Dr.

Lakhwinder Kaur Dhillon

 What is Leverage?
Leverage reflects the responsiveness or influence of one
financial variable over some other financial variable.

% Change in dependent variable

Degree of Leverage =
% Change in independent variable

*The two variables, for which the relationship is to be established

and measured, should be interrelated, otherwise, the leverage study
may not have any useful purpose
 In Finance, leverage refers to the use of fixed costs to magnify the
potential return to a firm

Fixed Cost

Fixed Fixed Financial

Operating Cost Cost

Fixed Operating costs e.g.- rent, depreciation

Fixed Financial costs e.g.- interest costs on long term debt
(Debentures) ; Preference Dividend
 Position of Fixed Cost in the Income Statement
Sales Revenues (S) EBIT

- Variable Cost (V) - Interest

Contribution (EBT) Earnings Before Tax
- Fixed Cost (F) - Tax
EBIT (EAT) Earnings After Tax

- Preference Dividend
Earnings available for equity
shareholders
EPS = Earnings available for
equity shareholders
No. of Shares
 Classification of Leverage

Operating Financial Combined

Leverage Leverage Leverage

Sales & EBIT EBIT & EPS Sales & EPS

Contribution/EBI Contribution/E
EBIT/EBT
T BT
 Remember
✓ When Sales level increases or decreases,
the EBIT also changes. Sales
✓ Change in EBIT impacts the EPS
accordingly
✓ The “Operating Leverage” measures the EBIT
relationship between the sales revenue
and the EBIT.
✓ The “Financial Leverage” measures the
relationship between EBIT and EPS
EPS
Calculate Operating Leverage from the following data-

Particulars Base Level New Level

1. Units sold 1,000 1,100
2. Sales price per unit Rs 10 Rs 10
3. Variable cost per unit 6 6
4. Fixed operating cost Nil Nil
Solution

EBIT for Various Sales Volume

Particulars Base Level New Level

Sales revenues Rs 10,000 Rs 11,000

Less: Variable costs (6,000) (6,600)

Less: Fixed costs — —

EBIT 4,000 4,400

DOL = ( 400 / 4000 ) x ( 10,000 / 1,000 ) = 1

There is no operating leverage.

•Operating leverage exists only when there are fixed
operating costs.

•If there are no fixed operating costs, there will be no

operating leverage.
Conclusion;

Analysis of operating leverage of a firm is very useful to the financial manager.

It tells the impact of change in sales on the level of operating profits of the firm.

A firm with high DOL can experience a magnified effect on EBIT for even a
small change in sales Level.

Higher DOL can dramatically increase the operating profit.

But if sales decline ????????

Therefore the firms should always try to avoid operating under high DOL
as high DOL Condition is a high-risk situation.
Degree of Operating Leverage reflects the responsiveness or
influence of Change in Sale on Change in EBIT

% Change in EBIT
Degree of Leverage =
% Change in Sales

Calculation of Operating Leverage can be done

by using the following Formula:

Operating Leverage = Contribution ÷ EBIT

11
Illustration

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 @ 10% rate of Interest.

i. Calculate Operating Leverage.

ii. What will be increase in the EBIT if Sales are
increased by 20%
iii. If the firm wants to double its earnings before
Interest and tax, how much of a rise in sales
would be needed on a percentage basis?

12
Financial Leverage
•The Financial Leverage measures the
relationship between the EBIT and the EPS.

•It reflects the effect of a change in EBIT on

the level of EPS.

• It results from the presence of fixed financial

charges (such as interest on debt and
dividend on preference shares).
Sales Revenues (S) EBIT

- Variable Cost (V) - Interest

Contribution (PBT) Profit Before Tax

- Fixed Cost (F) - Tax

EBIT (PAT) Profit After Tax

- Preference Dividend
Earnings available for equity
shareholders
EPS = Earnings available for
equity shareholders
No. of Shares
•Financial leverage is related to the
financing activities of a firm.

