Illustration 1:

Rinkoo Company is capitalized with Rs. 10,00,000 divided in 10,000 common shares of Rs.
1,000 each. The management wishes to raise another Rs. 10,00,000 to finance a major
programme of expansion through one of four possible financing plans.
The management may finance the company with:
(1) All common stock,
(2) Rs. 5 lakhs in common stock and Rs. 5 lakhs in debt at 5% interest,
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(3) All debt at 6% interest or
(4) Rs. 5 lakhs in common stock and Rs. 5 lakhs in preferred stock with 6% dividend.
The Company’s existing earnings before interest and taxes (EBIT) amounted to Rs.
12,00,000. Corporation tax rate is assumed to be 50 percent.
Impact of financial leverage, as observed earlier, will be reflected in earnings per share
available to common stockholders.
To calculate the EPS in each of the four alternatives, EBIT has to be first of all
calculated:

Thus, when EBIT is Rs. 1,20,000 proposal B involving a total capitalisation of 75 percent
common stock and 25 percent debt would be most favourable with respect to earnings per
share. It may further be noted that proportion of common stock in total capitalisation is the
same in both the proposals B and D but EPS is altogether different because of induction of
preferred stock.
While preferred stock dividends are subject to taxes, interest on debt is tax deductible
expenditure resulting in variation in EPS in proposals B and D. With a 50 percent tax rate,
the explicit cost of preferred stock is twice the cost of debt.
We have so far assumed that level of earnings would remain the same even after the
expansion of the firm. Now assume that level of earnings before interest and taxes doubles
the present level in correspondence with increase in capitalization.
Changes in earnings per share to common stockholders under different alternatives
would be as follows:

N.B. Figures in bracket denote EPS before additional issue.

It is evident from illustration 2 that increase in earnings before interest and taxes is
magnified on the earnings per share where financial leverage has been inducted. Thus, in
proposals B, and C where debt comprises a portion of total capitalisation, EPS would increase
more than twice the existing level while in proposal ‘A’ EPS has improved exactly in
proportion to increased in earnings before interest and taxes.
Since dividend on preferred stock is a fixed obligation and is less than the increase in
earnings, EPS in proposal D also increases more than double the rise in earnings. Another
important conclusion that could be drawn from the above illustration is that larger the ratio
of debt to equity, the greater the return to equity. Thus, in proposal C where debt represents
50 percent of the total capitalisation EPS is magnified three times over the existing level
while in proposal B where debt has furnished one third of the total funds, increase in EPS is
a little more than double the earlier level.
This volatility of earnings operates during a contraction of income as well as during an
expansion. Likewise, financial leverage magnifies over all losses sustained by the company.
Assume that the Rinkoo Company expects to sustain loss of Rs. 60,000 before interest and
taxes, loss per share under the different alternatives would be:
Illustration 2:

Thus, loss per share is highest under alternative C where proportion of debt is as high as 50
percent of the total capitalization and the lowest in proposal A where leverage is zero. This
is why the phrase ‘Trading on equity magnifies both profit and loss’ is very often quoted to
explain magic of trading on equity or financial leverage.
Thus, financial leverage is not useful in every case. As long as the borrowed capital can be
made to pay the business more than it costs, financial leverage will be profitable. Naturally
it will become source of decrease in profit rates when it costs more than what it earns.
To what extent debt capital should be used in order to improve earnings of the business is
another major problem facing a finance manager. For that matter indifference level of EBIT
has to be determined. We shall now discuss as to how indifference point is determined.