UNIT IV

LESSON

8
LEVERAGE ANALYSIS
CONTENTS
8.0 Aims and Objectives
8.1 Introduction
8.2 Concept of Leverage
8.3 Types of Leverages
8.3.1 Operating Leverage
8.3.2 Financial Leverage
8.3.3 Combined Leverage
8.4 Let us Sum up
8.5 Lesson End Activity
8.6 Keywords
8.7 Questions for Discussion
8.8 Suggested Readings

8.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to:
 Understand the concept of leverage and types of leverages.
 Present the procedure for calculation of leverages.
 Examine the significance of leverages.

8.1 INTRODUCTION
The financial or capital structure decision is of tremendous significance for the
management, since it influences the debt-equity mix of the company, which ultimately
affects shareholders’ return and risk. In case the borrowed funds are more when
compared to the owners’ funds, it results in increase in shareholders’ earnings. This is
because the cost of borrowed funds is less than that of the shareholders’ funds on
account of cost of borrowed funds being allowable as a deduction for income tax purposes.
But at the same time, the borrowed funds carry a fixed rate of return, which has to be
paid whether the company is earning profits or not. Thus, the risk of the shareholders
increases in case there is a high proportion of borrowed funds in the total capital structure
of the company. In a situation where the proportion of the shareholders’ funds is more
than the proportion of the borrowed funds, the return as well as the risk of the shareholders
will be much less.
154 Therefore, the finance manager has to estimate the total requirement of fund for meeting
Capital Budgeting and the needs of the firm and make arrangement to raise the necessary funds. The desired
Financing Decisions
structure of funds influences the shareholder’s return and risk. Leverage analysis is a
technique used by business firms to quantify risk-return relationship of different alternative
capital structure.

8.2 CONCEPT OF LEVERAGE

The term Leverage generally refers to a relationship between two interrelated variables.
In financial analysis, it represents the influence of one financial variable over some other
related financial variable. These financial variables may be costs, output, sales revenue,
Earnings Before Interest and Tax (EBIT), Earning per share (EPS), etc.
James C. Van Horne has defined the leverage as “the employment of an asset or funds
for which the firm pays a fixed cost or fixed return”. Thus, according to him, leverage
results as a result of the firm employing an asset or source of funds, which has a fixed
cost. The former may be termed as “fixed operating cost”, while the latter may be
termed as “fixed financial cost”. It should be noted that fixed costs or return is the
fulcrum of a leverage. If a firm is not required to pay fixed cost or fixed return, there will
be no leverage.
Since fixed cost has to be paid or incurred irrespective of the volume of output or sales,
the size of such cost has considerable influence over the amount of profits available for
the shareholders. When the volume of sales changes, leverage helps in quantifying such
influence. It may therefore, be defined as relative change in profits due to a change in
sales. A high degree of leverage implies that there will be a large change in profits due
to a relatively small change in sales and vice versa. Thus, higher is the leverage, higher
is the risk and higher is the expected return.

8.3 TYPES OF LEVERAGES

There are three commonly used measures of leverage in financial analysis. These are:

8.3.1 Operating Leverage

Operating Leverage is defined as the “firm’s ability to use fixed operating costs to magnify
effects of changes in sales on its earnings before interest and taxes”.
When there is an increase or decrease in sales level, the EBIT also changes. The effect
of change in sales on the level of EBIT is measured by Operating Leverage.
Operating leverage in a firm is a function of three factors:
(i) The amount of fixed costs.
(ii) The contribution margin.
(iii) The volume of sales.
The operating leverage can be calculated as shown below:
Contribution C
Operating Leverage = or
Operating Profit EBIT
Operating profit here means ‘Earning before Interest and Tax’ (EBIT).
Operating leverage may be favourable or unfavourable. In case the contribution (i.e.,
sales less variable cost) exceed the fixed cost, there is favourable operating leverage. In
a reverse case, the operating leverage will be termed as unfavourable.
Degree of Operating Leverage: The degree of operating leverage may be defined as 155
percentage change in the profits resulting from a percentage change in the sales. It may Leverage Analysis
be put in the form of following formula:
Percentage change in profits
Degree of Operating Leverage (DOL) =
Percentage change in sales

