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380 Corporate Finance BRILLIANT’S

The sources of funds in the first category àW_ loUr _| {OZ òmoVm| H$mo gpå_{bV {H$`m OmVm h¡
consist of various types of long-term debt in- CZ_| ~m°ÊS²>g, {S>~oÝMa Ed§ {à\$a|g eo`g© _w»` h¢Ÿ& `o g^r
cluding bonds, debentures and preference cm±J-Q>_© S>oãQ> _| AmVo h¢ VWm BZ na H$ånZr H$mo EH$
shares. Long-term debts carry a fixed rate of
interest which is a fixed obligation for the firm. {ZpíMV Xa go ã`mO XoZm hmoVm h¡Ÿ& `Ú{n {à\$a|g eo`g©
Although the dividend on preference shares na {S>{dS>|S> XoZm H$ånZr Ho$ A{Zdm`© Xm{`Ëd _| Zht AmVm
is not a contractual obligation, it is a fixed {H$ÝVw {\$a ^r Am°{S>©Zar eo`ahmoëS>g© H$mo ^wJVmZ H$aZo Ho$
charge and must be paid before any payment
to ordinary shareholders. The equity share- nyd© BÝh| ^wJVmZ H$aZm A{Zdm`© h¡Ÿ& Cnamoº$ g^r H$mo
holders are entitled to the remainder of the ^wJVmZ H$aZo Ho$ níMmV² Omo eof ~MVm h¡, dhr BpŠdQ>r
operating profits of the firm after meeting all eo`ahmoëS>g© H$mo nmZo H$m A{YH$ma h¡Ÿ&
the prior obligations.
Financial leverage results from the pres- O~ {H$gr \$_© _| {\$ŠñS> \$m`ZopÝe`c EŠgn|gog
ence of fixed financial charges in the firm’s in- hmoVo h¢ Vmo dhm± \$m`ZopÝe`c brdaoO CËnÞ hmoVm h¡Ÿ& BZ
come stream. These fixed charges are to be paid {\$ŠñS> \$m`Zo{Ýe`c EŠgn|gog H$m ^wJVmZ H$aZm A{Zdm`©
regardless of the amount of EBIT available. Fi- hmoVm h¡ ^bo hr EBIT H$_ hmo `m A{YH$Ÿ& O~ h_ EBIT _|
nancial leverage is concerned with the effects n[adV©Z H$m BpŠdQ>r hmoëS>g© H$mo CnbãY Am` na à^md
of changes in EBIT on the earnings available to H$m AÜ``Z H$aVo h¢ Vmo Bgo \$m`ZopÝe`c brdaoO H$hm
equity holders. It is defined as the ability of a Om`oJmŸ& AÝ` eãXm| _|, {H$gr H$ånZr Ûmam {\$ŠñS>
firm to use fixed financial charges to magnify \$m`ZopÝe`c EŠgn|gog Ho$ Cn`moJ Ho$ H$maU EBIT _| hmoZo
the effects of changes in EBIT on the EPS (earn- dmbo n[adV©Z H$m à{V eo`a Am` (EPS) na Omo à^md
ings per share). n‹S>Vm h¡, Cgo hr \$m`ZopÝe`c brdaoO H$hVo h¢Ÿ&
The use of the fixed charged sources of ñWm`r ì``m| dmco \§$S> Ho$ òmoVm| ({Og na H$ånZr H$mo
funds (on which company is required to pay EH$ {ZpíMV Xa na [aQ>Z© H$m ^wJVmZ H$aZm Oê$ar hmoVm
return at a fixed rate) such as debt and prefer- h¡) O¡go S>oãQ> VWm {à\$a|g H¡${nQ>c Ho$ gmW H¡${nQ>c
ence capital along with the owner's equity/or-
dinary shares in the capital structure is de- ñQ´>ŠMa _| Am°Za H$s B{ŠdQ>r/gm_mÝ` eo`g© Ho$ Cn`moJ
scribed as financial leverage. H$m \$m`ZopÝe`c crdaoO Ho$ ê$n _| dU©Z {H$`m OmVm h¡Ÿ&
The aim of financial leverage is to earn \$m`ZopÝe`c brdaoO H$m CÔoí` ñWm`r MmO© dmbo
more on the fixed charges funds than their costs. \$m`ZopÝe`c [agmog}g H$m ny§Or g§aMZm _| Cn`moJ H$aHo$
If there is surplus, it will increase the return on CZH$s bmJV go A{YH$ [aQ>Z© A{O©V H$aZm h¡ Vm{H$ BpŠdQ>r
owner’s equity and in case of deficit, the return Am°Za Ho$ [aQ>Z© _| d¥{Õ hmo gHo$Ÿ& `{X [aQ>Z©, H$m°ñQ> go
will decrease. A{YH$ hmoJm Vmo bm^ hmoJm AÝ`Wm hm{Z hmoJrŸ&
For example, if a company borrows ` 100 CXmhaU Ho$ {bE, `{X {H$gr H$ånZr Zo _mH}$Q> go
at 8% interest and invest to earn 12% return. ` 100 CYma {bE {Og na ã`mO H$s Xa 8% h¡Ÿ& `{X
The difference of 4% will belong to the share- H$ånZr Cgo AnZo {H$gr àmoOoŠQ> _| bJmH$a 12% [aQ>Z©
holders and it constitutes profit from financial A{O©V H$a nmVr h¡ Vmo AÝVa AWm©V² 4% H$m grYm bm^
leverage. On the other hand, if company could eo`ahmoëS>g© H$mo {_boJm VWm `h \$m`ZopÝe`c crdaoO go
earn only return of 6%, the loss to the share- cm^ àmá H$aoJmŸ& BgHo$ {dnarV `{X H$ånZr H$s [aQ>Z©
holders would be ` 2 per annum. Thus, finan- Ho$db 6% h¡ Vmo ` 2 H$s hm{Z ^s eo`ahmoëS>g© H$mo dhZ