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Leverage: Team Anuradha Kumar Akanksha Birmole Sumit Das

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This document discusses leverage and its types, and how it impacts risk and return for a firm. It defines leverage as using assets or funds that require fixed costs. There are two types: operating and financial. Operating leverage depends on fixed operating costs and impacts business risk. Financial leverage uses debt financing and impacts financial risk. The degree of operating leverage (DOL) and degree of financial leverage (DFL) measure the sensitivity of earnings to changes in sales and operating income. Total leverage is the combined effect and represents maximum risk. Examples are provided to demonstrate calculating DOL, DFL, and total leverage.

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Leverage: Team Anuradha Kumar Akanksha Birmole Sumit Das

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anu2789
41 views21 pages
This document discusses leverage and its types, and how it impacts risk and return for a firm. It defines leverage as using assets or funds that require fixed costs. There are two types: operating and financial. Operating leverage depends on fixed operating costs and impacts business risk. Financial leverage uses debt financing and impacts financial risk. The degree of operating leverage (DOL) and degree of financial leverage (DFL) measure the sensitivity of earnings to changes in sales and operating income. Total leverage is the combined effect and represents maximum risk. Examples are provided to demonstrate calculating DOL, DFL, and total leverage.

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Leverage

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This document discusses leverage and its types, and how it impacts risk and return for a firm. It defines leverage as using assets or funds that require fixed costs. There are two types: operating and financial. Operating leverage depends on fixed operating costs and impacts business risk. Financial leverage uses debt financing and impacts financial risk. The degree of operating leverage (DOL) and degree of financial leverage (DFL) measure the sensitivity of earnings to changes in sales and operating income. Total leverage is the combined effect and represents maximum risk. Examples are provided to demonstrate calculating DOL, DFL, and total leverage.

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Download as PPT, PDF, TXT or read online from Scribd
Download as ppt, pdf, or txt
41 views21 pages

Leverage: Team Anuradha Kumar Akanksha Birmole Sumit Das

Uploaded by

anu2789
This document discusses leverage and its types, and how it impacts risk and return for a firm. It defines leverage as using assets or funds that require fixed costs. There are two types: operating and financial. Operating leverage depends on fixed operating costs and impacts business risk. Financial leverage uses debt financing and impacts financial risk. The degree of operating leverage (DOL) and degree of financial leverage (DFL) measure the sensitivity of earnings to changes in sales and operating income. Total leverage is the combined effect and represents maximum risk. Examples are provided to demonstrate calculating DOL, DFL, and total leverage.

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LEVERAGE

TEAM Anuradha Kumar Akanksha Birmole Sumit Das

Introduction
Leverage provides the Framework for Financing Dcisions of a Firm. It May Be dfined as the Employment of an Assest or Source of Funds for which the Firm has to pay a Fixed Cost , or Fixed Return. Deleveraging is the action of reducing borrowings. A key measure of leverage is the debt to GDP ratio.

Types of Leverage
Operating Financial

Break-Even (BE) Point


Quantity where Total Revenue equals Total Cost Company has no Profit or Loss BE = FC / P VC A leveraged firm has a high BE point A non-leveraged firm has a low BE point

Risk in the Context of Leverage


Leverage influences stock price Alters the risk/return relationship in an equity investment Measures of performance Operating income (EBIT or Earnings Before Interest and Taxes)
Unaffected by leverage because it is calculated prior to the deduction for interest

Return on Equity (ROE) is Earnings after Taxes Stockholders Equity Earnings per Share (EPS) is Earnings after Taxes number of shares
Investors regard EPS as an important indicator of future profitability

Risk in the Context of Leverage


Redefining Risk for Leverage-Related Issues Leverage-related risk is variation in ROE and EPS: 1. Business riskvariation in EBIT 2. Financial riskadditional variation in ROE and EPS brought about by financial leverage. An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point) A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)

Business and Financial Risk

Operating Leverage
It is associated with asset acquisition or investment activities. It may be defined as the ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits(EBIT). Refers to the amount of fixed costs in the cost structure. Fixed and Variable Costs and Cost Structure. Fixed costs dont change with the level of sales, while variable costs do Fixed costs include rent, depreciation, utilities, salaries Variable costs include direct labor, direct materials, sales commissions The mix of fixed and variable costs in a firms operations is its cost structure

The Effect of Operating Leverage


As volume moves away from Breakeven(Used to determine the level of activity a firm must achieve to stay in business in the long run), profit or loss increases faster with more operating leverage The Risk Effect More operating leverage leads to larger variations in EBIT, or business risk The Effect on Expected EBIT Thus, when a firm is operating above breakeven, more operating leverage implies higher operating profit If a firm is relatively sure of its operating level, it is in the firms best interests to trade variable costs for fixed cost (assuming the firm is operating above breakeven)
a in Sales a larger in EBIT (or OI)

Breakeven Diagram at High and Low Operating Leverage

The Degree of Operating Leverage (DOL)A Measurement


Operating leverage amplifies changes in sales volume into larger changes in EBIT DOL relates relative changes in volume (Q) to relative changes in EBIT.

DOL = %change in EBT

%change in Sales EBIT

DOL = Sales Variable Costs

example
A company is perfectly selling 5000 units of a product @ Rs 20 per unit. If variable cost is Rs 6 per unit & fixed operational cost are Rs 80000. Find DOL sol :- sales = 20*5000 = 100000 VC = 30000 contribution = 70000 (-) FC = 80000 EBIT = 10000 therefore, DOL = 70000/10000 = 7%

Financial Leverage
Measure of the amount of debt used by a firm. a in EBIT (or OI) a larger in EPS. Financial Leverage measures the sensitivity of a firms earnings per share to a in operating income. Used as a means of increasing the return to common shareholders. Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS The degree of financial leverage (DFL) relates relative changes in EBIT to relative changes in EPS. An easier method of calculating DFL is:-

EBIT DFL = EBIT - Interest

Degree of Financial Leverage (DFL)


Degree of Financial Leverage -- The percentage change
in a firms earnings per share (EPS) resulting from a 1 percent change in operating profit.
Percentage change in earnings per share (EPS)

DFL

Percentage change in operating profit (EBIT)

% EPS DFL = or % EPS = DFL % EBIT % EBIT

Financial Risk
Financial Risk -- The added variability in earnings per
share (EPS) -- plus the risk of possible insolvency -- that is induced by the use of financial leverage. Debt increases the probability of cash insolvency over an all-equity-financed firm.

Total Firm Risk


Total Firm Risk -- The variability in earnings per share (EPS). It is the sum of business plus financial risk.
Represents maximum use of leverage Degree of Combined or Total Leverage (DCL or DTL) = %age in EPS / %age in Sales a in Sales a larger in EPS Short-cut formula:

The Compounding Effect of Operating Leverage and Financial Leverage

example
Ques :- a companys EBIT= 10000 & it has 5% bonds for Rs 40000 & preference shares = 20000. Calculate DFL Sol:- EBIT = 10000 (-) Interest = 2000 EBT = 8000 Therefore DFL = 10000/8000 = 1.25

Example
Ques :-A co. having a total capital of Rs 10 lacs with 60% as bonds @10% as equity. The expected sales of firm = 20000 units @20 per unit, VC = 10 per period, fixed operational cost = Rs 50000, calcualte DOL, DFL & DCL Sol:- Sales = 400000 VC = 200000 Contri = 200000 (-) FC = 50000

Example contd....
EBIT = 150000 (-) Int =60000 EBT = 90000 Therefore, DOL = 200000/150000 = 1.33 DFL = 150000/90000 = 1.67 DCl = DFL*DOL = 2.22

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