Significance of Operating Leverage: The operating leverage indicates the impact of

change in sales on operating income (EBIT). If a firm has a high degree of operating
leverage, small changes in sales will have large effect on operating income. In other
words, the operating profits (EBIT) of such a firm will increase at a faster rate than the
increase in sales. Similarly, the operating profits of such a firm will suffer a greater loss
as compared to reduction in its sales.
Generally, the firms do not like to operate under conditions of a high degree of operating
leverage. This is a very risky situation where a small drop in sales can be excessively
damaging to the firm’s efforts to achieve profitability.
The concept of operating leverage will be clear from the following illustration:
Illustration 1:
The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling
price per unit is Rs.10, Variable cost is Rs.6 per unit. Calculate the operating leverage in
each of the following three situations:
(i) When fixed costs are Rs.400
(ii) When fixed costs are Rs.1,000
(iii) When fixed costs are Rs.1,200.
Solution:
Statement Showing Operating Leverage

Situation-I Situation-II Situation-III

Sales Rs.4,000 Rs.4,000 Rs.4,000
Less: Variable cost Rs.2,400 Rs.2,400 Rs.2,400
Contribution (C) Rs.1,600 Rs.1,600 Rs.1,600
Less: Fixed Cost Rs. 400 Rs.1,000 Rs.1,200
Operating Profit Or EBIT Rs.1,200 Rs.1,600 Rs.400
C
Operating Leverage = 1.33 2.67 4
EBIT

The above illustration shows that the degree of operating leverage increases with every
increase in share of fixed cost in the total cost structure of the firm.
However, in case of situation I, operating leverage of 1.33 means that 1% increase in
sales would result into 1.33% increase in operating profit, i.e., EBIT. Further with a 1%
change in sales will result in change the EBIT by 2.67% and 4% in case of situation II
and situation III respectively.

8.3.2 Financial Leverage

Financial Leverage is defined as the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT or Operating profits, on the firm’s Earning Per
156 Share (EPS). The financial leverage occurs when a firm’s capital structure contains
Capital Budgeting and obligation of fixed financial charges, i.e., interest on debentures, dividend on preference
Financing Decisions
shares, etc., along with owner’s equity to enhance earnings of equity shareholders. The
fixed financial charges do not vary with the operating profits or EBIT. They are fixed
and are to be paid irrespective of level of operating profits or EBIT. The ordinary
shareholders of firm are entitled to residual income, i.e., Earnings after fixed financial
charges.
Thus, the effect of changes in operating profit or EBIT on the level of Earning Per Share
(EPS) is measured by Financial Leverage.
Computation: The calculation of financial leverage can be done according to the following
methods:
(a) Where Capital Structure consists of Equity Shares and Debt:
In such a case, financial leverage can be calculated according to the following formula:
Operating Profit EBIT
Financial Leverage = (or)
Profit before Tax EBT
Illustration 2:
X Ltd. has a choice of the following three financial plans. You are required to calculate
the financial leverage in each case and interpret it.

X Y Z
Rs. Rs. Rs.
Equity Capital 2,000 1,000 3,000
10% Debt 2,000 3,000 1,000
Operating Profit (EBIT) 400 400 400

Solution:
Statement Showing Financial Leverage

X (Rs.) Y (Rs.) Z (Rs.)

Operating Profit (EBIT) 400 400 400

Less: Interest on Debt @ 10% 200 300 100
Earning before Tax (EBT) 200 100 300

EBIT
Financial Leverage = 2 times 4 times 1.33 times
EBT

As Financial Leverage indicates the change that will take place in the taxable income as
a result of change in the operating income. Financial Leverage in case of Plan X is 2. It
means every 1% change in Operating Profit will result in 2% change in the taxable
profit. Similarly, it is 4% and 1.33% in case of Plan Y and Plan Z respectively.
Degree of Financial Leverage: Degree of Financial Leverage may be defined as the
percentage change in taxable profit as a result of percentage change in ‘operating profit’.
This may be put in the form of following equation:

Percentage change in taxable income

Degree of Financial Leverage (DFL) =
Percentage change in the operating income
(b) Where the Capital Structure consists of Preference Shares 157

and Equity Shares Leverage Analysis

The formula for computation of financial leverage can also be applied to a financial plan
having preference shares. Of course, the amount of preference dividends will have to be
grossed up (as per the tax rate applicable to the company) and then deducted from the
earnings before interest and tax.
Illustration 3:
The capital structure of X Ltd. consists of the following securities:
10% Preference Share Capital Rs.1,00,000
Equity Share Capital (Rs.10 shares) Rs.1,00,000
The amount of operating profit is Rs.60,000. The company is in 50% tax bracket.
You are required to calculate the financial leverage of the company. What would be new
financial leverage if the operating profit increases to Rs.90,000 and interpret your results.
Solution:
Computation of the Financial Leverage when EBIT is Rs.60,000

Rs.
Operating Profit or EBIT 60,000
Less: Preference dividend (after grossing up) 20,000
EARNING BEFORE TAX (EBT) 40,000
EBIT 60,000
Present Financial Leverage = = = 1.5
EBT 40,000

