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)
H6136-Ch03.qxd 9/8/05 10:39 AM Page 61

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