Financial levarage or Trading on Equity
Chapter notes, video classes, MCQ practice tests and quick-revision one-liners for Advanced Business and Financial Management — CAIIB.
One-liners from this chapter
Free sample — 8 of 65 rapid-fire Q&A cards.
What is financial leverage?
Financial leverage refers to the use of fixed-interest or fixed-dividend bearing capital (debt and preference shares) in the capital structure to magnify the earnings available to equity shareholders.
What is the formula for calculating Degree of Combined Leverage (DCL)?
DCL equals Degree of Operating Leverage multiplied by DFL
What does 'Trading on Equity' mean?
Trading on equity means using borrowed funds (debt) at a fixed rate of interest to earn a higher return on equity, thereby increasing the earnings per share for equity holders.
What is the financial break-even point in leverage analysis?
EBIT level at which EPS equals zero after covering interest
When is financial leverage said to be favourable?
Financial leverage is favourable when the return on investment (ROI) earned by the firm exceeds the cost of debt (interest rate), resulting in higher EPS for equity shareholders.
How does trading on equity benefit ordinary shareholders?
Borrowed funds earn more than interest cost, boosting equity returns
What is the formula for the Degree of Financial Leverage (DFL)?
DFL = EBIT / (EBIT – Interest), or equivalently, the percentage change in EPS divided by the percentage change in EBIT.
What is the effect of financial leverage on earnings per share variability?
Higher leverage amplifies EPS fluctuations with EBIT changes
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