Leverage

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Leverage is, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.
Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the
effects of changes in sales on its earnings before interest and taxes.

Operating Leverage(Operating Risk)

Operating Leverage= (Sales Revenue- Variable Cost)/ (Sales Revenue- Variable Cost-Fixed Cost)
Operating Leverage=Contribution/EBIT
Operating Leverage=percentage change in EBIT/ percentage change in Sales Revenue
Companies with high fixed costs tend to have high operating leverage
1. From the following selected operating data, determine the degree of operating leverage. Which company
has the greater amount of business risk? Why?

Variable expenses as a percentage of sales are 50% for company A and 25% for company B.

2. Firm X and Firm Y manufacture the same product and their cost sheets are given below: (Rs. /unit)
Units manufactured and sold Firm X Firm Y
20000 20000
Contribution 10 10
Selling Price 30 30
Fixed Costs 100000 150000
Compute the Operating leverage.

3. Calculate operating leverage for each of the four firms A, B, C and D from the following price and cost
data. What conclusions do you draw with respect to levels of fixed cost and degree of operating
leverage? Assume number of units sold is 5000.
 A B C D
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 80000 40000 200000 Nil

4. A firm sells products for Rs.100 per unit, has operating costs at Rs.50 per unit and fixed operating cost
at Rs.50000 per year. Show the various levels of EBIT that would result from sales of (i) 1000 units, (ii)
2000 units and (iii) 3000 units.

5. A firm sells its products for Rs 50 per unit, has variable operating costs of Rs 30 per unit and fixed
operating costs of Rs 5,000 per year. Its current level of sales is 300 units. Determine the degree of
operating leverage. What will happen to EBIT if sales change: (a) rise to 350 units, and (b) decrease to
250 units?
Financial Leverage
Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT)
or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability
of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It
involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.
Financial Leverage= EBIT/EBT or ESH= EBIT/[EBIT-I-{Dp/(1-t)}]
Post Tax Kd= Pre tax Kd*(1-t)
Financial Leverage= percentage change in EPS/ percentage change in EBIT
6. A company has Rs 1,00,000, 10% debentures and 5,000 equity shares outstanding. It is in the 35 per
cent tax-bracket. Assuming three levels of EBIT (i) Rs 50,000, (ii) Rs 30,000, and (iii) Rs 70,000,
calculate the impact of change in EBIT on change in EPS (base level of EBIT = Rs 50,000).

7. The financial manager of the Hypothetical Ltd expects that its earnings before interest and taxes (EBIT)
in the current year would amount to Rs 10,000. The firm has 5 per cent bonds aggregating Rs 40,000,
while the 10 per cent preference shares amount to Rs 20,000. What would be the earnings per share
(EPS)? Assuming the EBIT being (i) Rs 6,000, and (ii) Rs 14,000, how would the EPS be affected? The
firm can be assumed to be in the 35 per cent tax bracket. The number of outstanding ordinary shares is
1,000.

8. No Financial Leverage Effect(Solved)

9. The following information is available for Crompton Ltd. for the year ended 31st March
Interest on Debt : Rs.400000
Preference dividend : Rs.200000
Corporate Tax rate : 40%
Calculate the Financial Leverage if EBIT is Rs.1000000

10. Consider the information available for Greaves Ltd.

Net Sales Rs.16 crores
EBIT as a percentage of Sales 10%
Corporate tax rate 40%
Capital employed:
Equity share capital (Rs.10 each) Rs.4 crores
10% Preference share capital of Rs.100 each Rs.3 crores
12% Secured debentures Rs.2 crores
You are required to calculate
a) EPS and Financial Leverage of Greaves Ltd.

b) The percentage change in EPS if EBIT increases by 10%.

11. The operating results of a firm are as follows:

Sales (units) 25000
Interest per annum Rs.30000
Selling price per unit Rs.24
Tax rate 50%
Variable cost per unit Rs.16
No. of equity shares 10000
Fixed costs per annum Rs.80000
Compute: Breakeven sales, EBIT, EPS, Operating and Financial leverage.
As operating leverage increases, more sales are needed to cover the increased fixed costs. · High levels of
fixed costs increase business risk. High operating leverage businesses will need to maintain high sales to
cover their fixed costs.
 Combined Leverage: Total Risk
The operating leverage has its effects on operating risk and is measured by the percentage change in EBIT
due to percentage change in sales. The financial leverage has its effects on financial risk and is measured by
the percentage change in EPS due to percentage change in EBIT. If a firm has both the leverages at a high
level, it will be very risky proposition. Therefore, if a firm has a high degree of operating leverage the
financial leverage should be kept low as proper balancing between the two leverages is essential in order to
keep the risk profile within a reasonable limit and maximum return to shareholders.