Computation of Financial Leverage when EBIT is Rs.90,000

Rs.
Operating Profit or EBIT 90,000
Less: Preference dividend (after grossing up) 20,000
EARNING BEFORE TAX (EBT) 70,000
EBIT 90,000
Financial Leverage = = = 1.286
EBT 70,000

The existing financial leverage is 1.5. It means 1% change in operating profit will cause
1.5% change in taxable profit in the same direction. For example, in the present case,
operating profit has increased by 50% (i.e., from Rs.60,000 to Rs.90,000). This has
resulted in 75% increase in the taxable profit (i.e., from Rs.40,000 to Rs.70,000).
(c) Where the Capital Structure consists of Equity Shares,
Preference Shares and Debt:
In such a case, the financial leverage is calculated after deducting from operating profit
both interest and preference dividend on a before tax basis.
158 Illustration 4:
Capital Budgeting and
Financing Decisions X Ltd. has the following capital structure:
Equity Share Capital Rs.1,00,000
10% Preference Share Capital Rs.1,00,000
8% Debentures Rs.1,25,000
The present EBIT is Rs.50,000. Calculate the financial leverage assuming that company
is in 50% tax bracket.
Solution:
Computation of Financial Leverage

Rs. Rs.

Operating Profit or EBIT ..... 50,000

Less: Interest on Debentures 10,000
Preference dividend (after grossing up) 20,000 30,000
————— —————
EARNING BEFORE TAX (EBT) Rs.20,000
—————

EBIT 50,000
Present Financial Leverage = = = 2.5
EBT 25,000

Illustration 5:
A Ltd. has the following capital structure:
10,000 Equity Shares of Rs.10 each Rs.1,00,000
2,000 10% Preference Shares of Rs.100 each Rs.2,00,000
2,000 10% Debentures of Rs.100 each Rs.2,00,000
Calculate the EPS for each of the following levels of EBIT:
(i) Rs.1,00,000; (ii) Rs.60,000; (iii) Rs.1,40,000. The company is in 50% tax bracket.
Solution:
Computation of Earning Per Share

Plan 1 Plan 2 Plan 3

Earnings before interest and tax (EBIT) 1,00,000 60,000 1,40,000
Less: Interest on Debentures 20,000 20,000 20,000

Earning Before Tax (EBT) 80,000 40,000 1,20,000

Less: Income Tax @ 50% 40,000 20,000 60,000

Earning after Tax (EAT) 40,000 20,000 60,000

Less: Preference dividend 20,000 20,000 20,000

Earnings available for Equity Shareholders: 20,000 NIL 40,000

Earning Per Share (EPS) ....... NIL .......
10,000 10,000
Rs.2 NIL Rs.4
The above table shows that: 159
Leverage Analysis
(a) In case Plan 2, the EBIT has decreased by 40% (i.e., from Rs.1,00,000 to Rs.60,000)
while the earning per share has decreased by 100% (i.e., from Rs.2 per share to
NIL).
(b) In case Plan 3, the EBIT has increased by 40% (i.e., from Rs.1,00,000 to
Rs.1,40,000) as compared to Plan 1 while the earning per share has increased by
100% (i.e., from Rs.2 per share to Rs.4 per share).
The degree of financial leverage (DFL) can therefore be calculated as follows:
Percentage change in EPS
DFL =
Percentage change in EBIT

Financial Leverage in between plan 1 and Plan 2 = 100/40 = 2.5

Financial Leverage in between Plan 1 and Plan 3 = 100/40 = 2.5
The same result can be obtained by using the equation EBIT/EBT as shown below:
Computation of Financial Leverage

Plan 1 Plan 2 Plan 3

Operating Profit or EBIT 1,00,000 60,000 1,40,000
Less: Interest on Debentures Rs.20,000
Preference dividend (grossed up) Rs.40,000 60,000 60,000 60,000

Earning Before Tax (EBT) 40,000 NIL 80,000

EBIT 1,00,000
Present Financial Leverage = = = 2.5
EBT 40,000

Significance of Financial Leverage: Financial Leverage helps the finance manager in

designing the appropriate Capital structure. One of the objective of planning an appropriate
capital structure is to maximize the return on equity shareholders’ funds or maximize the
earning per share.
Financial Leverage is double edged sword. On the one hand, it increases earning per
share and on the other hand, it increases financial risk. A high financial leverage means
high fixed financial costs and high financial risk, i.e., as the debt component in capital
structure increases, the financial leverage increases and at the same time the financial
risk also increases, i.e., risk of insolvency increases.
The finance manager therefore, is required to trade off i.e., has to bring a balance
between risk and return for determining the appropriate amount of debt in the capital
structure of a firm. Thus, the analysis of financial leverage is most important tool in the
hands of financial managers who are engaged in financing the capital structure of business
firms, keeping in view the objectives of their firm.

