The Quasi-Government Sector
In most parts of the world, the financial system can be divided into two parts viz. the private sector and the government sector. However, in many parts of the world, there is a third sector called the quasi-government sector. This sector has the characteristics of both the government as well as the private sector. The […]
The Chinese Pension System
There has no doubt about the fact that the Chinese economy is one of the largest economies in the world today. Theoretically, China is the second-largest economy in the world. It is widely believed that the Chinese economy will surpass the American economy to become the largest in the world. However, many economists believe that […]
An Introduction to Hedge Funds
The term “hedge funds” have become ubiquitous in the financial markets nowadays. This is a term which incites a strong emotional reaction from all market participants and observers. Some are of the opinion that these funds are evil and endanger the entire market with their reckless risk taking. Others are of the opinion that hedge […]
Multi-Currency Accounts
In the globalized world of today, it is common for a business to go international. Almost any company which has a sizeable turnover has to deal with suppliers and vendors from across the globe. It is true that businesses receive the benefits of such expansion. However, there are also certain costs which are associated with […]
Conflict of Interest in Investment Banking
Investment banking institutions are engaged in multimillion-dollar transactions. This means that if an investment bank is perceived to be operating in a conflict of interest situation, it could severely damage the reputation of the bank. This lost reputation could end up becoming a financial loss is no time. There have been several instances where conflict […]
A high debt equity ratio makes the company financed by debt more than by equity. Therefore there are fixed interest payments involved. Hence when the going is good, the company makes a handsome return as a small percentage of change in EBIT creates a large percentage change in earnings per share. However the inverse of this is also true. Just like financial leverage helps to magnify profits, it also magnifies losses when EBIT fall down. Analysts want to quantify exactly how much variability does debt funding create in the operations of a particular company and have created a measure called “Degree of Financial Leverage” which we will study in detail.
Degree of Financial Leverage = % Change in EPS / % Change in EPS
There is a reasonable assumption about the absence of any changes in accounting policy which would make the EPS and EBIT figures incomparable from the previous years.
Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Lets say that the price of the house went up by 20% to 120. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 43. Since your original investment was Rs 30, you have gained Rs 13.
A price increase of 20% has led to an increase in the shareholders return by approximately 43%!
Thus, you are obligated to pay Rs 7 interest each year, regardless of what happens. Lets say that the price of the house went down by 20% to Rs 80. In this case you will pay back the creditors Rs 77 (principal + interest) and be left with Rs 3. Since your original investment was Rs 30, you have lost Rs 27.
A price decrease of 20% has led to a decrease in the shareholders return by approximately 90%
Leverage is very dangerous unless the company is reasonably certain of its earnings. Investors view the leverage ratio with great detail. This is because it enables a small change in the EBIT to completely wipe out the company’s capital and make it insolvent almost overnight.
Your email address will not be published. Required fields are marked *
