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Valuation of Shares

s jain (student) (67 Points)

24 December 2009

what is the meaning of Leverage Effect in case of valuation of Goodwill?what it means when it is said that the leverage effect is adverse/favourable in case of valuation of G/W?Plzz..reply soon...

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CA Dhiraj Ramchandani (CA, M. com) (10823 Points)
Replied 24 December 2009

MEANING OF LEVERAGE EFFECT IN NORMAL TERMS :

The leverage effect explains a company’s return on equity in terms of its return on capital employed and cost of debt. The leverage effect is the difference between return on equity and return on capital employed. Leverage effect explains how it is possible for a company to deliver a return on equity exceeding the rate of return on all the capital invested in the business, i.e. its return on capital employed. When a company raises debt and invests the funds it has borrowed in its industrial and commercial activities, it generates operating profit that normally exceeds the interest expense due on its borrowings.

CA Dhiraj Ramchandani (CA, M. com) (10823 Points)
Replied 24 December 2009

Now, in case of goodwill.... For calculation of leverage effect, two goodwill amounts are calculated :

1. GOODWILL FOR SHAREHOLDERS

2. GOODWILL FOR FIRM (incl. shareholders as well as long term debt providers)..

Now, if GOODWILL FOR SHAREHOLDERS is greater than that of FIRM, that means leverage is positive, because, shareholders are able to gain more than the FIRM overall.... And leverage is considered unfavourable in vice-versa condition