Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders. Favorable or positive leverage is said to occur when the firm earns more on the assets purchased with the funds than the fixed cost of their use.
Unfavorable or negative leverage occurs when the firm does not earn as much as the funds cost. We are interested in determining the relationships between earnings per share and earnings before interest and taxes (EBIT) under various financing alternatives and the indifference points between these alternatives.
To illustrate a break-even analysis of leverage, suppose X Company with long-term capitalization of $10 million, consisting entirely of common stock, wishes to raise another $5 million for expansion through one of three possible financing plans:
- all common stock;
- all debt, at 9% interest; or
- all preferred stock with a 7% dividend
Present annual earnings before interest and taxes (EBIT) are $1 400 000, the federal tax rate is 50%, and 200 000 shares of stock are presently outstanding. Common stock can be sold at $50 per share under financing option 1, thus 100 000 additional shares will have to be issued.
In order to determine the EBIT break-even, or indifference, points between the various financing alternatives, we begin by calculating earnings per share for some hypothetical level of EBIT.
Given the information in Table 5-12, we are able to construct a "break-even" or indifference chart similar to that prepared for operating leverage.
The break-even or indifference chart for X Company is shown in Figure 5-11. On the horizontal axis we plot earnings before interest and taxes (EBIT) and on the vertical axis, earnings per share (EPS). For each financing alternative, we must draw a strait line to reflect EPS for all possible levels of EBIT.
We see from the Figure 5-11 that earnings-per-share indifference point between the debt and common stock financing alternatives is $1 350 000 in EBIT. If EBIT is below that point, the common stock alternative will provide higher earnings per share; above that point the debt alternative is best. The indifference point between the preferred stock and the common stock alternatives is $2 100 000 in EBIT. There is no indifference point between the debt and preferred stock alternatives.
The indifference point between two methods of financing can be determined mathematically by
(EBIT* -C )(1-t) (EBIT* - C )(1-t) --------------- = ----------------- S S
where EBIT* = the EBIT indifference point between the two methods of financing for which we solve
C , C , = annual interest expenses or preferred-stock dividends on a before-tax basis for financing methods 1 and 2
t = corporate tax rate
S , S = number of shares of common stock to be outstanding after financing for methods 1 and 2
Supposed we wished to determine the indifference point between the common stock and the debt-financing alternatives in our example. We would have
(EBIT* - 0)(0.5) (EBIT* - 450 000)(0.5) ---------------- = ---------------------- 300 000 200 000
Rearranging, we obtain
0.5(EBIT*)(200 000) = 0.5(EBIT*) (300 000)
- 0.5(450 000)(300 000)
100 00 EBIT* = 135 000 000 000
EBIT* = $1 350 000
The indifference point in EBIT, where earnings per share fro two methods of financing are the same, is $ 1 350 2000. This ammount can be verified graphically in Figure 5-11. Thus, the financial leverage can be determined either graphically or mathematically.
An easier method for determining the degree of financial leverage is
EBIT Degree of financial leverage at EBIT of y = -------- EBIT - C
where C as before is the annual interest expense or preferred stock dividend on a before-tax basis. For our example, using the debt-financing alternative at $2 million in EBIT, we have
2 000 000 DFL at $ 2 000 000 = -------------------- = 1.29 2 000 000 - 450 000
For the preferred stock financing alternative, the degree of financial leverage is 2 000 000 DFL at $1 800 000 = -------------------- = 1.67 2 000 000 - 700 000
Through an EBIT-EPS analysis, we can evaluate various financing plans or degrees of financial leverage with respect to their effect on earning per share.