Financial leverage:

We have seen that financial leverage refers to the substitution of fixed-charge financing-mainly debt (interest and principal) but also preferred stock for common stock. If the firm finances entirely through equity, fluctuations in earnings per share arise entirely through the firm's business risk. If some of this equity is substituted by debt, a smaller group of people is holding the remaining shares. So the risk to them increases because a smaller group of people is holding on to the existing business risk. This added risk is called financial risk. Financial leverage also affects the expected level of earnings per share (EPS) and return on equity (ROE).  We state some of the basic results regarding the consequences of leverage:

1) When the return on assets exceeds the interest cost of debt, financial leverage raises both EPS and ROE and reduces them when the return on assets is less than the cost of debt.

2) Financial leverage raises the variability or volatility of both EPS and ROE. This is because the creditor claims are of a fixed nature. A fixed amount must be paid to creditors regardless of the financial situation of the firm.

3) Financial leverage generally raises the expected value of EPS as well as that of ROE. Therefore, leverage is likely to raise both EPS and ROE, but increases their variability. So the firm cannot focus on the expected EPS and ROE alone; it has to take variability into consideration as well.