Leverage
Leverage
Leverage
Unit 6 Leverage
Structure
6.1 Introduction
6.2 Operating Leverage
6.2.1 Application of Operating Leverage
6.3 Financial Leverage
6.3.1 Uses of Financial Leverage
6.4 Combined Leverage
6.4.1 Uses of Combined Leverage
6.5 Summary
Solved Problems
Terminal Questions
Answers to SAQs and TQs
6.1 Introduction
A company uses different sources of financing to fund its activities. These sources can be classified
as those which carry a fixed rate of return and those whose returns vary. The fixed sources of
finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on
the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital
structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or
source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage.
Leverage is the influence of an independent financial variable on a dependent variable. It studies
how the dependent variable responds to a particular change in independent variable.
There are two types of leverage – operating leverage and financial leverage. Leverage
associated with the asset purchase activities is known as operating leverage, while those associated
with financing activities is called as financial leverage.
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Learning Objectives:
After studying this unit, you should be able to understand the following.
1. Explain the meaning of leverage.
2. Mention the different types of leverage.
3. Discuss the advantages of leverage.
6.2 Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firm’s income
flows. A company’s operating costs can be categorized into three main sections:
· Fixed costs are those which do not vary with an increase in production or sales activities for a
particular period of time. These are incurred irrespective of the income and volume of sales and
generally cannot be reduced.
· Variable costs are those which vary in direct proportion to output and sales. An increase or
decrease in production or sales activity will have a direct effect on such types of costs incurred.
· Semivariable costs are those which are partly fixed and partly variable in nature. These costs
are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities.
The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of
changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm
has fixed costs. The percentage change in profits with a change in volume of sales is more than the
percentage change in volume.
Example:
A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses
amount to R. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000
units and 3000 units.
Solution
Sales in units 1000 2000 3000
Sales revenue Rs. 10000 20000 30000
Variable cost 5000 10000 15000
Contribution 5000 10000 15000
Fixed cost 5000 5000 5000
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The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales
results in a more proportionate increase in EBIT and vice versa. The former is a favourable operating
leverage and the latter is unfavourable.
Another way of explaining this phenomenon is examining the effect of the degree of operating
leverage DOL. The DOL is a more precise measurement. It examines the effect of the change in the
quantity produced on EBIT.
DOL=% change in EBIT / % change in output
To put in a different way, (ΔEBIT/EBIT)
(ΔQ/Q)
EBIT is Q(S—V)—F where Q is quantity, S is sales, V is variable cost and F is fixed cost.
Substituting this we get, {Q(S—V)}
{Q(S—V)—F}
Example:
Calculate the DOL of Guptha enterprises.
Quantity produced and sold – 1000 units
Variable cost – Rs. 100 per unit’
Selling price per unit – Rs. 300 per unit
Fixed expenses – Rs. 20000
Solution
DOL={Q(S—V)}
{Q(S—V)—F}
=1000(300—200)
1000(300—200)—20000
=100000/80000
DOL=1.25
If the company does not incur any fixed operating costs, there is no operating leverage.
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Example:
Sales in units 1000
Sales revenue Rs. 10000
Variable cost 5000
Contribution 5000
Fixed cost 0
EBIT 5000
Solution:
DOL={Q(S—V)}
{Q(S—V)—F}
{1000(5000)} / {1000(5000) – 0}
=5000000/5000000
=DOL=1
As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees
of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the
operating risks of the company and hence a higher degree of operating leverage. Higher operating
risks can be taken when income levels of companies are rising and should not be ventured into when
revenues move southwards.
6.2.1 Application of Operating Leverage
Measurement of business risk: Risk refers to the uncertain conditions in which a company
performs. Greater the DOL, more sensitive is the EBIT to a given change in unit sales. A high DOL is
a measure of high business risk and vice versa.
Production planning: A change in production method increases or decreases DOL. A firm can
change its cost structure by mechanizing its operations, thereby reducing its variable costs and
increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only
if the company is confident of achieving a higher amount of sales thereby increasing its earnings.
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6.3 Financial Leverage
Financial leverage as opposed to operating leverage relates to the financing activities of a firm and
measures the effect of EBIT on EPS of the company. A company’s sources of funds fall under two
categories – those which carry a fixed financial charge – debentures, bonds and preference shares
and those which do not carry any fixed charge – equity shares. Debentures and bonds carry a fixed
rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not
contractual obligations, dividend on preference shares is a fixed charge and should be paid off before
equity shareholders are paid any. The equity holders are entitled to only the residual income of the
firm after all prior obligations are met.
Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results
from the presence of fixed financial charges in the company’s income stream. Such expenses have
nothing to do with the firm’s performance and earnings and should be paid off regardless of the
amount of EBIT. It is the firm’s ability to use fixed financial charges to increase the effects of changes
in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to
shareholders. A company earning more by the use of assets funded by fixed sources is said to be
having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning
sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”.
Example:
The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest @ 5% on debentures
worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How
does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken as 40% and number of
outstanding shares as 1000.
Solution:
EBIT 10000 5000 15000
Interest on deb. 1250 1250 1250
EBT 8750 3750 13750
Tax 40% 3500 1500 5500
EAT 5250 2250 8250
Preference div. 1200 1200 1200
Earnings available 4050 1050 7050
to equity holders
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This example shows that the presence of fixed interest source funds leads to a more than
proportional change in EPS. The presence of such fixed sources implies the presence of financial
leverage. This can be expressed in a different way. The degree of financial leverage DFL is a more
precise measurement. It examines the effect of the fixed sources of funds on EPS.
DFL=%change in EPS
%change in EBIT
DFL={ΔEPS/EPS}
{ΔEBIT/EBIT}
Or DFL = EBIT
{EBIT—I—{Dp/(1T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.
Example:
Kusuma Cements Ltd. has an EBIT of Rs. 500000 at 5000 units production and sales. The capital
structure is as follows:
Capital structure Amount Rs.
Paid up capital 500000 equity shares of 5000000
Rs. 10 each
12% Debentures 400000
10% Preference shares of Rs. 100 each 400000
Total 5800000
Corporate tax rate may be taken at 40%
Solution:
EBIT 500000
Less Interest on debentures 48000
EBT 452000
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DFL= EBIT
{EBIT—I—{Dp/(1T)}}
500000
(500000—48000—{40000/(1—0.40)}
DFL=1.30
6.3.1 Use of Financial Leverage
Studying DFL at various levels makes financial decisionmaking on the use of fixed sources of funds
for funding activities easy. One can assess the impact of change in EBIT on EPS.
Like operating leverage, the risks are high at high degrees of financial leverage. High financial costs
are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the
necessary financial commitments. A firm not capable of honouring its financial commitments may be
forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these
circumstances. On the one hand trading on equity improves considerably by the use of borrowed
funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the
business. All these factors should be considered while formulating the firm’s mix of sources of funds.
One main goal of financial planning is devise a capital structure in order to provide a high return to
equity holders. But at the same time, this should not be done with heavy debt financing which drives
the company on to the brink of winding up.
Impact of financial leverage:
Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them
further to fuel their expansion activities. On being forced to continue lending, they may do so with
their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the
market rates or no further mortgage of securities. Financial leverage is considered to be favourable
till such time that the rate of return exceeds the rate of return obtained when no debt is used. This
can be explained with the help of the following example:
Following are the balance sheets of 2 firms A and B
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Balance sheet of A Balance sheet of B
Equity 10000 Assets 10000 Equity 40000 Assets 10000
capita 0 0 capital 0
l
Debt 60000
@
15%
Total 10000 Total 10000 Total 10000 Total 10000
0 0 0 0
Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and
interpret the results thereof.
EBIT
DFL=
{ EBIT - I - { Dp /( 1 - T )}}
4000
Company A = = 1
40000 - 0 - 0
4000
Company B = = 1 . 29
40000 - 9000 - 0
The company not using debt to finance its assets has a higher DFL. Financial leverage does not exist
when there is no fixed charge financing.
6.4 Total or Combined Leverage
The combination of operating and financial leverage is called combined leverage. Operating leverage
affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS. These cause
wide fluctuation in EPS. A company having a high level of operating or financial leverage will find a
drastic change in its EPS even for a small change in sales volume. Companies whose products are
seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more
pronounced. The combined effect is quite significant for the earnings available to ordinary
shareholders. Combined leverage is the product of DOL and DFL.
Q( S - V )
DTL =
Q ( S - V ) - F - I - { Dp /( 1 - T )}
Example:
Calculate the DTL of M/s Pooja Enterprises Ltd. given the following information.
Quantity sold 10000 units
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Variable cost per unit Rs. 100 per unit
Selling price per unit Rs. 500 per unit
Fixed expenses Rs. 1000000
Number of equity shares 100000
Debt Rs. 1000000 @ 20% interest
Preference shares 10000 shares of Rs. 100 each @ 10% dividend
Tax rate 50%
Q( S - V )
DTL =
Q ( S - V ) - F - I - { Dp /( 1 - T )}
DTL=1.54
Cross verification:
{Q ( S - V )}
DOL=
{ Q ( S - V ) - F }
10000( 500 - 100 )
=
10000 ( 500 - 100 ) - 1000000
DOL=1.33
EBIT
DFL=
EBIT - I - { Dp /( 1 - T )}}
3000000
3000000 - 200000 - { 100000 / 0 . 5 }
DFL=1.15
DTL=DOL*DFL
1.33*1.15=1.54
6.4.1 Uses of DTL
DTL measures the total risk of the company as it is a combined measure of both operating and
financial risk. It measures the variability of EPS.
