can someone explain to me how does buying back shares increases the firms financial leverage. thanks
Financial leverage is Assets/Equity. Buying back shares reduces cash and equity by the same dollar amount, but, because Assets > Equity, it reduces Equity by a greater percentage than it reduces Assets. Try some numbers:
- Assets = 100
- Liabilities = 60
- Equity = 40
Financial leverage = 100/40 = 2.5.
Suppose that you buy back 10 in stock. Then,
- Assets = 90 (= 100 – 10)
- Liabilities = 60
- Equity = 30 (= 40 – 10)
Financal leverage = 90/30 = 3.
thank you so much! i get it now
My pleasure.