Cash Flow Forecasting

It can be seen that under the more aggressive financing structure (scen-

ario B), the return on capital is higher to the shareholders at the lower

rate of interest of 6 per cent per annum. However, if interest rates rise

to 12 per cent, the company is making a loss under scenario B because

of the high interest charges and the return on capital is negative. This is

a demonstration of the fact that increased leverage increases the level

of risk. Under the more conservative financing structure (scenario A), the

return on capital is positive even with the higher interest rate of 12 per

cent per annum.

Financial flexibility

A discussion of capital structure issues needs to take into consideration

the fact that financing decisions are not a one-time event. In reality, the

individual decision regarding an appropriate debt–equity mix is part of

the long-term strategy of a firm. Moreover, the strategy is to some extent

Factors impacting financial performance

61

Table 3.5 The impact of financial leverage on return on capital – balance

sheets for a property company (€ 000s)

Scenario A Scenario B

Interest Interest Interest Interest

rate 6% rate 12% rate 6% rate 12%

Assets

Property 1000 1000

Liabilities

Bank loans 600 800

Equity 400 200

Total liabilities 1000 1000

Profit & Loss

Rental income 90 90 90 90

Less:

interest to bank (36) (72) (48) (96)

running costs (10) (10) (10) (10)

Net profit 44 8 32 (16)

Return on assets (%) 4.4 0.8 3.2 (1.6)

Return on capital (%) 11 2 16 (8)

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