What is Financial Leverage and why is it called ‘Trading on Equity’? Explain the effect of Financial Leverage on EPS with the help of an example.

 Q. What is Financial Leverage and why is it called ‘Trading on Equity’? Explain the effect of Financial Leverage on EPS with the help of an example.

Financial Leverage and Its Significance in Corporate Finance

Financial leverage refers to the use of borrowed funds (debt) to finance the operations or investments of a company with the aim of increasing the potential return on equity (ROE). In simpler terms, financial leverage involves using debt as a means to enhance the returns to equity shareholders. It allows a company to use a smaller amount of its own equity capital and borrow money to invest in projects, operations, or assets that generate returns exceeding the cost of debt. By doing so, a company aims to magnify its profits relative to the amount of equity capital it initially invested. The greater the proportion of debt in the company's capital structure, the higher the financial leverage.

Why Is Financial Leverage Called ‘Trading on Equity’?

The term "trading on equity" is used to describe the practice of using debt to finance a company's operations or investments with the goal of increasing the return on equity. The phrase suggests that a company is leveraging or "trading" its equity base for more debt to amplify the returns for its equity shareholders. Essentially, it involves utilizing debt to enhance the return on the owner's capital. The use of leverage allows the company to generate a return on its equity investment that exceeds the interest cost on the borrowed funds, thus increasing the overall return on equity.

The concept of "trading on equity" can be understood through the analogy of a trader who uses leverage (borrowed funds) to maximize returns on a smaller capital base. The trader is using the borrowed funds to purchase more assets, with the expectation that the returns generated from those assets will exceed the cost of borrowing. Similarly, companies use financial leverage to magnify returns for shareholders. The key to successful trading on equity is that the company must generate returns on its investments that exceed the cost of debt. If the return is less than the cost of borrowing, the company risks losing value for its shareholders.

For example, if a company borrows money at an interest rate of 5% and invests the borrowed funds in a project that yields a return of 12%, the difference between the return on investment (12%) and the cost of debt (5%) is the "trading on equity" or financial leverage in action. In this case, the leverage enhances the return on equity, making it more attractive for the shareholders.

However, if the company borrows money at 5% but the project only generates a return of 3%, the company will be losing money, as the cost of debt is greater than the return on investment. This situation leads to negative financial leverage, where the use of debt reduces the return on equity. In summary, "trading on equity" involves using borrowed funds to leverage the return on equity, and it’s a double-edged sword — it can amplify both gains and losses.

The Effect of Financial Leverage on Earnings Per Share (EPS)

Financial leverage has a significant effect on a company’s Earnings Per Share (EPS), which is a key indicator of a company’s profitability and performance. EPS is calculated by dividing the net income of the company by the number of outstanding shares of common stock. The basic formula for EPS is:

$$EPS = \frac{\text{Net Income}}{\text{Number of Shares Outstanding}}$$

The relationship between financial leverage and EPS is essential for understanding how the use of debt impacts a company's profitability. When a company employs financial leverage, it borrows funds to invest in assets or projects that are expected to generate returns. If these returns exceed the cost of the debt, the company can generate higher profits, which leads to a higher EPS. Conversely, if the returns do not exceed the cost of debt, the company may experience lower profits, thus reducing its EPS.

Financial leverage increases the variability of EPS because it introduces fixed costs in the form of interest payments on debt. If the company’s income rises, financial leverage magnifies the increase in EPS. However, if the company’s income falls, financial leverage can worsen the decline in EPS. This is why financial leverage is also referred to as a “double-edged sword”—it can work in favor of the company, boosting EPS in good times, but it can also lead to larger losses in bad times.

Example of the Effect of Financial Leverage on EPS

To understand the effect of financial leverage on EPS, let’s consider an example. Suppose there is a company, ABC Ltd., with the following financial details:

• Number of shares outstanding: 1,000,000
• Net income (without leverage): $2,000,000
• No debt in the capital structure, meaning that the entire investment is financed through equity.

In this case, the EPS would be:

$$$$

$$EPS = \frac{2,000,000}{1,000,000} = 2.00$$

Now, let’s assume that ABC Ltd. decides to introduce financial leverage into its capital structure by borrowing money. The company borrows $5,000,000 at an interest rate of 5%. The borrowed funds are used to invest in a new project that generates additional net income of $800,000 before paying interest. Now, let’s calculate the new EPS with financial leverage.

Calculating the Effect of Financial Leverage

1.      Interest expense on debt: The company has borrowed $5,000,000 at an interest rate of 5%. The interest expense would be:

$$$$

$$\text{Interest Expense} = 5,000,000 \times 0.05 = 250,000$$

2.      New net income with leverage: The new project generates additional income of $800,000, but the company must pay the interest on the debt. The net income after interest would be:

$$$$

$$\text{New Net Income} = 2,000,000 + 800,000 - 250,000 = 2,550,000$$

3.      New EPS with leverage: The company still has 1,000,000 shares outstanding, and the new net income is $2,550,000. The new EPS would be:

$$$$

$$EPS = \frac{2,550,000}{1,000,000} = 2.55$$

Thus, with financial leverage, the EPS has increased from $2.00 to $2.55, indicating that the use of debt has increased the return on equity and boosted the earnings per share. In this case, the company’s return on the borrowed funds exceeded the interest expense, leading to a positive impact on EPS.

Negative Financial Leverage: A Scenario of Losses

Let’s now consider a scenario where the company’s investment using the borrowed funds does not generate enough return to cover the cost of debt. Suppose that the project generates only $200,000 in additional income before interest. The calculations would be as follows:

1.      Interest expense on debt: As before, the interest expense on the $5,000,000 loan is:

$$$$

$$\text{Interest Expense} = 5,000,000 \times 0.05 = 250,000$$

2.      New net income with leverage: The new net income after deducting the interest expense would be:

$$$$

$$\text{New Net Income} = 2,000,000 + 200,000 - 250,000 = 1,950,000$$

3.      New EPS with leverage: The new EPS with the same number of shares outstanding (1,000,000) would be:

$$$$

$$EPS = \frac{1,950,000}{1,000,000} = 1.95$$

In this case, the EPS has decreased from $2.00 to $1.95. Despite using financial leverage, the company’s return on the borrowed funds was insufficient to cover the interest expense, leading to a decrease in earnings per share.

The Break-even Point of Financial Leverage

The break-even point in terms of financial leverage occurs when the return on the new investment exactly equals the cost of debt, meaning that the net income remains unchanged after paying interest on the borrowed funds. In such a case, the financial leverage neither increases nor decreases the EPS. If the return on investment is equal to the cost of debt, the financial leverage does not have an effect on the company's EPS, and the leverage is said to be neutral.

The break-even point can be calculated by finding the return on the new investment that exactly covers the interest expense. In the example above, the company borrowed $5,000,000 at an interest rate of 5%, so the interest expense is $250,000. To break even, the project must generate an additional income of at least $250,000. If the project’s return is greater than $250,000, the company will experience positive financial leverage. If the return is less than $250,000, the company will experience negative financial leverage.

Conclusion: The Dual Nature of Financial Leverage

$$$$

In conclusion, financial leverage is a powerful tool that can amplify both gains and losses for a company. When used effectively, it can enhance the return on equity, increasing the profitability and EPS of the company. However, if not managed carefully, financial leverage can lead to greater risk, and if the return on the borrowed funds does not exceed the cost of debt, the company could see a decline in its EPS. The key to successful financial leverage lies in ensuring that the returns on the borrowed funds exceed the interest expense, thus maximizing the returns to shareholders.

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