Question

Question 1

1. Does financial leverage affect the profitability of a firm? Discuss your argument in the context of profitability ratios and a firm’s earning power.  
2. A firm has an EBIT of $35,000. It is currently an all equity firm has 9,000 shares of stock outstanding at a market price of $45 a share. The firm has decided to leverage its operations by issuing $120,000 of debt at an interest rate of 9.5 percent. This new debt will be used to repurchase shares of the outstanding stock. Should the firm opt for restructuring its capital? Why?

Answer 1

a) Financial leverage refers to the portion of a company's operations financed with debt. Being highly leveraged means that you have a significant amount of debt in use. While debts used to generate revenue can boost revenue and profit over time, unproductive or excessive debt can inhibit profitability.

Interest Impact:

One of the most direct ways leverage negatively affects ongoing profit is payment of interest. When you owe money, you pay the lender interest over time. Every dollar in interest reduces your profit by the same amount. If you get a low interest rate on a particular loan, the cost of the interest may make a reasonable investment.

b) Current Situation

EBIT - $35000, O/S Shares 9000; Earnings per share - $3.89

Proposed leveraged position Debt ($120000)

No of shares can be repurchased ($120000/$45) = 2667 (balance O/s shares = 6333)

EBIT- $35000 - Int on ($120000*9.5%); EBT - $23600

Earnings per share under leveraged position - $23600/$6333 = $3.73

opting for new position would reduce earnings per share of shareholders by (3.89-3.73) 0.16$ hence it is not advisable to leverage the current position

Note : Assumed no tax for the entity (Earnings per share is caluclated only after tax)