What is financial leverage?

Answer 1

FINANCIAL LEVERAGE

The term financial leverage describes financing with debt and preferred stock to increase the potential return to the residual common shareholders' equity. Financial leverage works as follows:

1 . A firm obtains funds from creditors, preferred shareholders, and common shareholders.

2 . The firm invests the funds in various assets. Each period the firm generates a return on the assets. ROA measures this return before allocating any amounts to the suppliers of financing.

3 . Creditors receive a share of ROA equal to the interest rate on the amount borrowed. The tax deduction for the cost of the interest expense reduces the cost of this debt to the firm.

4 . Preferred shareholders receive a share of ROA equal to the preferred dividend rate on the preferred stock outstanding.

5 . The common shareholders have a residual claim on all income in excess of the cost of debt and preferred shareholder financing. As long as a firm earns an ROA that exceeds the cost of debt and preferred shareholder financing, the common shareholders benefit. They benefit because the amount earned on assets financed with debt and the preferred shareholders' funds exceeds the amounts the firm must pay for those funds; the excess belongs to the common shareholders. Common shareholders must assess whether the excess return compensates them adequately for the risk they undertake as the residual claimant on the firm's assets.