21.1: Financial Leverage

Question 1

What is invested capital (IC)?

Answer 1

Invested capital (IC) is a firm’s capital structure, consisting of shareholders’ equity and short- and long-term debt.

It represents the total funds invested in a company to generate returns.

Question 2

Define return on invested capital (ROI).

Answer 2

Return on invested capital (ROI) is the return on all the capital provided by investors, calculated as EBIT minus taxes divided by invested capital.

It measures a company’s efficiency in generating profits from its capital.

Question 3

What is return on equity (ROE)?

Answer 3

Return on equity (ROE) is the return earned by equity holders on their investment in the company, calculated as net income divided by shareholders’ equity.

It indicates how effectively a company uses shareholders’ funds to generate profits.

Question 4

Explain financial leverage.

Answer 4

Financial leverage is the use of debt as a source of capital, which can amplify returns on equity by using borrowed funds to generate additional earnings.

However, it also increases financial risk.

Question 5

What is business risk?

Answer 5

Business risk is the variability of a firm’s operating income (EBIT) caused by its operations.

It is independent of the financial structure and relates to the inherent risk in a company’s business activities.

Question 6

Define financial risk.

Answer 6

Financial risk is the variability of a firm’s net income caused by the use of financial leverage.

It arises from the obligation to meet fixed financial costs, such as interest payments, regardless of business performance.

Question 7

What is the formula for Return on Equity (ROE)?

Answer 7

The formula for Return on Equity (ROE) is:

ROE = ((EBIT - R_D * B) / SE) * (1 - T)
where:

EBIT = Earnings Before Interest and Taxes
R_D = Cost of Debt
B = Book Value of Debt
SE = Shareholders’ Equity
T = Tax Rate

Question 8

How does financial leverage affect ROE?

Answer 8

The effect of financial leverage on ROE can be expressed by:

ROE = ROI + ((ROI - R_D * (1 - T)) * (B / SE))
where:

ROI = Return on Invested Capital
R_D = Cost of Debt
B = Book Value of Debt
SE = Shareholders’ Equity
T = Tax Rate

Question 9

What is the formula for Return on Invested Capital (ROI)?

Answer 9

The formula for Return on Invested Capital (ROI) is:

ROI = (EBIT * (1 - T)) / (SE + B)
where:

EBIT = Earnings Before Interest and Taxes
T = Tax Rate
SE = Shareholders’ Equity
B = Book Value of Debt

Question 10

Calculate ROE given the following:

EBIT = 442
R_D = 6%
B = 700
SE = 1000
T = 25%

Answer 10

Substitute the values into the formula:

ROE = ((442 - 0.06 * 700) / 1000) * (1 - 0.25)
ROE = ((442 - 42) / 1000) * 0.75
ROE = (400 / 1000) * 0.75
ROE = 0.4 * 0.75
ROE = 0.3 or 30%

Question 11

How does financial leverage influence risk?

Answer 11

Financial leverage increases financial risk by raising the obligation to pay interest, which can lead to higher variability in net income.

It can magnify returns during profitable periods but also exacerbate losses during downturns.

Question 12

What is the relationship between ROI and business risk?

Answer 12

ROI reflects business risk as it indicates the firm’s ability to generate profits from its operations.

It is influenced by operational factors, and changes in ROI highlight how business risk impacts a company’s profitability.

Question 13

How can financial leverage be favorable to shareholders?

Answer 13

Financial leverage can be favorable when it allows a firm to earn a higher return on borrowed funds than the cost of debt, thereby increasing ROE and enhancing shareholder value through amplified returns.

Question 14

What are financial break-even points?

Answer 14

Financial break-even points are the points at which a firm’s Return on Equity (ROE) is zero.

At these points, the firm’s net income just covers its financial costs, such as interest expenses, resulting in no profit or loss.

Question 15

What is an indifference point in financial leverage?

Answer 15

An indifference point is the point at which two financing strategies produce the same Return on Equity (ROE).

It indicates when different financing options yield identical results in terms of profitability.

Question 16

Define the risk value of money.

Answer 16

The risk value of money refers to the principle that future cash flows involving different amounts of risk have different present values.

It recognizes that the risk associated with future cash flows affects their current worth.

Question 17

How does financial leverage affect ROE at different ROI levels?

Answer 17

Financial leverage affects ROE by amplifying the returns on equity when the ROI exceeds the after-tax cost of debt.

It increases ROE more steeply as the ROI rises but also increases the risk of negative returns if the ROI falls below the break-even point.

Question 18

Why is using debt financing beneficial for value-maximizing firms?

Answer 18

Debt financing is beneficial because it can increase the expected ROE for value-maximizing firms.

Since the after-tax cost of debt is often lower than the cost of equity, using debt can enhance shareholder returns by leveraging cheaper financing.

