Leverages

Leverages
Definition
Leverage is a technique named after a lever in physics, which amplifies a small input force into a greater
output force.
Successful leverage amplifies the smaller amounts of money needed for borrowing into large amounts of
profit.
Leverage is the use of fixed costs in a company’s cost structure.
Measures of Leverage
There are three measures of leverage:
 Operating Leverage
 Financial Leverage
 Combined/Total Leverage
Fixed costs that are operating costs (such as depreciation or rent, insurance, property tax, etc.) create
operating leverage.
Fixed costs that are financial costs (such as interest expense) create financial leverage.
EBIT= [(Q x S) – (Q x V) – F] = Q (S – V) – F
EPS= [(EBIT – I) (1 – T) – Dp] / N
= [Q(S - V) - F - I] (1- t) – Dp / N
N= No. of Equity Shareholders
This forms the base for the measurement of the different leverages.
Operating Leverage
O.L. arises from the existence of fixed operating expenses.
When a firm has operating expenses, 1% change in sales leads to more than 1% change in EBIT.
Example 1: Consider a firm selling a product at Rs. 1000 per unit. Its variable costs are Rs.500 per unit and
its fixed operating costs are Rs.200,000. The PBIT at two level of sales viz., 500 units and 600 units will
be?
Sales 500 units 600 units
Revenues 500,000 600,000 (20% increase)

Variable Operating costs 250,000 300,000
Fixed Operating costs 200,000 200,000
PBIT 50,000 100,000 (100% increase)
Degree of Operating Leverage

Fixed Operating costs magnify the impact in the inverse direction as well. e.g. 20% decline in sales (from
500,000 to 400,000) will lead to 100% fall in PBIT.
Operating leverage examines the effect of the change in the quantity produced on the EBIT of the company
and is measured by calculating the Degree of Operating Leverage (DOL).
The sensitivity of profit before interest and taxes to change in sales is DOL.
DOL= %Δ in EBIT/ %Δ in Output
DOL= ΔEBIT/EBIT / ΔQ/Q
Relation between Quantity Produced & DOL
From Eq. EBIT = Q(S – V) – F
Substituting for EBIT, we get
DOL = [Q(S – V)] / [Q(S – V) – F]
DOL= ΔEBIT/EBIT / ΔQ/Q
Or (DOL * ΔQ)/ΔEBIT = Q/EBIT
DOL= Q (S-V)/Q (S-V)-F [Refer to the word doc.]
Operating Breakeven Point & Business Planning
Q. Quantity produced=5,000, VC/unit=Rs. 200, SP/unit= Rs. 500, Fixed Cost= Rs. 900,000. Calculate DOL
for ABC Ltd.?
DOL= Q (S-V)/Q (S-V)-F
= 5,000 (500-200)/5,000 (500-200) -900,000
= 5,000*300/ (5,000*300)- 900,000
= 1500,000/ 600,000
= 2.5
Q.Calculate DOL if Quantity produced is 1000, 2000, 3000 and 4000 units?
Quantity Produced DOL
1000 0.5
2000 2.0
3000 Undefined
4000 4.0
5000 2.5
When the value of Q is 3000 the EBIT of the company is zero and this is the operating break-even point.
Break even quantity = F/S-V, S-V= Contribution
The operating breakeven point determines the level of sales expressed in units of production, at which the
company's revenues are equal to its operating costs so the operating profit is equal to 0.
DOL helps in measuring business risk and in production planning as greater the DOL, more sensitive is
EBIT to a given change in unit sales, i.e. the greater is the risk of exceptional losses if sales become
depressed.
Financial Leverage
Leverage is the use of debt or borrowed capital in order to undertake an investment or project. When one
refers to a company as "highly leveraged," it means that the company has more debt than equity. A firm
may borrow capital through issuing fixed-income securities or directly from a lender. Also known as
leverage or trading on equity.
The measure of financial leverage is the Degree of Financial Leverage (DFL)
Degree of Financial Leverage
DFL = (percentage Δ in EPS)/ (percentage Δ in EBIT)
DFL = (Δ EPS/EPS)/(Δ EBIT/EBIT)
Substituting EPS with [(EBIT – I)(1 – T) – Dp]/N
DFL = EBIT / {EBIT - I - [ Dp / 1 – T]}
Relation between Quantity Produced & DFL

