 # P/E and financial leverage problem

Why P/E decrease when financial leverage increases? Leverage equals D/E, isn’t it? An increase in financial leverage will cause a price-to-earnings (P/E) multiple to: A) increase. B) remain the same. C) there is insufficient information to tell. D) decrease. Your answer: A was incorrect. The correct answer was D) decrease. An increase in financial leverage will cause the required rate of return to increase, thereby decreasing the P/E. This is clear in the expression for trailing P/E: P0/E0 = [(1 b)(1 + g)] / (r g)

financial leverage is assets/equity

Right you are. L=1+D/E But if we increase L => growth must increase?

No banni, leverage is the level of debt in a capital structure vis-a-vis equity, so Roman’s got it right … D/E. I looked this up, and clearly NI decreases as leverage increases because of int expense. ROE goes up due to the tax savings associated w/ debt, but P/E?? The answer says that the cost of equity increases, but that would just mean that the cost of capital of this co’ would increase and hence the cost of financing new projects will rise. Can someone help me understand how will earnings (same as NI right?) increase for P/E to decrease? or is it that the price of a security will decrease by a greater amount than NI driving P/E down?

another way of thinking about this is if there is more debt that means that in a company the portion of equity is lower as assets=debt+equity that would mean that net profits are divided to less equity- so EPS increases therefore P/E should decrease clama to answer your question the NI decreases because of higher debt costs but that NI is divided to less equity . if you start from the presumtion that companies would borrow only if they can earn more on the money than they have to pay in interest then EPS increases in the same time the risk associated with the company increases too

Thanks florin … I got it now.

To Florine: >that would mean that net profits are divided to less equity- so EPS increases therefore >P/E should decrease Florine, why EPS decreases when E goes down? Maybe you mean ROE?

roman - wouldn’t that be the same ? if roe decreses then eps decreases holding everything the same. roe=ni/equity and eps =ni/shares right?