a) Financial Leverage
Definition:
Financial leverage refers to the use of debt in the capital structure of a company to enhance the return on equity. It measures the sensitivity of earnings per share (EPS) to changes in operating income due to the presence of fixed financial charges like interest.
Formula:
Financial Leverage = EBIT / EBT
Where:
EBIT = Earnings Before Interest and Taxes
EBT = Earnings Before Taxes
Example:
If EBIT = ₹500,000 and interest = ₹100,000, then:
EBT = ₹400,000
Leverage = ₹500,000 / ₹400,000 = 1.25
Significance:
- Helps in analyzing the impact of debt on profitability
- High leverage increases returns to shareholders but also raises financial risk
- Useful for capital structure decisions
b) Gordon’s Model of Dividend
Definition:
Gordon’s model, developed by Myron Gordon, is a dividend valuation model that suggests a relationship between a firm’s market value and its dividend policy. It assumes that dividends are relevant and have an impact on the firm’s valuation.
Formula:
P = E(1 – b) / (Ke – br)
Where:
P = Price of the share
E = Earnings per share
b = Retention ratio
r = Return on investment
Ke = Cost of equity capital
Assumptions:
- The firm is an all-equity firm
- Return on investment and cost of capital are constant
- Retention ratio is constant
- There is no external financing
- Infinite life of the firm
Implications:
According to Gordon, a firm’s value is maximized when it follows a conservative dividend policy, particularly when the return on investment is greater than the cost of equity (r > Ke).
Conclusion
Financial leverage highlights the impact of debt on a firm’s earnings, helping in risk assessment. Gordon’s model emphasizes the relevance of dividends in valuing a firm and guides policy decisions based on return and cost factors. Both concepts are integral to sound financial management.