3 The concept of financial leverage is a significant, as it has direct relation with capital structure. Do you agree? If so, substantiate your arguments.
Answer:- Financial leverage relates to the financing activities of a firm and measures the effect of EBIT on Earnings Per Share (EPS) of the company. A company’s sources of funds fall under two categories:
- Those which carry fixed financial charges like debentures, bonds, and preference shares
- Those which do not carry any fixed charges like equity shares Debentures and bonds carry a fixed rate of interest and are to be paid off irrespective of the firm’s revenues.
The dividends are not contractual obligations, but the dividend on preference shares is a fixed charge and should be paid off before equity shareholders. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.
Financial leverage refers to a firm’s use of fixed-charge securities like debentures and preference shares (though the latter is not always included in debt) in its plan of financing the assets.
The concept of financial leverage is a significant one because it has direct relation with capital structure management. It determines the relationship that could exist between the debt and equity securities. A firm which does not issue fixed-charge securities has an equity capital structure and does not have any financial leverage. However, it is common for firms to issue some debt securities, in which case, the leverage is either favourable or unfavourable. Financial leverage is a process of using debt capital to increase the rate of return on equity. For this reason, it is also referred to as trading on equity. Borrowing is done by a company because of the financial advantage that is expected from it. The use of borrowings for the purpose of such advantage for residual shareholders is also called ‘trading on equity’ or ‘leverage’.
Students, Get Completely solved SMU MBA Spring 2014 assignments from authorized organization www.smumbaassignments.com
Send your semester & Specialization name to our mail id : “ kvsude@gmail.com”or Call us at : +91 9995105420
These are just questions for reference. To check samples see our latest uploads in blog archive or search assignments
