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FINANCIAL LEVERAGE
The various means used to raise funds
represent the financial structure of an
enterprise
The term capital structure is used to
represent the proportionate
relationship between debt and equity
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Capital budgeting
decision
Need to raise funds
Capital structure
decision
Existing capital
structure
Effect on EPS
Dividend decision
Effect on risk
Effect on cost of
capital
Optimum
capital
structure
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MEASURES OF FINANCIAL
LEVERAGE
RATIO OF DEBT TO TOTAL CAPITAL
L1=D/(D+S)
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EPS=[(EBIT-INT)(1-T)-DIVP]/N
ROE=[(EBIT-INT)(1-T)]/S
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ANALYZING ALTERNATIVE
FINANCIAL PLANS: CONSTANT EBIT
The financial leverage will have a favorable impact
on EPS and ROE only when the firms return on
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0.05 PROBABILITY
0.6 BEFORE-TAX ROA
PROBABILITY
0.05
BEFORE-TAX ROA
-0.05
FINANCIAL PLAN I: NO
DEBT
EBIT
-25000 50000 75000 120000 160000 300000
LESS INTEREST
NIL
NIL
NIL
NIL
NIL
NIL
PBT
-25000 50000 75000 120000 160000 300000
LESS TAXES AT 60%
-15000 30000 45000 72000 96000 180000
PAT
-10000 20000 30000 48000 64000 120000
NO. OF SHARES
EPS
ROE(%)
FINANCIAL PLAN I:
50% DEBT
EBIT
LESS INTEREST
PBT
LESS TAXES AT 60%
PAT
NO. OF SHARES
50000
18750
31250
18750
12500
37500
0.33
3.3
75000
18750
56250
33750
22500
37500
0.6
6
120000
18750
101250
60750
40500
37500
1.08
10.08
160000
18750
141250
84750
56500
37500
1.51
15.1
300000
18750
281250
168750
112500
37500
3
30
0.05
-0.05
ECONOMIC CONDITIONS
0.1
0.15
0.35
0.3
0.1
0.15
0.24
0.32
0.05
0.6
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ROA
-0.05
0
25%
ROE ROE
-0.02 -0.047
50%
ROE
-0.01
75%
ROE
-0.26
poor
0.1
0.15
0.04
0.06
0.033
0.06
0.02
0.06
0.02
0.06
poor
normal
0.24
0.32
0.096 0.108
0.128 0.151
0.132
0.196
0.204
0.332
normal
0.6
0.24
0.42
0.78
good
very poor
good
0.3
very poor
0
EBIT
EPS
-25000 -0.2
25%
EPS
-0.47
50%
EPS
-1
75%
EPS
-2.6
50000
75000
0.4
0.6
0.33
0.6
0.2
0.6
0.2
0.6
120000 0.96
160000 1.28
300000 2.4
1.08
1.51
3
1.32
1.96
4.2
2.04
3.32
7.8
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