## Financial Leverage as Trading on Equity and Double-Edged Sword
### Financial Leverage as 'Trading on Equity'
Trading on equity = using fixed-cost funds (debentures, preference shares) alongside equity to increase returns to equity shareholders.
How It Works:
1. Company borrows at a fixed cost (interest on debt).
2. If the company earns more than the cost of debt, the surplus goes to equity shareholders.
3. This results in higher EPS.
When Favourable (Positive Leverage):
> Earnings > Cost of Debt → Company has favourable financial leverage → Shareholders get higher returns
When Unfavourable (Negative Leverage):
> Earnings ≤ Cost of Debt → Company has unfavourable financial leverage → EPS falls or becomes negative
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### Financial Leverage as a 'Double-Edged Sword'
Financial leverage amplifies outcomes in both directions — it can increase gains AND magnify losses.
| ROI vs. Interest | Effect on EPS & ROE | Verdict |
|---|---|---|
| ROI > Interest | EPS and ROE increase | Advantageous |
| ROI < Interest | EPS and ROE fall, financial distress possible | Harmful |
| ROI = Interest | No net benefit or harm | Neutral |
Key Insight: The same debt that boosts shareholder returns in good times creates a crushing fixed obligation in bad times.
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### DFL Range Reminder
- DFL can never be between 0 and 1
- It is either:
- ≤ 0 (when EBIT < Interest → negative leverage)
- = 1 (no fixed financial charges → neutral)
- ≥ 1 (when EBIT > Interest → positive leverage)
### Summary
```
ROI > Cost of Debt → Trading on equity works → Use leverage
ROI < Cost of Debt → Leverage destroys shareholder value → Avoid excess debt
```