"When comparing levered and unlevered capital structures, leverage increases EPS for high levels of operating income because:"
Answer: Interest payments on the debt stay fixed, meaning more income is distributed over fewer shares
My question is, wouldn’t leverage decrease net income? I understand how it increases, say ROE, but it seems that every example (plus my own understanding) in the book shows NI of an unlevered firm being greater than that of a levered firm. Why are they saying that more income is distributed? Also, I’m assuming the increae in leverage in this case is because it was used to buyback shares? Thanks!
With greater leverage net income is lower because of higher interest expense, but net income per share (EPS) is greater. The assumption is that you’re increasing leverage by having fewer shares outstanding: borrowing money and buying back treasury stock.
This however holds only true if the after cost of debt are lower that the current earnings yield (equivalent to current EPS / share price or current net income / market cap). Regards, Oscar
That makes sense - but the question reads as if actual income is increased. That is what confused me.
I’m going to ask two more questions, if you don’t mind, so I don’t clog up the front page: I.) “When a firm increases debt in the capital structure:”
A: Expected return on firms common stock increases. I searched CFAI Reading 37 and even did a word search, and couldn’t find any instance of this being covered. Where is this point covered in the reading? II.) “In a world of no taxes, the introduction of a small amount of debt into the capital structure of an all equity firm:” A: does not impact the risk of the firm Going over the CFAI material, I couldn’t find any mention of debt not impacting the risk of the firm, given no taxes. Could someone explain this to me? Thank you!