8.3.3 Combined Leverage

We have seen above that operating leverage influences for the operating risk and financial
leverage influence for the financial risk of a firm. However, a firm has to look into
overall risk or total risk of the firm, i.e., Operating risk as well as Financial risk. Hence,
if we combine the operating leverage and financial leverage, the result is Combined
Leverage/Composite Leverage.
160 Thus, combined leverage expresses the relationship between revenue on account of
Capital Budgeting and sales (i.e., contribution or sales less variable cost) and the taxable income. It helps in
Financing Decisions
finding out the resulting percentage change in taxable income on account of percentage
change in sales. This can be computed as follows:
Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL)
C EBIT C
= × =
EBIT EBT EBT
Illustration 6:
X Ltd. has Sales of Rs.1,00,000. The variable costs are 40% of the sales while the fixed
operating costs amount to Rs.30,000. The amount of interest on long-term debt is
Rs.10,000.
You are required to calculate the Composite Leverage.
Solution:
Statement Showing Computation of Combined Leverage
Sales
1,00,000
Less: Variable Costs (40% of Sales) 40,000
—————
Contribution (C) 60,000
Less: Fixed Operating Costs 30,000
—————
Earning before Interest and Tax (EBIT) 30,000
Less: Interest on Debt 10,000
—————
Taxable Income/Earning before Tax (EBT) 20,000
—————
C 60,000
Combined Leverage= = = 3 Times
EBT 20,000

The Combined Leverage of ‘3’ times indicates that with every increase of 1% in sales
will influence for the increase in the taxable income by 3%.
Significance of Combined Leverage: The ratio of contribution to earnings before tax,
given by combined leverage shows the combined effect of financial and operating
leverage. A high operating leverage and a high financial leverage combination is very
risky. If the company is producing and selling at a high level, it will make extremely high
profit for its shareholders. But even a small fall in the level of operations would result in
a tremendous fall in earnings per share. A company must, therefore, maintain a proper
balance between these two leverages.
A high operating leverage and a low financial leverage indicate that the management is
careful since the higher amount of risk involved in high operating leverage has been
sought to be balanced by low financial leverage. However, a more preferable situation
would be to have a low operating leverage and a high financial leverage. A low operating
leverage would automatically imply that the company reaches its break-even point at a
low level of sales.
Therefore, risk is diminished. A highly cautious and conservative manager will keep both
its operating and financial leverage at very low levels. The approach may, however,
mean that the company is losing profitable opportunities.
Illustration 7: 161
Leverage Analysis
A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed costs of
Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating,
financial and combined leverages? If the firm wants to double it Earnings Before Interest
and Tax (EBIT), how much of a rise in sales would be needed on a percentage basis.
(C.A. Final, N.S. Nov. 1979)
Solution:
Computation of Operating, Financial and Combined Leverages

Contribution 3,00,000
Operative Leverage = = = 3 times
EBIT 1,00, 000

EBIT 1,00, 000

Financial Leverage = = = 2 times
EBIT INT 1,00,000 50,000

Combined Leverage = Operative Leverage × Financial leverage

= 3×2=6

Profit as Present Rs.

Sales 10,00,000
Less: Variable Cost 7,00,000
Contribution 3,00,000
Less: Fixed Costs 2,00,000
Operating Profit (EBIT) 1,00,000
Less: Interest (10% on Rs. 5,00,000) 50,000
Profit before tax 50,000
Comments: Operating leverage is 3 times. This means that if sales increase by 100
percent, operating profit will rise by 300 per cent (i.e., 3 times the rise in sales). Therefore,
in case the firm wants to double its earnings before required. This is confirmed by the
following computation:
Sales after 33.33% rise Rs. 13,33,333
Contribution 9,33,333
4,00,000
Fixed Cost 2,00,000
Operating Profit 2,00,000
Illustration 8:
X Corporation has estimated that for a new product its break-even point is 2000 Units, if
the item is sold for Rs. 14 per unit. The cost accounting department has currently identified
variable cost of Rs. 9 per unit. Calculate the degree of operating leverage for sales
volume of 2500 Units and 3000 units. What do you infer from the degree of operating
leverage at the sales volumes of 25000 units and 3000 units and their difference, if any?
(C.S. Final, N.S. Nov., 1979)
162 Solution:
Capital Budgeting and
Financing Decisions Operating Leverage in X Corporation

