Can someone help me understand the logic behind why increased financial leverage also increase the variability of EPS and roe???
Increased Financial Leverage increases the volatility of Net Income, right? Now, EPS is NI / Common shares outstanding. So, given that common shares outstanding has not changed, volatility in NI will translate to volatility in EPS. Also, for ROE, it is NI / Equity. So, if Capital Structure has not changed, any volatility in NI will be reflected in ROE too.
why does it increase the volatility of net income was question ??
Okay, that will be a lot of theory. But let me attempt. Any time you have fixed costs in your cost structure, you get leverage. Meaning, starting from the top line (sales), you have to have enough revenues to cover all of your fixed costs and variable costs to break even. And once you have broken even, any additional sales will only be deducted by your Variable Costs, because your fixed costs are already covered. This will boost your profit Margins unproportionately on those incremental sales, giving you the benefit of leverage. Please go thru the text and you will get the concept. It is not as difficult. You may also want to read my blog post on this, which has an explaination with an example. But, beware, I had written this before I started reading for L2, so it may not have all those fancy terms covered in CFAI text. http://sandeep-rastogi-fin.blogspot.com/2009/07/financial-and-operating-leverage_16.html
floyd Wrote: ------------------------------------------------------- > Can someone help me understand the logic behind > why increased financial leverage also increase the > variability of EPS and roe??? ROE = NetIncome/Equity = (NetIncome/Sales)*(Sales/Assets)*(Assets/Equity) //dupont model If you assume that Profit margin = NetIncome/Sales and Asset turnover = Sales/Assets are independent of leverage, you will see that fluctuations of ROE are higher for higher levels of leverage (Assets/Equity). Then higher variability of ROE results in higher variability of EPS (that seems obvious).
Heres a real world example. Think of 2 trucking companies. Co1 buys a fleet of trucks using loans and Co2 hires independant truckers on 1099 basis. Demand for trucking distribution goes up, Co1 has fixed costs/payments and can set higher prices to the market will maintaing costs. Higher NI. Co2 will have to pay the market rate for truckers, pass through on costs from truckers inline with market and maintains a profit margin % of gross revenue. Then consider demand decreases. Co1 may have some trucks sitting idle that it has to continue CPLTD payments on regardless of revenue, eats away at NI. Co2 just decides that there is no demand, doesnt hire any truckers unless ther is a contract. No revenue, no cost. Keeps the profit margins per contract.