25-04-2014, 02:41 PM
Capital Structure, Leverage & Firm’s Value
What is Leverage
A firm can make use of different sources of
financing whose cost are different. These cost
may be classified into those which carry a fixed
rate of return and those on which the return
Vary.
The employment of an asset or source of funds
for which the firm has to pay a fixed cost or
fixed return may be termed as a Leverage.
Business risk vs. Financial risk
Business risk depends on business factors such as competition, product liability, and operating leverage.
Financial risk depends only on the types of securities issued.
More debt, more financial risk.
Concentrates business risk on stockholders.
Conclusions
Basic earning power (BEP) is unaffected by financial leverage.
L has higher expected ROE because BEP > kd.
L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.