Per Unit 2500 Units 3000 Units

(Rs.) (Rs.) (Rs.)
Sales 14 35000 42000
Variables Costs 9 22500 27000

Contribution 5 12500 15000

Fixed Costs (2000 X Rs. 5 per unit) 10000 10000
__________ __________
EBIT 2,500 5,000

Contribution 12, 500 15, 000

Operating Leverage = = = 5 times = = 3 times
EBIT 2, 500 5, 000
________________________________________________________________
Inference: The degree of operating leverage is much higher at the sales volume of 2500
units than at the sales volume of 3000 units, i.e., 5 times and 3 times respectively. It
means that at the sales volume of 2500 units, the variation in operating profit will be 5
times the variation in sales volume. This is apparent from the profit statement for 3000
units. A 20% increase in sales volume has resulted in a 100% increase in operating
profits. However, at the sales volume resulted in a 100% increase in operating profits.
However, at the sales volume of 3000 units, the degree of operating leverage is only 3
times. This means that at this level, the rise in operating profit will be 3 times the rise in
sales volume.
A very high degree of operating leverage is not considered desirable as a small fall in
sales volume will result in a substantial fall in operating profit.
Illustration 9:
The following data relate to Company XYZ Ltd. Rs.
Sales 2,00,000
Less: Variable Expenses (30%) 60,000
Contribution 1,40,000
Fixed operating expenses 1,00,000
EBIT 40,000
Less: Interest 5,000
Taxable Income 35,000
1. Using the concept of leverage, by what percentage will taxable income increase if
sales increase by 6 percent.
2. Using the concept of operating leverage by what percentage will EBIT increase if
there is a 10 percent increase in sale?
3. Using the concept of financial leverage, by what percentage will taxable income
increase if EBIT increases by 6 percent?
Solution: 163
Leverage Analysis
1. Degree of composite leverage on sales level of Rs. 2,00,000
Contribution 1, 40, 000
= = = 4 times
Taxable Income 35, 000
If sales increase by 6 percent, taxable income will increase by 4 × 6 = 24 percent.
Workings:
Sales Rs. 2,12,000
Less: Variable Expenses (30%) 63,600
Contribution 1,48,400
Less: Fixed Expenses 1,00,000
EBIT 48,400
Interest 5,000
Taxable Income 43,400
Increase in Taxable Income Rs. 8400 i.e. 24% over Rs. 35000
2. Degree of operating leverage on sales level of Rs. 2,00,000
Contribution 1, 48, 400
= = = 3.5 times
Taxable Income 43, 400
If sales increase by 10% EBIT will increase by 3.5x10 = 35 percent :
Workings:
Sales Rs. 2,20,000
Less: Variable Expenses (30%) 66,000
Contribution 1,54,000
Less: Fixed Expenses 1,00,000
EBIT 54,000
Increase is Rs. 54000 – Rs. 40000 or Rs. 14,000
14,000
i.e. = × 100 = 35%
40,000
3. Degree of financial leverage if EBIT increases by 6%
= 40,000 × 1.06 = 42,400
EBIT 42, 400
= = = 1.15
Taxable Income 37, 400
If EBIT increased by 6 percent, taxable income will increase by 1.15 × 6
= 6.9 percent.
Workings:
EBIT (4,000 × 1.06) 42,400
Less : Interest 5,000
Taxable Income 37,400
2400
Increase is Rs. 37,400 - 35000 or × 100 = 6.9 %
35,000
164 Illustration 10:
Capital Budgeting and
Financing Decisions The following data relates to two companies A Ltd. and B Ltd.
A (Rs.) B (Rs.)
Capital employed – 2,50000
9 % Debentures 500000 250000
Equity Share Capital
(in Rs. 10 shares) 100000 100000
Return on capital employed 20% 20%
The equity shareholders of A Ltd. find to their dismay that inspite of same return earned
by their company on the total capital employed, their earnings per share is much less as
compared to B Ltd.
You are required to state for the satisfaction of the shareholders of A Ltd., the reasons
for such lower earning per share on their capital. Assume that the tax at 50%.
Solution:
In order to find out the reasons of a lower rate of earning for the shareholders of
A Ltd., the earnings per share for both the companies will have to be calculated :
Computation of Earning Per Share
A B
Rs. Rs.
Earnings before Interest and Tax (EBIT) 100000 100000
Less: Debenture interest – 22500
Profit before tax (PBT) 100000 77500
Less: Taxes at 50% 50000 38750
Earning after tax (EAT) 50000 38750
Number of Shares 50000 25000
Earning per share 1 1.55
Financial Leverage EBIT / PBT =1 = 1.29
The above working explains that there are two causes for a lower earnings per share in
case of the company A as compared to company B. These causes are as follows:
1. The company B has a favourable financial leverage or, in other words, it is taking
the advantage of trading on equity. It has been a position to borrow half of its
capital employed at much lower cost as compared to the total return on its capital
employed. It is paying an interest of 9% on its debentures of Rs. 250000 but is
earning a return of 20%. This saving of 11% has accrued to the shareholders as
owners of the firm. This has been shown below:
(Rs.)
Earnings on Assets financed by debentures 50,000
Less: Interest charges 22,500

