Question

Consider two firms, X and Z. These firms are identical in every respect, except, financial leverage. The cost of equity for X is 6%. The cost of equity for Z is 9%. Which firm is less levered financially?

Answer 1

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In financial analysis:

Leverage means the influence of one

financial variable over some other related financial variable.

These financial variables can be sales, contribution, variable or fixed costs, Earnings Before Interest and Tax, Earning per share.

financial leverage= EBIT/EBT

EBIT= earnings before interest and tax.

EBT= earnings before tax.

Factors which affect financial leverage are financial fixed costs.

For example: interest on bank loans, preference dividend, interest on debt etc.

Higher Financial leverage represents higher debt financing.

Higher debt financing is used to increase the equity return.

With the increase in financial leverage, a company's risk increases, which increases the RISK for equity.

As debt financing is taken, there is an increase in the risk of non-payment in case of liquidation for equity shareholders. Thus increased risk & higher expectation of return.  

So a company with less Financial Leverage has less Cost of Equity.

Answer: Firm X, as it has the cost of equity of 6% (which is less than 9% of Z).