Question 19

What are the risks associated with using debt financing?

Answer 19

Risks include increased variability in ROE, which can lead to higher financial risk and potential financial distress.

Firms must cover fixed interest payments regardless of their profitability, increasing the likelihood of financial challenges during downturns.

Question 20

Calculate the ROE using the financial leverage formula given:

ROI = 19.5%
R_D = 4.5%
B = 0.7 (Debt-Equity Ratio)
SE = 1

Answer 20

Substitute the values into the financial leverage formula:

ROE = ROI + ((ROI - R_D) * B / SE)
ROE = 19.5 + ((19.5 - 4.5) * 0.7 / 1)
ROE = 19.5 + (15 * 0.7)
ROE = 19.5 + 10.5
ROE = 30%

Question 21

How does financial leverage affect the range of ROE values?

Answer 21

Financial leverage increases the range of ROE values by introducing more variability.

With higher debt levels, the impact of changes in ROI is magnified, resulting in a broader range of potential ROE outcomes compared to financing with only equity.

Question 22

What is the importance of understanding financial break-even points?

Answer 22

Understanding financial break-even points is crucial for firms to determine the minimum ROI needed to cover their financial costs.

It helps firms assess the viability of their financing strategies and ensures they do not incur losses due to insufficient returns.

Question 23

What are profit planning charts?

Answer 23

Profit planning charts are charts that show the relationship between Return on Equity (ROE) and Earnings Per Share (EPS) against Earnings Before Interest and Taxes (EBIT), allowing firms to analyze the impact of financing on their profits.

Question 24

What is an EPS indifference point?

Answer 24

An EPS indifference point is the EBIT level at which two financing alternatives generate the same Earnings Per Share (EPS).

It helps firms determine which financing option is more favorable based on expected EBIT levels.

Question 25

What is the formula for Earnings Per Share (EPS) using EBIT?

Answer 25

The formula for Earnings Per Share (EPS) is:

EPS = (EBIT - R_D * B) * (1 - T) / #

where:

EBIT = Earnings Before Interest and Taxes
R_D = Cost of Debt
B = Book Value of Debt
T = Tax Rate

Question 26

How is the EPS indifference point calculated?

Answer 26

The EPS indifference point is calculated by setting the EPS of two financing options equal and solving for EBIT:

EPS (Debt) = (EBIT - R_D * B) * (1 - T) / #_Debt
EPS (Equity) = EBIT * (1 - T) / #_Equity

Solve for EBIT where:

EBIT_Indifference = ((R_D * B * #_Equity) / ((1 - T) * (#_Debt - #_Equity)))

Question 27

How does financial leverage impact EPS?

Answer 27

Financial leverage impacts EPS by amplifying the effect of changes in EBIT.

With higher debt levels, EPS becomes more sensitive to changes in EBIT due to the fixed interest expenses.

This can increase EPS more in profitable times but can also decrease it during downturns.

Question 28

What does the EPS-EBIT chart illustrate?

Answer 28

The EPS-EBIT chart illustrates the relationship between EBIT and EPS for different financing strategies.

It shows how different levels of debt influence EPS and helps identify the indifference point where EPS is the same for both strategies.

Question 29

Why is the EPS indifference point important for financial decision-making?

Answer 29

The EPS indifference point is important because it helps firms choose between debt and equity financing by identifying the EBIT level at which both options yield the same EPS.

This analysis aids in selecting the optimal financing strategy based on expected EBIT levels.

Question 30

Calculate the EPS indifference point for a firm with:

R_D = 6%
B = 700
#_Debt = 1000
#_Equity = 1280
T = 25%

Answer 30

EPS (70%) = (EBIT - 0.06 * 700) * 0.75 / 1000
EPS (0%) = EBIT * 0.75 / 1280

Solve for EBIT:

(EBIT - 42) * 0.75 / 1000 = EBIT * 0.75 / 1280
960 EBIT = 750 EBIT - 31.5
210 EBIT = 40,320
EBIT = 192

The EPS indifference point is at EBIT = $192.

Question 31

How can profit planning charts assist in financial planning?

Answer 31

Profit planning charts assist by visualizing the effects of different financing options on profits, enabling firms to assess the financial impact of varying EBIT levels on ROE and EPS.

This helps in making informed financing and operational decisions.

Question 32

Describe how we determine the ROE and EPS indifference points for a firm based on various financing alternatives, and explain why this analysis provides the firm with useful information.

Answer 32

We determine ROE and EPS indifference points by equating the formulas for different financing strategies and solving for EBIT.

This analysis helps firms understand at what level of EBIT each financing option becomes preferable, enabling more strategic financial decision-making and optimizing shareholder value.