Contd...
 Favourable leverage effect 27,500 165
Leverage Analysis
(11% on Rs. 250000) 13,750
Less: Tax at 50%
After tax favourable leverage effect 13,750

Thus, Rs. 13750 are additionally available to the shareholders B Co. as compared
to the shareholders of A Co.
2. The total number of equity share issued by B Co. are only 25000 as compared to
50000 shares issued by A Co. Consequently the after tax favourable leverage
effect of Rs. 13750 has accrued to shareholders of 25000 shares. This has resulted
in increase in earnings per share in case of Company B as compared to company
A by Re. 0.55 (i.e. Rs. 13750 ÷ 25000) per share.
Illustration 11:
Calculate operating leverage and financial leverage under situations A, B and C and
financial Plans I, II and III respectively from the following information relating to the
operating and capital structure of which give the highest value and the least value. How
are these calculations useful to financial manager in a company
Installed Capacity 1200 Units
Actual Production and Sales 800 Units
Selling Price per unit Rs .15
Variable Cost per Unit Rs. 10
Fixed Cost : Situation A Rs. 1000
Situation B Rs. 2000
Situation C Rs. 3000
Capital Structure Financial Plan
I II III
Equity 5000 7500 2500
Debt 5000 2500 7500
Cost of Debt 12%
Solution:
Computation of Operating Leverage

Situation A Situation B Situation C

Sales (S) 12,000 12,000 12,000
Less: Variable Cost (VC) 8,000 8,000 8,000
Contribution (C) 4,000 4,000 4,000
Fixed Cost (FC) 1,000 2,000 3,000
Operating Profit (OP) 3,000 2,000 1,000
Operating Leverage (C/OP) 1.33 2 4
166 Computation of Financial Leverage
Capital Budgeting and
Financing Decisions Fin. Plan I Fin. Plan II Fin. Plan III
Situation A:
Operating Profit 3,000 3,000 3,000
Less: Interest 600 300 900
PBT 2,400 2,700 2,100
Financial Leverage = OP/PBT 1.25 1.11 1.4
Situation B:
Operating Profit 2000 2000 2000
Less: Interest 600 300 900
PBT 1400 1700 1100
Financial Leverage = OP/PBT 1.43 1.18 1.82
Situation C:
Operating Profit 1000 1000 1000
Less: Interest 600 300 900
PBT 400 700 100
Financial Leverage = OP/PBT 2.5 1.43 10
Combination of Operating Leverage and Financial Leverage
Highest Value Situation C and Financial Plan III 4 × 10 = 40
Least Value Situation A and Financial Plan II 1.33 × 1.11 = 1.476
The operating leverage and the financial leverage computed as above have a great
utility for the financial manager. Since they disclose the extent of both operating
and financial risk assumed by a company under a particular situation, both the
leverage should neither be too high nor too low. A high degree of this leverage will
indicate that the company is working under a very observing extra conservatism at
the cost of equity shareholders. A financial manager would try to keep the financial
leverage high and the operating leverage low to maximise the earnings per share.
In case, the financial leverage is high, he should try to bring down the financial
leverage gradually. Analysis of leverages is thus very crucial in financial decision
making.
Illustration 12:
The Hardware Company has to make a choice between debt issue for its expansion
programme. Its current position is as follows:
Rs.
Debt 5% 20,000
Equity capital (Rs 10 per share) 50,000
Surpluses 30,000
Total Capitalisation 1,00,000
Sales 300,000
Less: Total Costs 2,69,000
Contd...
 Income before interest and Tax 31,000 167
Leverage Analysis
Less: Interest 31,000
1,000
Income Tax 50 % 30,000
Income after tax 15000
The expansion programme is estimated to cost of Rs. 50000. If this is financed through
debt, the rate of new debt will be 7% and the price earning ratio will be 6 times. If the
expansion programme is financed through equity shares can be sold netting Rs. 25 per
share, and the price earning ratio will be 7 times. The expansion will generate additional
sales of Rs. 150000 with a return of 10% on sales before interest and taxes.
If the company is to follow a policy of maximising the market value of its shares, which
form of financing should it Choose?
Solution:
Determination of Market Value of Shares under
different Financial Plans

