© 2000 John Petroff 
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1)- Major benefits from financial leverage

Let us say that Company X has an operating income (EBIT) of $3,500 millions on revenues of $20,000 millions in 1996, and in that year it had the choice to retire some of its shares to a level of 240,000,000 shares outstanding with the proceeds of a new debt issue (assuming that this is not violating securities exchange rules), or retire some of its debt by issuing new shares up to a total of 960,000,000.

Table T-11.1 shows all the consequences of varying the proportion of debt to total assets from 20% to 80% on various measures of profit, earnings per share(EPS) and return on investment. Also included in the table are different statistics of financial leverage explained in next section.

Table T-11.1

Company X data for financial leverage example
Debt/Total Assets 0.66666 0.2 0.3 0.4 0.5 0.6 0.7 0.8
Debt 16,000 4,800 7,200 9,600 12,000 14,400 16,800 19,200
Equity 8,000 19,200 16,800 14,400 12,000 9,600 7,200 4,800
Total Assets 24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000
# shares (thousands) 400 960 840 720 600 480 360 240
Sales 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000
COGS 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Gross Profit 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Fixed Expenses 16,500 16,500 16,500 16,500 16,500 16,500 16,500 16,500
EBIT 3,500 3,500 3,500 3,500 3,500 3,500 3,500 3,500
Interest 1280 384 576 768 960 1152 1344 1536
PBT 2,220 3,116 2,924 2,732 2,540 2,348 2,156 1,964
Tax 888 1246 1170 1093 1016 939 862 786
PAT 1,332 1,870 1,754 1,639 1,524 1,409 1,294 1,178
EPS 3.33 1.95 2.09 2.28 2.54 2.94 3.59 4.91
I% 0.08 0.08 0.08 0.08 0.08 0.08 0.08 0.08
ROE 0.17 0.1 0.1 0.11 0.13 0.15 0.18 0.25
ROA - 0.08 0.07 0.07 0.06 0.06 0.05 0.05
DFL - 1.12 1.2 1.28 1.38 1.49 1.62 1.78
FLI - 1.25 1.43 1.57 2.17 2.5 3.6 5
WACC - 0.09 0.08 0.09 0.09 0.09 0.09 0.09
Debt/equity 2 0.25 0.43 0.67 1 1.5 2.33 4
Interest Coverage 2.73 9.11 6.08 4.56 3.65 3.04 2.6 2.28

Table T-11.1 clearly shows the increase in earnings per share EPS as the proportion of debt is increased from 20% to 80%. EPS rises from $1.95 to $4.91.

The improvement in earnings per share is attributable to three causes:
- interest paid on debt is lower than the return expected by shareholders: in Table T-11.1, the interest rate is 8%, whereas return on equity ROE ranges from 10% to 25%;
- interest expense is deductible from income tax, whereas earnings going to shareholders are not: interest expenses creates a tax shield for an increasing portion of income to be distributed to shareholders;
- fewer shares among which earnings are divided.

The tax shield can be observed by comparing the change in PAT with the change in interest expense, as the proportion of debt is increased from 20% to 80%. Whereas interest expense increases by $1,152 millions, from $384 millions to $1,536 millions (or 300%), PAT decreases by only $642 millions, from $1,870 millions to $1,178 millions (or 34%). The increase in EPS form a smaller PAT is attributable to a smaller number of shares outstanding. As the proportion of debt is increased from 20% to 80%, the number of shares decreases form 960,000,000 to 240,000,000. The decrease in number of outstanding shares is proportionately much larger (75%) than the decrease in PAT (34%). Consequently, EPS rises from $1.95 to $4.91, by $2.96 (or (1-.34)/(1-.75)=264%). The combination of the tax shield with the lesser amount of equity needed, produces the increase in earnings pre share and rate of return on equity. This is called financial leverage.

Later, other benefits of financial leverage will be identified.

See review questions Q-11B1.1 through Q-11B1.4.

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