© 2000 John Petroff

1)- Increased earnings and stock price volatility

The detrimental effect of financial leverage was already indicated as the potential for default if the company is unable to service the debt (i.e. pay interest and principal installment on time). Financial risk can be first measured by the variability of earnings per share. In the previous example of Company X, Table T-11.2, Table T-11.3 and Table T-11.4 show calculations of earnings per share with three possible scenarios of sales decreasing to 38,000, 36,000 and 34,000 units, or a drop of only 5%, 10% and 15%, respectively. The resulting values of earnings per share for levels of financial leverage varying from 20% to 80% are copied into Table T-11.7 so that mean and standard deviation of earnings per share can be calculated.

It can be observed in Table T-11.7 that the greater proportion of debt the larger the standard deviation (while the mean increases only slightly). The statistics of Table T-11.7 are extracted and further summarized below in Table T-11.8

One will recall that a stock risk-adjusted rate of return is determined by the volatility of the stock price relative to the market, and measured by BETA. The price of a stock is directly affected by earnings expectations. Variability in earnings implies variability in stock price, and consequently increased BETA and required rate of return. In turn, a higher required rate of return implies a lower price. This means that the stock may go up as a result of higher earnings expectations, but the increase will not be proportional because of the increased volatility.

Higher volatility translates in a higher risk premium not just for stock rate of return but for interest charged on loans, as well. Thus, the calculations in tables Table T-11.1 through Table T-11.4 should not be based on a same interest rate charged at 8% for all debt alternatives, but it should increase with increased debt because of the increase in risk premium associated with earnings and price variability. This modification reduces somewhat the rising earnings results associated with greater financial leverage, and it further exacerbates earnings per share variability, as will be seen in subsequent sections. How damaging is this increased stock volatility and resulting stock price slide? For most except shareholder of the corporation, this does not seem very damaging. We will identify far more serious consequences of financial leverage next.

See review questions Q-11C1.1 through Q-11C1.5.