Preference shares have a fixed rate of dividend. Such dividend is paid only if the company earns profit. Debt consist of debentures or loans or both. Interest on debentures and loans is fixed. Financial leverage refers to the use of fixed cost sources of finance such as debentures and preference capital in the capital structure so as to increase the return on equity shares. It generally refers to using borrowed funds, or debt so as to attempt to increase the returns to equity. Equity shares are the base to issue debentures or raise loans. In a way equity is traded, so we use the term trading on equity. Fixed return securities like debt and preference capital are used to increase the return on equity without increasing operative income. With a loan component in the total equity shareholders are likely to have the benefit of a higher rate of return on share capital. This is because loans carry a fixed charge and the amount of interest paid is deductible from earnings before tax payment. The benefit to shareholders will be realized only if the average rate of return on total capital invested is more than the rate of interest payable on loan. But debt has a risk factor as interest has to be paid irrespective of profits earned by the company. The impact of financial leverage on return on equity can be concluded that higher the leverage, the greater is the magnifying effect on the ROE. Due to this reason in recession return on equity of a company with high leverage falls sharply.
Posted on: 01-Jun-2020 | Posted by: NIFM |
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