Q ABC Ltd., has an EBIT of Rs.6,00,000 at 5,000 level of production, the capital structure of the company
is as follows:
Capital Structure Amount (Rs.)
Authorized Issued and Paid-up Capital
500,000 Equity Shares @ Rs.10 each 50,00,000
15% Debentures 500,000
10% Preference Shares
5000 Preference Shares @ Rs.100 500,000
Total 60,00,000
EBIT = 600,000
Interest on Debt. = (75,000)
Pref. Dividend = (50,000)
Corporate Tax = 50%
DFL = EBIT / [ EBIT - I - Dp/1 – T]
= 600,000/ 600,000-75,000-50,000/1-0.5
= 1.41
Financial Breakeven Point & Financial Planning

Consider the case of ABC Ltd. and measure DFL for varying levels of EBIT i.e. at 50,000, 100,000,
175,000, 600,000, 700,000 and 750,000?
The DFL at EBIT level of 175000 is undefined and this point is the Financial Break-even Point.
Financial Break-even Point can be defined as: EBIT = I + Dp/(1 – T)
EBIT DFL
50,000 *0.40
100,000 1.33
175,000 ∞
600,000 1.41
700,000 1.33
750,000 1.30
Financial Leverage and Risk

If increased financial leverage leads to increased return on equity, why companies do not resort to ever
increasing amounts of debt financing and why insist on norms for Debt-Equity?
The reason is that as the company becomes more financially leveraged, it becomes riskier, i.e., increased
use of debt financing will lead to increased financial risk which leads to:
Increased fluctuations in the return on equity.
Increase in the interest rate on debts.
Total/Combined Leverage
A combination of the operating and financial leverages is called total leverage.
Thus, the degree of total leverage (DTL) is the measure of the output and EPS of the company. DTL is the
product of DOL and DFL and can be calculated as follows:
DTL = % change in EPS / % change in output
DTL = (ΔEPS/EPS)/(ΔQ/Q)
DTL = DOL x DFL
= {[Q(S – V)]/[Q(S – V) – F]} X {[Q(S – V) – F]/Q(S – V) – F – I – [Dp/1 – T)]}
= Q (S-V) /Q (S-V)- F -I- Dp/(1-T)
Q Calculating the DTL for ABC Ltd. given the following information:
Equity Earnings = Rs.1,62,500
Quantity Produced (Q) = 5000 Units
Variable Cost per unit (V) = Rs.200
Selling Price per unit (S) = Rs.500
Number of Equity Shareholders (N) 5,00,000
Fixed Expenses (F) = Rs.9,00,000
Interest (I) = Rs.75,000
Preference Dividend (Dp) = Rs.50,000
Corporate Tax (T) = 50%
Ans. DTL=3.53, Thus, when the output is 5,000 units, a one percent change in Q will result in 3.5% change
in EPS.
DTL and Overall break-even point

Q = [ F+I+[Dp /(1-T)]]/ (S-V)
Q. calculate the overall break-even point for the various levels of Q, given the following information: F =
Rs.8,00,000, I = Rs.80,000, Dp = Rs.60,000, S = Rs.1,000, V = Rs.600.
Break even quantity = 2,500.
Q. Calculating DTL for various levels of output:1000,2000,3000,3500?
Q DTL
1000 -0.67
2000 –4.00
2500 ∞
3000 6
5000 2
Indifference Point
Indifference point is the point where the total cost of the two alternatives is equal. It can also be defined as
the EBIT level above which the benefits of leverage operate in relation to earnings per share.
(EBIT - I) (1-T) - Pd = (EBIT - I) (1-T) - Pd
N1 N2

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Sales 500 units 600 units

Revenues 500,000 600,000 (20% increase)

Fixed Operating costs 200,000 200,000

PBIT 50,000 100,000 (100% increase)

Degree of Operating Leverage

Quantity Produced DOL

Relation between Quantity Produced & DFL

Capital Structure Amount (Rs.)

Authorized Issued and Paid-up Capital

500,000 Equity Shares @ Rs.10 each 50,00,000

15% Debentures 500,000

10% Preference Shares

5000 Preference Shares @ Rs.100 500,000

Financial Breakeven Point & Financial Planning

Financial Leverage and Risk

DTL and Overall break-even point

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