How does a firm’s financial leverage affect: Financial leverage changes a firm’s returns and risk.

a. Its profitability? Financial leverage changes a firm’s earnings per share. To the left of the indifference point (lower EBIT) between financing alternatives financial leverage reduces EPS. To the right of the indifference point (greater EBIT) EPS is increased as the firm takes on financial leverage. This observation indicates the importance of knowing the indifference point and where a company’s level of EBIT is relative to it.

b. Its level of risk? Financial leverage increases the volatility of a firm’s earnings per share. As a firm increases its financial leverage, its EPS will rise and fall by magnified amounts in response to changes in EBIT. This makes the EPS stream riskier for investors. Also, the possibility that EPS could be lower than if there were less financial leverage (if EBIT is left of the indifference point) and the power over the firm given to creditors should the firm have difficulty paying its debts create additional risks for shareholders.