•Since such financial expenses do not vary

with the operating profits, financial leverage
is concerned with the effect of changes in
EBIT on the earnings available to equity-
holders.

•It is defined as the ability of a firm to use

fixed financial charges to magnify the effect
of changes in EBIT on the earnings per
share (EPS).
✓ Financial leverage exists only when
there are fixed Financial costs (e.g.
Interest on Debentures, Preference
Dividend) .
✓ If there are no fixed Financial costs,
there will be no Financial leverage.
Illustration.
ABC company has currently an all equity capital structure
consisting of 15000 equity shares of Rs.100 each. The
management is planning To raise another 25 lakhs to
finance a major Programme of expansion And is
considering three alternative method of financing:

i. To issue 25000 equity shares of Rs.100 each.

ii. To issue 25000, 8% debenture of Rs.100 each
iii. To issue 25000, 8% preference share of Rs.100 each.

The company’s expected earnings before interest and taxes

will be Rs.8 Lakhs. Corporate tax rate is 50%. Analysis the
options and suggest the Best alternative with reasons.

17
Leverage Means Risk
✓Leverage is a double-edged
sword
✓It magnifies profits as well as
losses
✓An aggressive or highly
leveraged firm has a relatively
high break-even point (and high
fixed costs)
✓A conservative or non-
leveraged firm has a relatively
low break-even point (and low
fixed costs)
Sales (total revenue) (80,000 units @ $2) $160,000
— Fixed costs 60,000 Operating
— Variable costs ($0.80 per unit) 64,000 leverage
Operating income $ 36,000
Earnings before interest and taxes $ 36,000
— Interest 12,000
Earnings before taxes 24,000
— Taxes 12,000 Financial
leverage
Earnings after taxes $ 12,000
Shares 8,000
Earnings per share $1.50
Master Table to Calculate the Leverage
Sales
Less: Variable Cost
Contribution
Less: Fixed Cost
Operating Profit or EBIT
Less: Interest
Earning before Tax (EBT)
Less: Tax
Earning after Tax
Less: Preference Dividend
Earning Available to Equity Shareholder
Q1.Calculate the degree of operating leverage, degree of financial leverage &
degree of
Combined leverage from the following information.
Firm 1 Firm 2 Firm 3
Units 60000 15000 100000
Selling Price $.60 $5 $.10
Variable cost $.20 $1.50 $.02
Fixed cost $7000 $14000 $1500
Interest on borrowings$4000 $8000 -

Q2.The following information for the year ending 31st March 2011 is
available
Interest on Debt $400000
Preference Dividend $200000
Corporate Taxes 40%
Calculate the degree of financial Leverage if
i. EBIT is $1000000 and
ii. EBIT is $1500000
Q3.Consider the following figures:
Net Sales are Rs.16 Crores
EBIT as a percentage of sales is 10%
Corporate tax rate is 40%
Capital employed :
Equity shares @ of Rs.10 each is Rs 4 Crores
10% preference share @ of Rs 100 each Rs 3 Crores
12% secured debenture @ of Rs 100 each Rs. 2 Crores
You are required to calculate EPS & percentage change in EPS if EBIT
increases by 10%
Q4. Consider the following information of Pearson Ltd.
Selling price per unit Rs.200
Variable cost per unit Rs.120
Fixed Cost Rs.2000000
Interest on Debt Rs.1200000
Preference Dividend Rs.800000
Tax rate 40%
No of units produce 120000 Calculate the combine leverage &
percentage change in EPS if sales are increased by 5%
Q5. ZOOP Ltd had the following Balance Sheet for the year ended 31st March 2011

Liabilities Assets

Equity Capital (@Rs.10each) 1000000 Fixed Asset (net) 2500000

Reserve and Surplus 200000 Current Assets 1500000
15% debenture 2000000
Current Liabilities 800000