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Self Assessment Questions 1
1. ________________arises due to the presence of fixed operating expenses in the firm’s income
flows.
2. EBIT is calculated as _____________.
3. Higher operating risks can be taken when _____________of companies are rising.
4. Dividend on __________is a fixed charge.
5. Financial leverage is also referred to as ____________.
6.5 Summary
Leverage is the use of influence to attain something else. The advantage a company has with its
current status is used to gain some other benefit. There are three measures of leverage – operating
leverage, financial leverage and total or combined leverage. Operating leverage examines the effect
of change in quantity produced upon EBIT and is useful to measure business risk and production
planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It
also refers to the debtequity mix of a firm. Total leverage is the combination of operating and
financial leverages.
Solved Problems
1. The following information has been collected from the annual report of Garden Silks. What is the
degree of financial leverage?
Total sales Rs. 1400000
Contribution ratio 25%
Fixed expenses Rs. 150000
Outstanding bank loan Rs. 400000 @ 12.5%
Applicable tax rate 40%
Solution: DFL = EBIT / (EBITI) = 200000/20000050000 = 1.33
EBIT = Sales*25% less fixed expenses
1400000*25% = 350000150000 = 200000
2. X and Y have provided the following information. Which firm do you consider risky?
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X Ltd. Y Ltd.
Sales in units 40000 40000
Price per unit 60 60
Variable cost p.u 20 25
Fixed financing Rs. 100000 Rs. 50000
cost
Fixed financing Rs. 300000 Rs.
cost 200000
Solution: DOL = Q(SV) / Q(SV)F
Company X: 40000(6020) / 40000(6020)400000
1600000/1200000 = 1.33
Company Y: 40000(6025) / 40000(6025)250000
1400000/1100000= 1.22
3. Calculate EPS with the following information.
EBIT Rs. 1180000
Interest Rs. 220000
No. of shares outstanding 40000
Tax rate applicable 40%
Solution: EBIT 1180000
Less Int 220000
EBT 960000
Tax 40% 384000
EAT 576000
EPS = EAT/no of shares outstanding
576000/40000 = Rs. 14.4
4. The leverages of three firms are given below. Which one of the combinations should be chosen
for the combined leverage to be maximum and what are the inferences?
A B C
Operating leverage 1.14 1.23 1.33
Financial leverage 1.27 1.3 1.33
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Solution: We should calculate the combined leverage to draw inferences. Combined leverage of
A is 1.14*1.27 = 1.45,
Combined leverage of B is 1.23*1.3 = 1.60,
Combined leverage of C is 1.33*1.33 = 1.77
We find that the combined leverage is highest for firm C and this suggests that this firm is working
under very high risky situation.
Terminal Questions
1. Mishra Ltd. provides the following information. What is the degree of operating leverage?
Output 100000 Units
Fixed costs Rs. 15000
Variable cost per unit Rs. 0.50
Interest on borrowed funds Rs. 10000
Selling price per unit Rs. 1.50
2. X Ltd. provides the following information. What is the degree of financial leverage?
Output 25000 units
Fixed costs Rs. 25000
Variable cost Rs. 2.50 per unit
Interest on borrowed funds Rs. 15000
Selling price Rs. 8 per unit
3. The following information is available in respect of 2 firms. Comment on their relative
performance through leverage
A Ltd. (Rs. In lakhs) B Ltd. (Rs. In lakhs)
Sales 1000 1500
Variable cost 300 600
Fixed cost 250 400
EBIT 450 500
Interest 50 100
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4. ABC Ltd. provides the following information. Calculate the DFL.
Output 200000 units
Fixed costs Rs.3500
Variable cost Rs. 0.05 per unit
Interest on borrowed funds Nil
Selling price per unit 0.20
Answers to Self Assessment Questions
Self Assessment Questions 1
1. Operating leverage
2. Q(S—V)—F
3. Income levels
4. Preference shares
5. Trading on Equity
Answers to Terminal Questions:
{Q ( S - V )}
1. Hint DOL =
{ Q ( S - V ) - F }
EBIT
2. Hint DFL =
{ EBIT - I - { Dp /( 1 - T )}}
3. Hint calculate DFL
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