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Basic Terminology of Financial Leverage & Indifference EBIT Before we move on to the comprehensive question on Degree of Financial Leverage - Debt/Equity Capital Structure - Indifference EBIT, it is important to know what all these terms mean. That's the goal of this tutorial. Return on Equity Return on Equity is an accounting ratios formula that measures the profitability of a company. The formula is:
For example, if the net income of a corporation for 2006 is $1 million while the value of the total common shares outstanding is $12 million, then ROE: Return on Equity = 1 million / 12 million 8.33% means the shareholders of the corporation are getting a return of 8.33% for every dollar they invest into the corporation. Return on Equity formula helps in comparing the profitability of different corporations in the same line of business or industry. Degree of Financial Leverage Degree of Financial Leverage measures the amount of risk a company takes up when it borrows more debt (and increases the debt portion of its capital structure). The formula for Degree of Financial Leverage is:
To illustrate Degree of Financial Leverage, lets do a hypothetical question. Imagine there are 3 firms, Firm A, Firm B and Firm C. Each one has an interest expense of $12000 in the year 2006. The Earnings Before Taxes for each firm is given below in the table. Can you calculate the Degree of Financial Leverage using this data? Interest Expense = $80,000 x 15% = $12000
Out of the Firm's A, B and C, which is more riskier? This riskiness is measured by the Degree of Financial Leverage. Since the Degree of Financial Leverage for Firm A is 1.92 which is higher than that of Firm B (1.32) and C (1.19), this means Firm A is much more riskier than Firm B & C. Degree of Financial Leverage is very helpful in comparing various firms and the riskiness of their capital structures in a particular industry. Capital Structure The term capital structure means the amount of debt (bonds) + equity (common + preferred shares) that a corporation has that makes up its capital structure. Go here for a complete tutorial on capital structure.
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