Financial Plans
OP or EBIT (Present 31000+ Rs. Rs.
10% of Rs. 150000) 46000 46000
Less: Interest 4500 1000
PBT 41500 45000
Less: Income tax (50%) 20750 22500
PAT 20750 22500
Earning per share (EPS) 20750 22500
5000 7000
= 4.15 = 3.214
Price earning ratio (P/E Ratio) 6 times 7 times
Market Value of a share (EPS x P/E Ratio) 24.90 22.50
The above analysis shows that the market value of the company's share will be higher in
case it chooses the debt alternative. Hence, the company should rise additional funds of
Rs. 50000 through debt.
Illustration 13:
Bhaskar Manufacturer Ltd. has Equity share capital of Rs. 500000 (face value
Rs. 100). To meet the expenditure of an expansion program, the company wishes to
raise Rs. 3,00,000 and is having following four alternative sources to raise the funds:
Plan A : To have full money from the issue of Equity shares.
Plan B : To have Rs. 1,00,000 from Equity and Rs. 2,00,000 from borrowings from
the financial institutions @ 10% per annum.
Plan C : Full money from borrowings @ 10% per annum.
Plan D : Rs. 1,00,000 in Equity and Rs. 2,00,000 from 8% Preference shares.
The company is having present earnings of Rs. 1,50,000. The corporate tax is 50%.
Select a suitable plan out of the above four plans to raise the required funds.
168 Solution:
Capital Budgeting and
Financing Decisions Determination of Suitable Plan for Raising Funds
(Rs. in Lakhs)

EBIT Interest Tax PAT Pref. Profit No. of EPS

50% Div (Net) Shares (Rs.)

Plan A 1.50 - 0.75 0.75 - 0.75 8000 9.38

Plan B 1.50 0.20 0.65 0.65 - 0.65 6000 10.83
Plan C 1.50 0.30 0.60 0.60 - 0.60 5000 12.00
Plan D 1.50 - 0.75 0.75 0.16 0.59 6000 9.83

Return to shareholders in the form of earning per share is highest in Plan C and is
therefore acceptable.
Illustration 14:
A Ltd. has a share capital of Rs. 1,00,000 dividend into share of Rs. 10 each. It has a
major expansion programme requiring an investment of another Rs. 50000. The
management is considering the following alternatives for raising this amount.
i) Issue of 5000 equity shares of Rs. 10 each
ii) Issue of 5000, 12% preference shares of Rs. 10 each
iii) Issue of 10% debentures of Rs. 50000
The company's present earnings before interest and tax (EBIT) are Rs. 40000 per annum
subject to tax @ 50%. You are required to calculate the effect of each of the above
financial plan on the earnings per share presuming.
a) EBIT continues to be the same even after expansion.
b) EBIT increase by Rs. 10000.
Solution:
a) When EBIT is Rs. 40000 per Annum
Projected Earning Per Share

Plan I Plan II Plan III

EBIT Rs. 40,000 Rs. 40,000 Rs. 40,000
(-) Interest - - 5000
Profit before Tax (EBT) 40000 40000 35000
(-) Tax @ 50% 20000 20000 17500
Profit after Tax (EAT) 20000 20000 17500
(-) Pref. Dividend - 6000 -
Profit for Equity 20000 14000 17500
Number of equity shares 15000 10000 10000
EPS (Rs.) 1.33 1.40 1.75
b) When EBIT is expected to increase by Rs. 10000 169
Leverage Analysis
Projected Earning Per Share

Plan I Plan II Plan III

EBIT Rs. 50,000 Rs. 50,000 Rs. 50,000
(-) Interest - - 5000
Profit before Tax (EBT) 50000 50000 45000
(-) Tax @ 50% 25000 25000 22500
Profit after Tax (EAT) 25000 25000 22500
(-) Pref. Dividend - 6000 -
Profit for Equity 25000 19000 22500
Number of equity shares 15000 10000 10000
EPS (Rs.) 1.67 1.90 2.25
So, under both assumptions of EBIT, the EPS would be highest in Plan III.
Illustration 15:
A company needs Rs. 12,00,000 for the installation of a new factory which is expected
to earn an EBIT of Rs. 2,00,000 per annum. The company has the objective of maximizing
the earnings per share. It is considering the possibility of issuing equity shares plus raising
a debt of Rs. 2,00,000 or Rs. 6,00,000 or Rs. 10,00,000. The current market price of the
share is Rs. 40 and will drop to Rs. 25 If the borrowings exceed Rs. 7,50,000. The cost
of borrowing are indicated as under:
Up to Rs. 2,50,000 10%
Rs. 250000 - 625000 14%
Rs. 625000-100000 16%
Assuming the tax rate to be 50%, find out the EPS under different options.
Solution:
Plan I Plan II Plan III
Rs. Rs. Rs.
Total financing 12,00,000 12,00,000 12,00,000
– Debt financing 200000 600000 1000000
Equity Financing 1000000 600000 200000
Issue Price 40 40 25
Number of Shares 25000 15000 8000
Computation of Interest
10% of Rs. 2,00,000 20000 - -
10% of Rs. 2,50,000 - 25000 25000
14% of Rs. 3,50,000 - 49000 -
14% of Rs. 3,75,000 - - 52500
16% of Rs. 3,75,000 - - 60000
Total Interest 20000 74000 137500
Contd...
170
Calculation of EPS:
Capital Budgeting and
Financing Decisions EBIT 2,00,000 2,00,000 2,00,000
Interest 20000 74000 137500
Profit before Tax (EBT) 180000 126000 62500
Tax @ 50% 90000 63000 31250
Profit after Tax (EAT) 90000 63000 31250
Number of Shares 25000 15000 8000
EPS (Rs.) 3.60 4.20 3.91