4000000 4000000
Additional information
Fixed cost (excluding interest payment) Rs.800000
Variable operating cost ratio 80%
Total Asset turnover ratio 3
Income tax 50%

You are required to calculate i. EPS ii. OL iii. FL iv. Combined leverage.
Q6. The following are the operating result of a firm:
Sales (units) 25000
Interest p.a. Rs.30000
Selling price unit Rs.24
Tax Rate50%
Variable cost Rs.16 per unit
No. of equity shares 10000
Fixed Cost p.a. Rs.80000
Compute the followings:
i. Break even sales
ii. EBIT
iii. EPS
iv. Operating Leverage
v. Financial Leverage
vi. Combined Leverage.
Q7. The following details of ABC ltd is available as on 31st March 2011. you are
require to prepare the Income Statement of the company.

Operating leverage 3
Financial leverage 2
Interest charge p.a. Rs.20 Lakhs
Taxes 50%
Variable cost as a percentage of sales is 60%

Q8. You are a finance manager of Gel pen Ltd. The degree of operating leverage of
Your company is 5. The degree of financial leverage is 3. Director of your company
Has found that the degree of operating leverage & degree of financial leverage of your
Nearest competitor INK pen Ltd are 6 & 4 respectively. In his opinion the Ink pen ltd
Is better than that of Gel pen ltd. because of high value of degree of leverages.
Do you agree to your managing Director? Justify.
Q9.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 variable cost is Rs. 9 per unit. Calculate
the Degree of operating leverage for sales volume of 2500 units and 3000 units.

Q10. The
. capital structure of a company consists of ordinary share capital of
Rs10,00,000 (shares of Rs 100 each) and Rs 10,00,000 of 10% debenture.
The selling price is Rs 10 per unit; Variable costs amount to Rs 6 per unit and fixed
Expenses amounted to Rs 2,00,000. The income tax is assumed to be 50%. The sales
Level are expected to increase from 1,00,000 units to 1,20,000 units.
You are required to calculate the degree of operating, financial leverage

Q11. A firm’s sales, variable costs and fixed cost amount to Rs 75,00,000, Rs 42,00,000
And Rs 6,00,000 respectively. It has borrowed Rs. 45,00000 at 9% and its equity capital
Totals Rs 55,00,000.
What is firms ROI?
Does it have favorable financial leverage
Calculate operating, financial & combined leverage.
If the sales drop to Rs. 50,00,000, what will be the new EBIT?
 Q12. Following is the Balance sheet of Z ltd

Liabilities Amount Assets Amount

Equity Share Capital 60000 Fixed Asset 150,000
Retaining Earnings 20000 Current Assets 50000
10% long term debts 80000
Current Liabilities 40000

The company’s total Asset turnover ratio is 4, its fixed operating costs are Rs 1,00,000
And its variable operating cost is 40%. The income tax is 50%. Calculate the financial
Leverage when face value of the share is Rs 10. also calculate the operating leverage.
Q13. Installed Capacity is 20,000 units, Actual Production and sales is 75% of installed
Capacity, selling price per unit Rs 10, Fixed cost Rs 30,000, Total operating cost 80%.
Calculate operating leverage

Q14. Calculate operating leverage, Financial Leverage & combine leverage under
Situation 1 & 2 and financial plan A & B
Installed capacity 2000 units
Annual production and sales 50% of installed capacity
Selling price per unit is Rs20: Variable cost per unit Rs.10
Fixed Cost: Situation 1 is 4000 & for Situation 2 is 5000
Capital Structure for Plan A is Equity Rs 5000 & Debt (cost 10%) is Rs.15000
for Plan B is Equity Rs.15000 & Debt (cost 10%) is Rs.5000
Q15. 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 @ 10% rate of Interest. What are the operating
Financial, and combined leverage? If the firm wants to double its earnings before
Interest and tax, how much of a rise in sales would be needed on a percentage basis?