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1. Define financial leverage.

Financial leverage refers to the companys use of debt. It defines the companys capital structure
which indicates how much of the total assets are financed by debt and equity.

Pam has a small restaurant business with current equity of PHP60,000. With the increasing demand,
she is planning to expand her restaurant space. After much analysis she determined that an initial
investment of PHP50,000 in fixed assets is necessary. These funds can be obtained in either of two
ways. The first is the no-debt plan, under which she would ask a relative to become an investor
(owner) by investing the full PHP50,000. The other alternative, the debt plan, involves borrowing
PHP50,000 from the nearby rural bank at 10% annual interest.
Pam expects PHP 30,000 in annual sales, PHP18,000 in operating expenses, and a 30% tax rate.

The no-debt plan results in after-tax profits of PHP8,400, which is an 8.4% return on equity (new equity
of PHP100,000)
The debt plan results in PHP4,400 of after-tax profits or 8.8% return on equity (equity still at
PHP50,000).

What capital structuring you will choose? The no-debt plan or The debt plan? Why?

types of leverage ratios

Debt ratio This ratio measures the proportion of total assets finance by total liabilities or
money provided by creditors (not by the business owners).
Debt-to-equity ratio A variation of debt ratio, shows the proportion of debt to equity.
Interest coverage ratio This ratio shows the companys ability to pay its fixed interest charges in
relation to its operating income or earnings before interest and taxes.

USE THE SAME EXAMPLE OF FINALCIAL POSITION AND FINANCIAL PERFORMANCE FOR YOUR ACTIVITY.
Factors influence capital structure

Nature of Business

Stage of Business Development

Macroeconomic conditions

Prospects of the industry

Taxes

Management style

Nature of Business If the business is risk then it has to be financed conservatively hence, lower debt
ratio.

State of Business Development A newly formed business may have difficulty borrowing from banks.
Banks usually look for the historical financial performance of borrowers.

Macroeconomic conditions If the overall economy is good then management can be more aggressive
on taking in risk through increased debt financing.

Prospects of the industry A growing industry makes business more confident to take on more financial
risk.

Taxes - Interest expenses are tax deductible while cash dividends are not. By having more debt than
equity, businesses save on taxes as interest expense (multiplied by the tax rate) decreases income tax
due.

Management style Management and the board of directors can be aggressive or conservative in terms
of taking on risk.