The Effect of Leverage How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing,we increase the fixed interest expense If we have a really good year,then we pay our fixed costs,and have more left over for our stockholders If we have a really bad year,we still have to pay our fixed costs,and have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE 5
5 The Effect of Leverage n How does leverage affect the EPS and ROE of a firm? n When we increase the amount of debt financing, we increase the fixed interest expense n If we have a really good year, then we pay our fixed costs, and have more left over for our stockholders n If we have a really bad year, we still have to pay our fixed costs, and have less left over for our stockholders n Leverage amplifies the variation in both EPS and ROE
Example:Financial Leverage,EPS,and ROE-I We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares of stock? Fin ancial Leverage Ex ample 6
6 Example: Financial Leverage, EPS, and ROE - I n We will ignore the effect of taxes at this stage n What happens to EPS and ROE when we issue debt and buy back shares of stock?
Example:Financial Leverage,EPS,and ROE-II Variability in ROE Current:ROE ranges from 6.25%to 18.75% Proposed:ROE ranges from 2.50%to 27.50% Variability in EPS Current:EPS ranges from $1.25 to $3.75 Proposed:EPS ranges from $0.50 to $5.50 ■ The variability in both ROE and EPS increases when financial leverage is increased
7 Example: Financial Leverage, EPS, and ROE - II n Variability in ROE q Current: ROE ranges from 6.25% to 18.75% q Proposed: ROE ranges from 2.50% to 27.50% n Variability in EPS q Current: EPS ranges from $1.25 to $3.75 q Proposed: EPS ranges from $0.50 to $5.50 n The variability in both ROE and EPS increases when financial leverage is increased
Break-Even EBIT Find EBIT where EPS is the same under both the current and proposed capital structures If we expect EBIT to be greater than the break- even point,then leverage is beneficial to our stockholders If we expect EBIT to be less than the break-even point,then leverage is detrimental to our stockholders 8
8 Break-Even EBIT n Find EBIT where EPS is the same under both the current and proposed capital structures n If we expect EBIT to be greater than the break- even point, then leverage is beneficial to our stockholders n If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
Example:Break-Even EBI'T EBIT EBIT-400,000 400,000 200,000 EBIT EBT-0nam） EBIT=2EBIT -800000 EBIT=$800,000 800,000 EPS 二 $2.00 400,000 Break-even Graph 9
9 Example: Break-Even EBIT $2.00 400,000 800,000 EPS EBIT $800,000 EBIT 2EBIT 800,000 EBIT 400,000 200,000 400,000 EBIT 200,000 EBIT 400,000 400,000 EBIT