effect of leverage on P/E ratio

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PuneCFA

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hi all,
I want to know what is the effect of financial leverage (change in capital structure) on P/E ratio.
Suppose two companies A & B same in balance sheet, operations means everything. Now was change capital structure of company A means change debt and equity portion in total capital of company. Suppose we assume we increase debt portion.
What will be effect on P/E ratio of company, is will increase/decrease or no effect.
Please reply with explanation also?
 
I don’t know if I’m correct since I don’t have my books with me but I’ll take a shot in the dark.
Increasing financial leverage A/E will increase ROE since FL X NPM X TAT = ROE. Therefore if ROE increases and holding RR constant, RR X increased ROE = increased G.
If G is higher, then your DPR/(r-g) will increase.
That’s holding all other factors constant.
 
NPM???
Debt increased - so holding all else constant - NI should come down… (Since Interest cost went up, even after the tax adjustment your Net Income would be lower than what it was before).
so FL Increased, but NPM went down….
unless you have numbers to put to it … this is not so straightforward.
what if the company had taken on Debt to pay dividends - in the short run DPR would go up…
too many variables to make a right guess on this.
 
You’re right CPK. I did say it was a shot in the dark!
 
cpk - are you on to level III? I remember your posts from last year’s level II forum
 
nice work. I wish i was there too…. I got caught band 10… i suffered from an FSA AM session meltdown….
 
@cpk123… so do you mean that affect on P/E ratio can be anything.. I mean could increase,decrease or even same?
Just few days back in a interview some1 asked me this question he just said tow companies having same in balance sheet, operations etc. Now he said we changed capital structure of
it. What would be effect on P/E ratio?
Nothing else he given or mentioned out.
Now you people tell me. because I could not answer correctly.
My guess from this data is that just he was saying to change debt/equity ratio may be by repurchase some shares back by issuing debt, nothing related with dividend or all. I mean its not so complex.
 
for a black and white answer increase in debt means lower NI so P/E will be higher.
 
I answered this he said no. this is wrong
please some one tell me exact answer
 
P/E ratio is a function of investor required rate of return. The higher the required rate of return, the lower the P/E ratio. Taking more debt increases systematic risk of a corporation. Increased systematic risk results in increased required rate of return. This will result in lower P/E ratio.
 
I have two answers:
a) No clue - seems like an empirical question to me and teh question isn’t even especially well-defined as there are short term effects and long term effects.
b) There’s supposed to be an optimal capital structure so increasing leverage increases P/E when you move toward optimal and decreases when you move away from it in the short run.
 
@nomad_SA Thanks for good article, well explained.
after reading it two points come in my mind. Well to change capital structure there can be many ways like one which is mentioned in this paper market capitalization is same but total capital is either given fully by equity or 50% debt and 50% equity. In this case obvious market capitalization is same and with increase use of debt , interest charges would be high and P/E ratio will go up.
But suppose a company issue more debt and use that debt to repurchase shares. In this case also capital structure will change but now market capitalization would not remain same and in fact it will also come down along with reduction in net income.
So now what is the effect on P/E ratio.
May be there are more way to change capital structure and to use that issued debt.
so tell me what would be effect on P/E ratio or its not possible to come out will some conclusion without data.
 
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