Debt financing and equity financing

financial leverage
 FINANCAIL LEVERAGE
• Financial leverage means the presence of debt
in the overall capital structure of an equity.
Debt is a cheaper source of finance but it is
risky.
• Financial leverage= debt/total equity
• More debt will result in increase in earning only
when rate of earnings of the company, ROI is
more than rate of interest on debt
(Debt increase it leads increase Earning Per
Share(EPS).) return of investment(ROI) > Rate of
interest. 15%> 11%.
Suggestion. Add more debt to increase EPS
If rate of interest is more than earning or ROI of
then more debt means loss of capital.

Debt increase it leads decrease Earning Per

Share(EPS).) return of investment(ROI) < Rate of
interest. 9%> 12%
Suggestion. Issue equity to increase EPS
• Situation 1
• Total capital 50,00,000
• Equity share 50,00,000 (500000 shares each
share price Rs. 10, 500000X10= 50,00,000)
• Debt= Nil
• Tax rate= 30%
• Earning before interest and tax 700000
• Situation 2
• Total capital 50,00,000
• Equity share 40,00,000 (400000 shares each
share price Rs. 10, 400000X10= 40,00,000)
• Debt= 1000000 at 10%
• Tax rate= 30%
• Earning before interest and tax 700000
• Situation 3
• Total capital 50,00,000
• Equity share 30,00,000 (300000 shares each
share price Rs. 10, 300000X10= 30,00,000)
• Debt= 2000000 at 10%
• Tax rate= 30%
• Earning before interest and tax 700000
• Situation 4
• Total capital 50,00,000
• Equity share 40,00,000 (400000 shares each
share price Rs. 10, 500000X10= 50,00,000)
• Debt= 1000000 at 10%
• Tax rate= 30%
• Earning before interest and tax (EBIT) 300000
• Situation 5
• Total capital 50,00,000
• Equity share 30,00,000 (300000 shares each
share price Rs. 10, 300000X10= 30,00,000)
• Debt= 2000000 at 10%
• Tax rate= 30%
• Earning before interest and tax 300000
• Situation 6
• Total capital 50,00,000
• Equity share 50,00,000 (500000 shares each
share price Rs. 10, 500000X10= 50,00,000)
• Debt= NIL
• Tax rate= 30%
• Earning before interest and tax 300000
 DEBT AND EQUITY
• Advantages of debt financing
1. Ownership and control business is retained
by the business
2. Interest repayment are tax deductible
3. Loan funds are often easier and quicker to
obtain than equity funds
4. Loans provide a business with the
opportunity to grow
5. Profit are not share with the lender of the
loan.
• Disadvantages of debt financing
1. There are initial establishment cash and
ongoing fees and charges
2. Interest has to be paid on top of the amount
borrowed. These can increase
overtime(making the loan more expensive
than originally plan)
3. Repayment are often fixed and inflexible
4. Amount must be repaid in a set period of time
5. Increase a business gearing , which can effect
their solvency.
• Advantages of equity financing
1. The capital does not have to be repaid with
interest
2. Owners receive returns through dividend
repayments and increase in the share value
3. There is flexibility in dividend payments
4. There is a greater potential for growth as
owners have invested interest in the success of
the business
5. Lower gearing in the business which decrease
risk.
Disadvantages of equity financing
1. Increase the number of owners, reducing
level of control how much profit are shared.
Also increase the time to make decision.
2. Shareholders expect higher returns on their
capital investment.
3. Equity can be hard to obtain as it takes time
and money to organize
4. Legal and administration costs are high
5. Can open up a business to takeovers ( another
business buying a majority 51% of the business)