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(^84) Financial Management
of the total funds, increase in EPS is little more than double the earlier level. This
volatility of earning operatesí during contraction of income as well as during an expansion.
Likewise, financial leverage magnifies all losses sustained by the company. Assume
that the Rekha Company expects to sustain a toss of Rs. 60,000 before interest and
taxes, loss per share under the different alternatives would be:
Ilhrstration
Proposal Proposal Proposal Propsal
A B C D
Rs. Rs. Rs. Rs.
Loss before interest
and Taxes ñ60,000 ñ60,000 ñ60,000 ñ60,000
Add: Interest - 25,000 60,000 -
Loss Per Share 3 5.67 12 4
Thus loss per share is highest under alternative C where proportion of debt is, as high
as 50 per cent of the total capitalisation and the lowest in proposal A where leverage
is zero. This is why the phrase ëfinancial leverage magnifies both profits and loss is
very often quoted to explain magic of the financial leverage.
Thus, the financial leverage is useful as long as the borrowed capital can be made to
pay the company more than what it costs. Naturally it will become source of decrease
in profit rates when it costs more than what it earns. To what extent debt capital should
be used in order to improve earnings of the company is a major financing problem
facing a finance manager. It should be remembered here that the financial leverage
offers
financial advantages only up to a point. Beyond that point debt financing may be
detrimental to the company. For instance, as we expand the use of debtí in our capital
structure, lenders will perceive a greater financial risk for the company. For that
reason, they may raise the average interest rate we pay, and place certain restrictions
on the company. Furthermore, concerned equity stockholdersí may drive down the
price of the stock forcing the management away from the companyís main objectives
of maximizing
overall value of the company in the market. Thus, before using the financial leverage
as a technique of improving net earnings of the company, its impact on EPS must
carefully weighed.
A graphical presentation of a financing plan
A financing plan that consisted of Rs.40,000 of 5-percent bonds, 500 shares of Rs. 4
preferred stock, and 1,000 shares of common stock was used to illustrate financial
leverage in Table 3.1. This financing plan can be illustrated graphically; like all plans
of this type, it can be plotted as a straight line. This is because it is affected only by
the deduction of certain fixed rupees costs. Plotting two values of EBIT Rs.10,000 and
Rs.14,000-and associated earnings per share of Rs. 2 and Rs. 4 gives us the line in
Figure 3.1.