Page 596 - Accounting Principles (A Business Perspective)

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Exhibit 118 provides a more comprehensive example of favorable financial leverage. The two companies in the
illustration are identical in every respect except in the way they are financed. Company A issued only capital stock,
while Company B issued equal amounts of 10 per cent bonds and capital stock. Both companies have USD

20,000,000 of assets, and both earned USD 4,000,000 of income from operations. If we divide income from
operations by assets (USD 4,000,000/USD 20,000,000), we see that both companies earned 20 per cent on assets
employed. Yet B's stockholders fared far better than A's. The ratio of net income to stockholders' equity is 18 per
cent for B, while it is only 12 per cent for A.
Assume that both companies issued their stock at the beginning of 2010 at USD 10 per share. B's USD 1.80 EPS
are 50 per cent greater than A's USD 1.20 EPS. This EPS difference probably would cause B's shares to sell at a
substantially higher market price than A's shares. B's larger EPS would also allow a larger dividend on B's shares.

Company B in Exhibit 118 is employing financial leverage, or trading on the equity. The company is using its
stockholders' equity as a basis for securing funds on which it pays a fixed return. Company B expects to earn more
from the use of such funds than their fixed after-tax cost. As a result, Company B increases its rate of return on
stockholders' equity and EPS. 48
Companies A and B Condensed Statements
Balance Sheets
2010 December 31
Company A Company B
Total assets $20,000,000 $20,000,000
Bonds payable, 10% $10,000,000
Stockholders' equity (capital stock) $20,000,000 10,000,000
Total equities $20,000,000 $20,000,000
Income statements
For the year ended 2010 December 31
Income from operations $4,000,000 $4,000,000
Interest expense 1,000,000
Income before federal income taxes $4,000,000 $3,000,000
Deduct: Federal income taxes (40%) 1,600,000 1,200,000
Net income $2,400,000 $1,800,000
Number of common shares outstanding 2,000,000 1,000,000
Earnings per share (EPS) (Net income/Number $1.20 $1.80
of common shares outstanding)
Rate of return on assets employed (Income
from Operations/Total assets; both companies
$4,000,000/$20,000,000) 20% 20%
Rate of return on stockholders' equity (Net
income/Stockholders' equity):
Company A ($2,400,000/$20,000,000) 12%
Company B ($1,800,000/$10,000,000) 18%
Exhibit 118: Favorable financial leverage
Several disadvantages accompany the use of debt financing. First, the borrower has a fixed interest payment that
must be met each period to avoid default. Second, use of debt also reduces a company's ability to withstand a major
loss. For example, assume that instead of having net income, both Company A and Company B in Exhibit 118
sustain a net loss in 2010 of USD 11,000,000. At the end of 2010, Company A will still have USD 9,000,000 of

stockholders' equity and can continue operations with a chance of recovery. Company B, on the other hand, would
have negative stockholders' equity of USD 1,000,000 and the bondholders could force the company to liquidate if B
could not make interest payments as they came due. The result of sustaining the loss by the two companies is as
follows:

48 Issuing bonds is only one method of using leverage. Other methods of using financial leverage include issuing

preferred stock or long-term notes.

Accounting Principles: A Business Perspective 597 A Global Text