The EPS is highest (i.e. Rs. 4.20) under the plan II. The borrowings under this plan i.e.
Rs. 600000 is also within limits and the market price would be maintained at Rs. 40.

Check Your Progress

State whether the following statements are true or false:

1. The size of fixed cost has considerable influence over the amount of profits
available for the shareholders.
2. When the volume of sales changes, leverage helps in quantifying such influence.
3. Leverage may be defined as relative change in profits due to a change in
sales.
4. A high degree of leverage implies that there will be a large change in profits
due to a relatively small change in sales and vice versa.
5. The higher the leverage, the higher is the risk and the higher is the expected
return.

8.4 LET US SUM UP

Leverage refers to the commitment of a business firm with regard to fixed operating and
financial charges and its impact on earnings per share available for equity shareholders.
Leverage can be categorized into operating, financial, and combined leverages. Operating
leverage indicates the percentage of change in EBIT as a result of change in sales,
whereas the Financial leverage reflects that the percentage of change in taxable profits
being influenced by the change in earnings before interest and tax. However, the impact
in taxable profits as a result of change in sales shall be reflected by the Combined
Leverage. The financial manager, while determining the capital structure of a firm, should
consider the significance of leverages with a view to attain the business goals.

8.5 LESSON END ACTIVITY

Discuss various types of leverages and the computing procedures.

8.6 KEYWORDS
Financial leverage: The leverage arising from fixed financial charges.
Operating leverage: The leverage arising from fixed Operating costs.
Degree of financial leverage: The percentage change in earnings per share as a result
of one percent change in earnings before interest and taxes.
Degree of operating leverage: The percentage change in earnings before interest and 171

taxes as a result of one percent change in sales. Leverage Analysis

Degree of combined leverage: The percentage change in earnings per share as a

result of one percent change in sales.

8.7 QUESTIONS FOR DISCUSSION

1. Define the concept ‘Leverage’.
2. What are the different types of Leverages?
3. What is the significance of Operating Leverage?
4. Explain the significance of Financial Leverage?
5. What is Combined Leverage?
6. What is ‘Financial Risk’ ?
Essay Type Questions
1. What is Leverage? Explain different kinds of Leverages with appropriate examples.
2. What is the role of a finance manager in deciding capital structure? Illustrate by
using the Operating and Financial Leverages.
3. What is the significance of Operating, Financial, and Composite Leverages?
Practical Problems
1. X Ltd. supplies the following information:
Sales Rs.9,60,000; Variable cost Rs.5,60,000; Fixed costs Rs.2,40,000; Interest on
Debentures Rs.60,000. Assuming tax rate of 50%, calculate
(i) Operating Leverage;
(ii) Financial Leverage; and
(iii) Combined Leverage.
2. Calculate Operating, Financial, and Combined leverages from the following data:
Sales 1,00,000 units @ Rs.2 per unit = Rs.2,00,000
Variable cost per unit @ Re.0.70
Fixed costs Rs.1,00,000
Interest charges Rs.3,668.

Check Your Progress: Model Answers

1. T, 2. T, 3. T, 4. T, 5. T.

8.8 SUGGESTED READINGS

Satyaprasad and P.V.Kulkarni, Financial management, Himalaya Publishing Co., New Delhi 2005.
Prasanna Chandra, Financial Management – Theory & Practice, Tata McGraw-Hill Publishing
Company Limited, New Delhi.
R.P. Rustagi, Financial Management, Theory, Concepts and Problems, Galgotia Publishing
Company, New Delhi.
Soloman, Ezra & Pringle John,J., An Introduction to Financial Management.
Weston, J.Fred & Brigham Eugne F., Managerial Finance.