DCL = DOL * DFL

DCL= Contribution/[(EAT-Dp]/(1-t)
DCL measures the percentage change in EPS due to percentage change in sales. If the degree of operating
leverage of a firm is 6 and its financial leverage is 2.5, the combined leverage of this firm would be 15(6 x 2.5).
That is, 1 per cent change in sales would bring about 15 per cent change in EPS in the direction of the change in
sales. The combined leverage can work in either direction. It will be favourable if sales increase and
unfavourable when sales decrease because changes in sales will result in more than proportionate returns in the
form of EPS.

The usefulness of DCL lies in the fact that it indicates the effect that sales changes will have on EPS. Its
potential is also great in the area of choosing financial plans for new investments.

If, for example, a firm begins to invest heavily in more risky assets than usual, the operating leverage will
obviously increase. If it does not change its financing policy, that is, the capital structure remains constant, there
would be no change in its financial leverage. As a result, the combined leverages would increase causing an
increase in its total risk. The firm, in order to keep its risk constant, may like to lower its financial leverage.
This could be done if the new investments are financed with more equity than the firm has used in the past. This
would lower the financial leverage and compensate for the increased operating leverage caused by investment
in more risky investments.

If the operating leverage has decreased due to low fixed costs, the firm can afford to have a more levered
financial plan to keep the total risk constant at the same time having the same prospects of magnifying effects
on EPS due to change in sales
● A combination of high operating leverage and a low financial leverage indicates that the management
should be careful as the high risk involved in the former is balanced by the later.
● A combination of low operating leverage and a high financial leverage gives a better situation for
maximising return and minimising risk factor, because keeping the operating leverage at low rate full
advantage of debt financing can be taken to maximise return. In this situation the firm reaches its BEP at
a low level of sales with minimum business risk.
● A combination of low operating leverage and low financial leverage indicates that the firm losses
profitable opportunities

12. The following figures relate to two companies: Rs. lakhs

P Ltd. Q Ltd.
Sales 500 1000
Variable costs 200 300
Fixed costs 150 400
Interest 50 100
Calculate: Operating, Financial and Combined leverage, comment on the risk position of the two firms.

13. The Balance sheet of Alpha Numeric company is given below:

Liabilities Assets
Equity capital @Rs.10 each 90000 Fixed assets net 225000
10% long term debt 120000 Current assets 75000
Reserves and Surplus 30000
Current liabilities 60000
300000 300000
The company’s sales turnover ratio is 3, its fixed operating cost is Rs.150000 and its variable operating
cost ratio is 50%. The income tax rate is 50%.
Compute: Leverages and determine the likely level of EBIT if EPS is Rs.2

14. A firm’s sales, variable costs and fixed cost amount to Rs.7500000, Rs.4200000 and Rs.6,00,000
respectively. It has borrowed Rs.45,00,000 @ 9% and its equity capital totals to Rs.55,00,000.
a) What is the firm’s ROI?
b) Does it have a favourable financial leverage?

c) If the firm belongs to an industry whose asset turnover is 3, does it have high or low asset
leverage?
d) What are the operating, financial and combined leverage of the firm?
e) If sales drop to Rs.50,00,000, what will the new EBIT be?
f) At what level will the EBT of the firm equal to zero?
 i.
15. The ABC Ltd. has the following balance sheet and income statement information:
Balance Sheet as on March 31
Liabilities Rs. Assets Rs.
Equity Capital (Rs.10 per share) 800000 Net fixed assets 1000000
10% Debt 600000 Current assets 900000
Retained earnings 350000
Current liabilities 150000
1900000 1900000
Income Statement for the year ended March 31
Sales 340000
Operating expenses (including Depreciation Rs.60000) 120000
EBIT 220000
Less: Interest 60000
Earnings before tax 160000
Less: Taxes 56000
Net earnings (EAT) 104000
(i) Determine the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses except depreciation are variable costs?

(ii) If total assets remain at the same level, but sales (i) increase by 20 per cent and (ii) decrease by 20
per cent, what will be the earnings per share in the new situation?

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