How Financial Leverage Works

INV

Financial leverage is derived from using debt to finance an investment. This debt creates a financial cost (interest), but if the investment generates a higher income to pay the interest, the surplus increases the profit of the company.

An example of the usefulness of this concept is found on speculation experienced in the property market. Investors buy a home, pay a small part and the rest is financed at low interest (around 4%).

Within a few months, the house has appreciated greatly. And this is the cause of the housing bubble suffered by several countries, such as Spain.

For example, you buy a home for 100,000 euros, and you pay 20,000 deposit and the remaining 80,000 is financed by mortgage. After one year, the house is sold at 150,000 euros and returns the mortgage interest paid $ 3,000.

Same goes for the company: the failure to fund the entire equity investment, the benefit received in terms of the investment is greater (provided the asset will generate more interest than the cost of external funds financed).

Highly leveraged investors earn profits well above the ordinary if all goes as expected, but if the rate of return is lower than the interest rate, they lose much more money than if they had not been leveraged.

Paul Krugman, speaking of the risk hedge funds says that some of these funds “in good standing have been taking positions hundred times the size of capital from its owners.

This means that a 1% increase in asset prices or equivalent fall in the price of debt, doubling the capital. ”

Multiplication of profits or losses will depend on the degree of leverage.

Indifference or Equilibrium Analysis

Equilibrium Analysis is an analysis of indifference, when the level of EBIT produces the same level of earnings per share (EPS), for more than two capital structures.

Formula

[ECX +1] shows a general equation to clear the UPA. Note that use of this ambiguous result, because as you will see, there are various financing alternatives and each will carry a special configuration derived from this equation.

[ECX +1]: UPA: \ frac {(EBIT – I) (1-t)-DP} {NA} \, \!

Legend:

EBIT Earnings Before Taxes and Interest
I Interest payable annually
t tax rate
DP Annual Preferred Dividends
NA Number of common shares

At financed Common stock, will not have to deal with Preferred dividends paid annually (PD), nor with interest [ECX +1].

[ECX + COM]: UPA: \ frac {(EBIT) (1-t)} {NA} \, \!

Al financed Preferred shares will not have to deal with interest payable annually, then:

[ECX + PREF]: UPA: \ frac {(EBIT) (1-t)-DP} {NA} \, \!

And finally, to finance with debt, it will have to deal with Preferred dividends:

[ECX + DEU]: UPA: \ frac {(EBIT-I) (1-t)} {NA} \, \!

Degree of financial leverage (DFL)

Indicates existing sensitivity with earnings per share UPA to a change in the EBIT. Percentage change in UPA on the percentage change in EBIT caused by the UPA.

GAF to EBIT of X units of currency. [EC3.0]: GAF = \ frac {\ Delta \% EPS} {\ Delta \% EBIT} \, \!

GAF to EBIT of X currency units (derived from [EC3.0]). [EC3.1]: GAF = \ frac {} {EBIT EBIT – I – [\ frac {DP} {(1-t)}]} \, \!

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