Financial Leverage

Financial Leverage
Financial leverage is using OPM (Other People's Money) to improve Return On Equity (ROE.) rather than utilizing owners equity. If a company can borrow money at a rate lower than the return on assets or ROI then the owners' equity position will be improved. This occurs because less of the equity is required to purchase assets.
Improving Return on Equity
Consider a company who has expected earnings before interest and taxes (EBIT) of $500,000 and needs to obtain $1M in new financing either through the sale of 50,000 shares of common stock or obtaining a long-term loan at 10% interest. Total assets of the company are $4.2M and the corporate tax rate is 30%. (Kuhlemeyer, 2001)
Without Leverage With Leverage
Assets 4,200,000 4,200,000
EBIT $500,000 $500,000
Interest 0 $100,000
EBT $500,000 $400,000
Taxes $150,000 $120,000
Net Income $350,000 $280,000
Shares Outstanding ($20/share) 100,000 50,000
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