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(^82) Financial Management
For example, the petrochemicals industry, with its huge capital requirements has
traditionally been highly leveraged. The results have been very large profits during the
good years, but substantial losses during periods when petrochemical prices falls.
Cyclical factors shouldn't scare companies away from having any debt at all. The key
is to accumulate no more interest and principal repayment obligations than can reasonably
be met in bad times as well as good. Ultimately, considering the variability of your profit
stream, a decision must be made regarding the level of extra risk you are willing to take
to achieve a higher potential rate of return on shareholder investments.
Impact of Financial Leverage
Financial leverage acts as a lever to magnify the influence of fluctuations. Any fluctuation
in earnings before interest and taxes (EBIT) is magnified on the earnings per share.
(EPS) by operation of leverage. The greater the degree of leverage, the wider the
variation in EPS given any change in EBIT. The following illustration would explain
how leverage technique works.
Illustration
Pramila company is capitalised with Rs. 10,00,000 divided in 1,000 common shares of
Rs. 1,000 each. The management wishes to raise another Rs. 10,00,000 to finance a
major programme of expansion through one of our possible financing plans. The
management may finance the company with :
(I) all common stock,
(II) Rs. 5 lakhs in common stock and Rs. 5 lakhs in debt at 5 per cent interest, or
(III) all debt at 6 per cent interest or
(IV) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with 5 per
dividend.
The companyís existing earnings before interest and taxes (EBIT) amounted to Rs.
1,20,000. Corporation tax is assumed to be 50 percent.
Solution:
Impact of financial leverage, as observed earlier, will be reflected in earnings per share
available to common stockholders. To calculate, the EPS in each of the four alternative
EBIT has to be first of all calculated:
Proposal Proposal Proposal Propsal
A B C D
Rs. Rs. Rs. Rs.
EBIT 120000 120000 120000 120000
Less Interest - 25000 60000 -
EBT 120000 95000 60000 120000
Less Taxes @ 50% 60000 475000 30000 60000
EAT 60000 475000 30000 60000
Preferred Dividend - - - 25000
Earnings Available to
Common stock holders 60000 47000 30000 35000
No of Equity Shares 20000 15000 10000 15000
EPS 3.0 3.67 3.0 2.33