A model for evaluating the tradeoff between earnings per share and financial leverage
The BRC Journal of Advances in Business
One of the most important topics in corporate finance is long-term financing. In standard textbooks the decision regarding whether to issue debt or equity to finance an approved project is often analyzed in terms of financial leverage. In many textbook problems students are asked to compute Earnings per Share (EPS) and Degree of Financial Leverage (DFL) under both debt and equity financing options. The computations generally yield results that indicate that the debt issuance results in higher EPS and higher DFL relative to the equity issuance. A clear choice between debt and equity cannot be made because while debt offers higher return, it also entails higher risk. Thus, no conclusion can be reached and the final decision must be left to subjective judgment. Currently there is no technique for objectively evaluating the tradeoff between risk and return.
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Cheng, J., Fitzpatrick J. & Seyedian, M. (2010). A model for evaluating the tradeoff between earnings per share and financial leverage. The BRC Journal of Advances in Business, 1(1), 1-13. Retrieved from http://www.cambriainstitute.com/journals/advb139v1n1y2010f1.pdf