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Degree of Financial Leverage?

Prateek (Student) (97 Points)

20 March 2018

What is Degree of financial leverage?Please define it in a simple manner with the help of an example.

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HarshBhatt (hmbhatt) (35 Points)
Replied 20 March 2018

First of all its very to important to understand how does Fixed cost mechanism work, irrespective of entity's sale the Fixed cost remains constant.

Interest expense on Amount borrowed is a type of fixed cost.

Now assume that an entity has
Debentures @ 7% - 1000
10 Equity shares - 1000 (If no Debentures then 20 Shares having value 2000)

E.g. Entity earns 500
EPS if Debentures - (500-70)/10 = 43
EPS if no Debentures - 500/20 = 25

Therefore when we use Financial Leverage the Investor earns a higher Earning. But this is only possible when the Return on Investment is greater than the borrowing rate.

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