Financial leverage - Capital Structure, Accountancy and Financial management Video Lecture | Accountancy and Financial Management - B Com

today we are going to study about
leverage a general dictionary meaning of
town leverage refers to an increase
means of accomplishing some purpose
leverage allows us to accomplish certain
things which are otherwise not possible
like lifting of an heavy object may be
like a car I'm using the example of a
car in leverage because we use a lever
to lift the car while repairing a bunch
of therefore the term leverage or the
lever is being used for lifting any
heavy object but this concept of
leverage is also valid in business
leverage may be defined as the
employment of an asset or a source of
Finance for which the firm has to pay a
fixed cost the fixed cost and the fixed
return Here I am talking about remains
constant irrespective of the change in
the volume of output or sales and this
is going to have an effect on the
earning available for the equity
shareholders since the word leverage
itself is about lifting something that's
why then even in the business it will
help us to lift something and it could
be the earning per share or it may be
the net operating income available to
the form it must however be noted that
higher is the degree of leverage high
Restless as well as return to the owner
because owner has a liability to pay a
fixed interest it should also they
remember that leverage can have a
negative or in reversible if it also
from the definition of leverage
you can easily see that the definition
is very much similar to the definition
of capital structure the capital
structure was about debt equity ratio
however the leverage says the same thing
it is the employment of an asset or ass
also fine for which the form has to pay
a fixed cost and the fixed cost here
which we are talking about it can be
interests which are being paid on the
date securities
so both the leverage and the capital
structure are saying the same things but
the point to be noted is that that how
can the leverage of the use of a fixed
cost bearing asset can help us to
increase the earning per share and the
net operating income leverage can be
basically of two types the number one is
financial leverage and another one is
operating leverage and today we are
going to discuss about the very first
type of leverage and that does financial
leverage the use of long term fixed
interest-bearing debt and preference
share capital along with the equity
share capital is called as financial
leverage or in a simple language it can
be the use of debt with equity we don't
as the financial leverage so here the
debt plays a role of lever in an
organization so as to increase the
earning per share available to any
investor it is true that the capital
structure cannot affect the total
earnings of a form but it can affect the
share of earning for equity shareholders
a form is known to have a favorable
leverage if it's earning or more than
what debt would cost however if it does
not earn as much as the debt cost then
it will be known as the unfavorable
leverage and simple word whenever our
form rails funds by using debt financing
then the company has a liability to pay
a fix
rate of interest and this interest is
the cost of capital for a phone so for
the purpose of meeting with this cost of
capital or for the purpose of paying
this cost of capital a form needs to
make an earning so that he can meet the
cost of capital
therefore the earning should be more
than the cost of capital and if this
situation happens that is a firm will be
able to earn more than the cost of
capital then this kind of financial
leverage will known as the favorable
leverage however if the earnings will be
less than the cost of capital then this
kind of leverage will known as the
unfavorable leverage to an organization
now let us discuss the financial
leverage by using an example suppose a
company has an equity share capital of
rupees 5 lakhs which is divided into
shares of rupees 100 each which means
that the number of shares available to a
company is 5000 which is 5 lakh divided
by the price of the share that is rupees
100 which will be equals to 5 thousand
number of shares if the phone wishes to
further raise an additional amount of
rupees 3 lakhs
for the purpose of expansion or maybe
modernization then the company has three
plans the first plan is that the company
can finance this 3 lakhs from all common
shares which means by issuing the equity
shares in the market if the company is
going to select this plan then the
company's further going to issue 3
thousand more shares in the market now
the plan B is about that the company can
raise to B's 1 lakh in the form of
common shares and rest of rupees 2 lakhs
from Dementors at the rate of 10 percent
so in this case the company will be
issuing 1000 new
that is each dish and rest of the money
that is to luck will be raised by
issuing to Lang debentures at the rate
of 10% and 10% is the rate of interest
another plan in front of the company is
that the company may be is full of 3
lakhs from debentures or from debt
financing at the rate of M question per
annum in this case no equity share is
being issue the only existing equity
share is the previous one that is the
initial 5 thousand number of shares will
be there and the further rupees 3 lakh
will be raised from the debentures at
the rate of 10 percent interest now let
us see that house neglige going to work
in this example the earning before
interest in acts available to a company
that is EBIT is 1 lakh 50,000 so this is
the stream of earning for a company that
is 1 lakh 50,000 whatever may be the
plan selected by a phone now from the
earnings we need to deduct interest
which is being paid on the debt
securities so if a company will go for a
plan came then the company can raise the
money by issuing whole of the equity
shares and there is no fixed income
securities associated with the ton a
that is no amount is being raised by
issuing the debentures therefore we
don't need to deduct any interest in
plan a while you can see that if a
company selects to plan B here the
company is raising one half by issuing
common shares that is equity shares and
the rest of the 2 lakhs is raised by
issuing 2 lakh debentures at the rate of
end portion that is the interest
stay there for the interest rate
associated while taking the client be
will be 10% of - laughs which is equals
to 20,000 therefore we need to deduct
20,000 from the earnings in form of
interest likewise if a form selects Plan
C then the company is raising all of the
amount by issuing the debentures at the
rate of 10 person therefore the amount
of interest that the company need to pay
is 10% of 3 lakhs that is the amount
raised by issuing the debentures and
this will be equals to 30,000 so we need
to deduct this 30,000 from the earnings
so the earnings after interest and the
before tax in plan a will be one-half if
T thousand in plan B it will be 1 lakh
30,000 and in Plan C it will be one life
20,000 now we need to deduct access and
the tax rate available to a form is 50%
in plan a we need to pay 75,000 in form
of taxes and we will be left with 75,000
itself in Plan B the taxes applicable to
the form will be 65 thousand and we are
left with 65,000 with us and if the form
will select Plan C then the tax is
applicable to the form will be 60
thousand and we are left with the 60,000
now these amounts are the earnings which
are being available for the common
shareholders in plan in looking at the
example initially the company had issued
5,000 shares and further the companies
has issued 3,000 motions that's why the
total number of shares in plan a will be
8,000 like within Plan B initially the
company had 5,000 shares and the new
shares issued by the company is 1000
therefore the total number
shares will be 5,000 emission shares
plus 1,000 new shares and it will be six
thousand shares and in the plan C the
company has not issued any new shares
and the initial number of shares go five
thousand therefore the number of equity
shareholders will remain five thousand
so now in the plant in the earning per
share available to each shareholder will
be earning available to poor shareholder
divided by the number of shares that the
seventy-five thousand divided by the
eight thousand and the amount will be
rupees nine point three eight in plan B
it will be earning available was sixty
five thousand however number of shares
for six thousand therefore the earning
per share will be n point eight three in
plan C the earning available to the
shareholders for sixty thousand and the
number of shares were five thousand
therefore the earning per share will be
rupees twelve there is a formula to
calculate the degree of financial
leverage which is equals to earning
before interest in taxes divided by the
earnings before taxes so the degree of
leverage in case of plan a will be one
which is valid 50,000 of EBIT divided by
EBT of 150 thousand in case of Plan B
it's one point one five three and in
case of plant seeds it's one point two
five so from the example you can easily
see that whenever we have a higher
degree of leverage which means that when
we have high amount of debt in our
capital structure then this is going to
give a leverage effect on earning per
share because you can see that from this
example the company is taking the
highest level of leverage in plan C and
by doing so the earning per share is
maximum in
case the analysis of this informations
shows that the financial leverage has
helped in improving the earning per
share of equity shareholders it helps to
conclude that higher the ratio of debt
to equity the greater the return for the
equity share holders thank you