Leverage: Prepared By: Cacatian, Joevannie D. MPBM

LEVERAGE
Prepared by:
CACATIAN,
JOEVANNIE D.
MPBM
L LESSON OBJECTIVES:
z
E
After this chapter, you should be able
V to:
E
R 1.Understand the concept of leverage in
financial management.
A 2.Differentiate the types of leverage.
G 3.Calculate operating leverage, financial
E leverage and combined leverage.
L Defining Leverage
z
E  It means to furnish the ability to use fixed cost assets

V or funds to increase the return to its shareholders.
 The object of application of which is made to gain
E higher financial benefits compared to the fixed
charges payable.
R  Leverage results from using borrowed capital as a
A funding source when investing to expand the firm's
asset base and generate returns on risk capital.
G  The employment of an asset or fund for which the firm
E pays a fixed cost or fixed return. (James Horne)
L Types of Leverage
z
E
V
E
R
A
G
E
L Operating Leverage
z
E  It is the leverage associated with investment

V activities.
 It is defined as the company’s ability to use fixed
E operating costs to magnify the effects of changes
R in sales on its earnings before interest and taxes.
 The company is said to have a high degree of
A
operating leverage if it employs a great amount
G of fixed costs and smaller amount of variable
E costs.
L Operating Leverage Formula
z
E
𝐶

V
𝑂𝐿=
E 𝑂𝑃
R Where,
A OL = Operating Leverage
G C = Contribution
OP = Operating Profits
E
L Degree of Operating Leverage
z
E
 It may be defined as percentage change in the
V profits resulting from a percentage change in the
E sales
R
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
A 𝐷𝑂𝐿=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
G
E
L z Example 1
E From the following selected operating data, determine the
V degree of operating leverage. Which company has the greater
amount of business risk? Why?
E Company A Company B
R Sales P 25,000,000 P 30,000,000
Fixed Costs 7,500,000 15,000,000
A
G Variable expenses as a percentage of sales are 50% for
Company A and 25% for Company B.
E
L z
Solution
Statement of Profit
E Company A Company B
V Sales
Less: Variable Cost
P 25,000,000
12,500,000
P 30,000,000
7,500,000
E Contribution
Less: Fixed Cost
12,500,000
7,500,000
22,500,000
15,000,000
R Operating Profit 5,000,000 7,500,000
A

Company A: OL =
G
Company B: OL =
E
L Financial Leverage
z
E  It is the leverage associated with financing activities.

V  It represents the relationship between the company’s
earnings before interest and taxes (EBIT) or operating
E profit and the earning available to equity shareholders.
 It is the ability of the to use fixed financial charges to
R magnify the effects of changes in EBIT on the
A earnings per share.
 It involves the use of funds obtained at a fixed cost in
G the hope of increasing the return to the shareholders.
E
L Financial Leverage
z
E  Favorable financial leverage occurs when the

V company earns more on the assets purchased
with the funds, than the fixed cost of their use.
E Hence, it is called as positive financial
R leverage.
A  Unfavorable financial leverage occurs when
the company does not earn as much as the
G funds cost. It is called negative financial
E leverage.
L Financial Leverage Formula
z
E
𝑂𝑃

V
𝐹𝐿=
E 𝑃𝐵𝑇
R Where,
A FL = Financial Leverage
G OP = Operating Profits or EBIT
PBT = Profit before tax
E
L Degree of Financial Leverage
z
E
 It may be defined as the percentage
V
change in taxable profit as a result of
E percentage change in earnings before
R interest and tax (EBIT).
A

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
G 𝐷𝐹𝐿= 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
E
L z Example 2
E A company has the following capital structure:
V
Equity share capital P 1,000,000
E 10% Preference Share Capital 1,000,000
R 8% Debentures 1,250,000
A The present EBIT is P500,000. Calculate the
G financial leverage assuring that the company is in
50% tax bracket.
E
L z Solution
E Statement of Profit
V Earnings Before Interest and Tax (EBIT) P 500,000

Interest on Debentures (1,250,000 x 8%) 100,000
E Earnings before Tax 400,000
Income Tax (400,000 x 50%) 200,000
R Profit 200,000
A
Financial Leverage =
G
E
L Combined Leverage
z
E
 This uses both financial and operating
V leverage to magnify any changes in sales into
E a larger relative changes in earnings per share.
 It expresses the relationship between the
R
revenue in the account of sales and the taxable
A income.
G  It is also known as composite leverage or total
leverage.
E
L Combined Leverage Formula
z
E
V
E
R Where,
CL = Combined Leverage
A OL = Operating Leverage
FL = Financial Leverage
G C = Contribution
OP = Operating Profits (EBIT)
E PBT = Profit Before Tax

L z
Example 3
E
V Kumar Company has sales of
E P25,000,000, variable cost of
R P15,000,000, fixed cost of P5,000,000
A and debt of P12,500,000 at 8% rate of
interest. Calculate the combined
G
leverage.
E
L z Solution
E Statement of Profit
V Sales P 25,000,000
Less: Variable Cost 15,000,000
E Contribution Margin 10,000,000
Less: Fixed Cost 5,000,000
R Profit 5,000,000
A Calculation of Operating Leverage
G
Operating Leverage =
E
L z Solution
E Calculation of Financial Leverage
V Earnings before interest and tax P 5,000,000

Less: Interest on debenture (12,500,000 x 8%) 1,000,000
E Earnings before tax 4,000,000
R
Financial Leverage =
A Calculation of Combined Leverage

G
= 2 x 1.25 = 2.5
E
L z Alternative Solution
E Calculation of Combined Leverage
V
CL =
E
R
A
G
E
L z
E
V
E
R
ATTENDANCE
A
G
E
z
z

Leverage: Prepared By: Cacatian, Joevannie D. MPBM

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LEVERAGE

E  It means to furnish the ability to use fixed cost assets

E  It is the leverage associated with investment

E  It is the leverage associated with financing activities.

E  Favorable financial leverage occurs when the

V Earnings Before Interest and Tax (EBIT) P 500,000

E PBT = Profit Before Tax

V Earnings before interest and tax P 5,000,000

A Calculation of Combined Leverage

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