What is Financial Leverage?Financial leverage is the use of increasing debt to purchase more assets. Leverage is usually employed to increase the return on equity (ROE). However, an excess of financial leverage magnifies the risk of failure, as it becomes increasingly difficult to repay the debt by the borrower.Financial leverage is measured as the ratio of total debt to total assets in its formula. When the proportion of debt to assets increases, the amount of financial leverage does so too.Financial leverage is favorable when debt can be put to generate returns greater than the interest expense related to the debt.Many ... Read More

The EBIT-EPS analysis gives the best ratio of debttoequity which the businesses can use to find an optimum balance in their debt and equity financing. The analysis shows the effect of the balance sheet’s structure on the company’s earnings.Basics of EBIT-EPS ApproachIt is important to understand what EBIT and EPS mean to understand what the analysis is meant to be.EBIT refers to earnings before interest and tax. The metric makes interest and taxes irrelevant. Therefore, an investor can understand how the company is performing out of the balance sheet’s composition which essentially makes interest and taxes the focal point of ... Read More

Certainty equivalent is the amount of cash an investor would accept today than going for a larger amount of cash tomorrow. Investors often use this to deny the risk. The Certainty equivalent helps investors earn a guaranteed income on their investment rather than going for increased risk on their investment portfolios. It is a method of reducing risk while also reducing the income from given investment instruments.Certainty Equivalent is Popular among Risk-Averse InvestorsCertainty equivalent is quite a popular method among risk-averse investors. These investors do not want to invest in high-return but risky investments. Instead, they forgo higher returns for ... Read More

Sequential analysis deals with the sequence of events an investment process follows instead of just accept or reject a process. Sequential analysis is more relevant in practice because it shows all the probable events in terms of a decisions tree that constitutes the probability of an outcome generated in the process.Decisions trees are not a perfect measure of a future event, but they represent quite a close approach to the original outcome in general. However, some steps must be followed while constructing a decision tree which are explained below.Defining the InvestmentsThe investment for which the sequential investment has to be ... Read More

A company’s financial leverage is its dependence on debt. It can impact the company’s return on equity (ROE) positively or negatively due to the increased risk probability.Impacts of Financial LeverageAs an individual or a company will have to pay back the debt, it will always bring about a heightened level of risk. The income an individual or a company earns must be used to pay back the debt, even if the earnings or cash flows go down.From a firm’s perspective, the use of financial leverage (debt) can positively – or sometimes negatively – impact the ROE due to an increased level ... Read More

As financial planning and policymaking are of top priority for firms, they must use proper scrutiny and analysis of the following elements of capital structure −Capital MixMaturity and PriorityTerms and ConditionsCurrencyFinancial InnovationsLet's check the importance of each of these important elements of capital structure in detail.Capital MixFirms often need to take a decision on how much debt and equity must be sourced for the operation of the business.Debt can be acquired from a variety of sources. The firm must realize what is the debt-equity ratio to keep a track of the financial mix that is optimum for it.The firm should ... Read More

Capital rationing is a strategy opted by companies that restrict the company’s investment in only one project at a given point of time. When several investments are available, the business needs to invest in the most profitable one.Companies that rely on capital rationing usually have higher return on investment. This is simply because the company chooses the option where profitability is guaranteed and at its maximum.Benefits of Capital RationingCapital rationing often leads to the most successful projects and hence it often guarantees the highest return on investment. Investors are interested in capital rationing because this gives them the idea of ... Read More

Embedded OptionAn embedded option is a type of provision in financial security that gives the issuer or the holder of the security a specific right but not an obligation to perform some select actions in the future. The embedded options cannot be separated from the security, as they exist only as a component of the latter. Embedded options can be fixed to any financial security, but they are mostly attached to bonds.The point to note is that, one security may have multiple embedded options. The only restriction in such cases is that the options should not be mutually exclusive. For ... Read More

What is Written Down Value Method of Depreciation?The Written Down Value (WDV) method of depreciation is also known as Reducing Installment or Reducing Balance Method or Diminishing Balance Method. In this method, the depreciation is calculated at a constant fixed percentage each year on the diminishing book value, commonly known as WDV of the asset (book value less depreciation).The use of the balance brought forward from the previous year or book value and the fixed rate of depreciation decreases the depreciation charges over the lifespan of the asset. That is, when the entire lifespan of an asset is considered, the ... Read More

The theory of the net income approach suggests increasing the value of a firm by decreasing the overall cost of capital. The cost of capital in the theory is measured in terms of Weighted Average Cost of Capital (WACC). It can be done by incurring and collecting a higher proportion of debt because it is a cheaper source of finance in comparison to equity finance.WACC is the weighted average costs of equity and debts, and the weights are the units of capital collected from each source.According to the Net Income Approach theory, changes in the financial leverage of a firm ... Read More