Leverage : It is an investment strategy of using borrowed money.
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According to Gitman financial leverage is “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on firm's earnings per share”. In other words, financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to the equity shareholders.
The use of increasing amounts of debt and preferred stock raises the firm’s fixed financial costs; this, in turn, increases the level of EBIT that the firm must earn in order to meet its financial obligations and remain in business. The reason a firm accepts the risk of fixed cost financing is to increase the possible returns to stockholders.
The use of fixed -cost financing sources is referred to as the use of financial leverage. Financial leverage causes a firm’s earnings per share (EPS) to change at a rate greater than the change in operating income (EBIT). For example, if a firm is 100 percent equity financed and EBIT increases decreases) by 10 percent, EPS will also increase (decrease) by 10 percent. When financial leverage, such as long-term debt, is used, a 10 percent change in EBIT will result in a greater than 10 percent change in EPS. Figure illustrates the concept of financial leverage. Line A represents the financial leverage used by a firm financed
entirely with common stock . A given percentage change in EBIT results in the
same percentage change in EPS.
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