Dividend Discount Generic Model
In the previous two articles, we saw how information regarding the possible future price, dividends and rate of return expected by the investor can be used to derive the present value of an equity security. However, these models were limited in their scope. Firstly, they had limited horizon periods viz. one period and two periods. […]
Disadvantages of Bootstrapping
In the previous article, we have learned about what self-financing i.e. bootstrapping is. We have also learned about what are the various advantages of using the bootstrapping technique. However, despite the advantages listed in the previous article, relatively few startup founders actually go the bootstrapping route. This is because of the fact that bootstrapping also […]
Common Terminologies Used in Forex Markets
Financial markets have their own terminologies. The Forex market has a number of terms which it shares with other financial markets but which mean different things in the Forex market. Also, there are some words which are completely unique to Forex. In this article, we have a closer look at Forex terms. These terms will […]
What is Annuity? – Meaning and Concept
An annuity, just like a perpetuity, is a shortcut used while making present value calculations. Unlike the perpetuity, which is very difficult to find in real life, we find examples of annuity all around us. The monthly mortgage payments we make, the car loan or student loan that we pay off are all annuities. Annuities […]
Why is Financial Modelling so Complex?
Finance itself is a complicated field. It is difficult to understand the nature of relationships between various financial variables which finally culminate in the financial statements. However, financial modeling is considered to be one of the most complex tasks, even in the financial field. There are several reasons behind this assumed complexity. Some of the […]
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.
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