,AND COST IS 12% THEN LOSS WILL BE 4%

• MEASURE OF FINANCIAL LEVERAGE

1. DEBT RATIO = D/D+E =D/V, D=DEBT,E IS THE VALUE OF THE SHAREHOLDER’S EQUITY,V=VALUE OF THE TOTAL CAPITAL=D+E
2. DEBT –EQUITY RATIO = D/E
3. INTEREST COVERAGE RATIO = EBIT/INTEREST

• FIRST TWO MEASURE OF FINANCIAL LEVERAGE ARE ALSO MEASURE OF CAPITAL GEARING. THEY ARE STATIC IN NATURE AS THEY SHOW BORROWING POSITION OF THE ORGANIZATION AT A POINT OF TIME AND FAILS TO DISCLOSE THE FINANCIAL RISK
• THE THIRD MEASURE OF FINANCIAL LEVERAGE KNOWN AS COVERAGE RATION INDICATES THE CAPACITY OF THE COMPANY TO MEET FIXED FINANCIAL CHARGES,
• IMPACT OF FINANCIAL LEVERAGE
• A FIRM IS CONSIDERING TWO FINANCIAL PLANS WITH A VIEW TO EXAMINE THEIR IMPACT ON EPS. THE TOTAL FUNDS REQUIRED INVESTMENTS IN ASSETS ARE RS 5,00000.
• FIRST FINANCIAL PLAN:-
• DEBT ( INT@10% P.A.)= 4,00,000
• EQUITY SHARES ( RS 10 EACH)=1,00,000
• NO OF EQUITY SHARES 10,000
• SECOND FINANCIAL PLAN:-
• DEBT ( INT@10% P.A.)= 1,00,000
• EQUITY SHARES ( RS 10 EACH)=4,00,000
• NO OF EQUITY SHARES 40,000

• SOLUTION OF FIRST FINANCIAL PLAN
• EARNING BEFORE INTEREST AND TAXES IS RS.1,25,000
• EBIT                 = 1,25,000
• LESS INTEREST     =  40,000
• EBT                     = 85,000
• LESS TAX              = 42,500
• EAIT                     = 42,500
• EPS ( EARNING PER SHARE) = 42,500/10,000 =4.25
• SOLUTION OF SECOND FINANCIAL PLAN
• EARNING BEFORE INTEREST AND TAXES IS RS.1,25,000
• EBIT                 = 1,25,000
• LESS INTEREST     =  10,000
• EBT                     = 1,15,000
• LESS TAX              = 57,500
• EAIT                     = 57,500
• EPS ( EARNING PER SHARE) = 57,500/40,000 =1.438
• DEGREE OF FINANCIAL LEVERAGE
• DFL=  PERCENTAGE CHANGES IN EPS/PERCENTAGE CHANGE IN EBIT OR
• DFL = EBIT/(EBIT-I) = EBIT/EBT
• SIGNIFICANCE OF FINANCIAL LEVERAGE

1. PLANNING CAPITAL STRUCTURE: FINANCIAL LEVERAGE HELPS IN PLANNING THE CAPITAL STRUCTURE. DEBT EQUITY RATIO
2. PROFIT PLANNING: THE EARNING PER SHARE IS AFFECTED BY THE DEGREE OF FINANCIAL LEVERAGE,IF THE PROFITABILITY OF THE ORGANIZATION IS INCREASING THE USE OF DEBT WILL ENHANCE THE EPS AND VICE VERSA

• LIMITATION

1. DOUBLE – EDGED WEAPON: LOWER THE INTEREST THE GREATER WILL BE THE PROFIT AND VICE VERSA
2. NOT BENEFICIAL FOR COMPANIES HAVING IRREGULAR INCOME
3. INCREASES RISK AND RATE OF INTEREST: EVERY RUPEE OF EXTRA DEBT INCREASES THE RISK AND
4. RESTRICTION IMPOSED BY FINANCIAL INSTITUTION