How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense. If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders. If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders. Leverage amplifies the variation in both EPS and ROE.
The effect of financial leverage depends on EBIT. Financial leverage increases ROE and EPS when EBIT is greater than the cross-over point. The variability of EPS and ROE is increased as leverage increases.
Some of you may feel that if a company expects to achieve the break-even EBIT, it should automatically issue debt. This is a break-even point relative to EBIT and EPS. Beyond this point, EPS will be larger under the debt alternative, but with additional debt, the firm will have additional financial risk that would increase the required return on its common stock. A higher required return might offset the increase in EPS, resulting in a lower firm value despite the higher EPS.