LEVERAGE

VITBS NOV10

CONCEPT OF LEVERAGE
Leverage in the general sense means influence of power i.e., utilizing the existing resources to attain something else. Leverage in terms of financial analysis is the influence which an independent financial variable has over a dependent / related financial variable. When leverage is measured between two financial variables it explains how the dependent variable responds to a particular change in independent variable

Cont..
Let X be an independent financial variable and Y its dependent variable, then the leverage which Y has with X can be assessed by the percentage in Y to a percentage change in X. LY/LX = Y/Y X/X Where, LY/LX = Measure of leverage dependent Y has with independent X, X = change in x, Y = Change in Y, X/X= Percentage change in X, Y/Y = Percentage change in Y

Measures of Leverage
The three measures of Leverage explain the importance of leverage in Financial analysis. 1. Operating Leverage 2. Financial Leverage 3. Combined Leverage

The three measures of leverage depend up on various income statement items and their relationship.
INCOME STATEMENT OF XYZ LTD.

Item Total Revenue ( Qty sold (Q) x Selling price (S)) Less variable expenses (V) Fixed Expenses (F) Earnings before Interest and Tax (EBIT) Less Interest on debt (I) Profit before Tax (PBT) Less Tax @ 50% Profit after tax (PAT) Less Preference dividend (Dp) Equity Earnings

Amount 2500000 1000000 900000 600000 75000 525000 262500 262500 50000 212500

Cont.
Total revenue = Quantity sold(Q) x Selling price (S) Hence, EBIT = Q x S Q x V F = Q (S-V) F (1) EPS = [(EBIT I) ( 1 T) Dp] / N (2) = [Q (S V) F I] (1 T) Dp] / N (3) Where N = No. of equity shareholders. These three equations which establish the relationship between various items of income statement form the base for the measurement of different leverages.

Operating Leverage
OL 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). DOL= percentage change in EBIT/ Percentage change in output = EBIT/ EBIT Q/Q From Eq (1), EBIT= Q(S-V)-F Substituting for EBIT, we get DOL = [ Q(S-V) ] / [ Q ( S V)- F] (4)

When the data is given only for one year, then we have to compute the Operating leverage, by the following formula: DOL= Contribution/ EBIT (operating profit)

Problem: Calculate the operating leverage. Interest Rs. 5000; Sales Rs. 50000; variable cost Rs.25000; Fixed cost Rs. 15000. Solution: Computation of EBIT: Sales Rs. 50000 Less: Variable cost Rs. 25000 Contribution Rs. 25000 Less: Fixed cost Rs. 15000 EBIT Rs. 10000 Op Leverage = Contribution/ EBIT = 25000 / 10000 = 2.5 times.

Illustration
From the following particulars of ABC Ltd calculate the DOL. Particulars Prev year 2009 Sales revenue 1000000 Variable cost 600000 Fixed cost 250000 Current year 2010 1250000 750000 250000

solution
Calculation of EBIT on a percentage change

Particulars Sales Less VC Contribution Less: Fixed cost EBIT

2009 1000000 600000 400000 250000 150000

2010 1250000 750000 500000 250000 250000

%change 25 25 25

66.67

DOL= %age change in EBIT/%age change in EPS = 66.67 / 25 = 2.667 times Op Leverage 2.667 indicates that when there is 25% change in sales, the change in EBIT is 2.667 times.

Calculate the Dol for XYZ Ltd given the following information

Quantity produced Variable cost per unit Selling price per unit Fixed expenses

= 5000 = Rs.200 = Rs.500 = Rs.900000

DOL of xyz Ltd

=[ 5000(500 -200)] / [5000(500-200) -900000 =2.50

Application and Utility of Operating Leverage

To understand the application of DOL one has to understand the behavior of DOL vis--vis the changes in the output by calculating the DOL at various levels of Q.
Qty produced 1000 2000 3000 4000 5000 Degree of operating leverage -0.5 -2.0 Undefined 4.0 2.5

Contd.

When the value of Q is 3000, the EBIT of the company is zero and this is the Operating break even point. Thus, at OBEP, Where EBIT is zero, the quantity produced can be calculated as follows: Q = F / (S-V) For XYZ company, Q = 900000/ (500 200) = 3000

After measuring DOL for a particular company at varying levels of output, following observations can be made

Each Level of output has a distinct DOL DOL is undefined at the operating BEP IF Q is less than the OBEP, then the DOL will be negative If Q is greater than the operating break even point , then the DOL will be positive. However, the DOL will start to decline as the level of output increases and will reach a limit of 1.LEVERAGE.xls

Implications Determining the behavior of EBIT

DOL helps in ascertaining the change in operating income for a given change in output (Qty produced and sold). IF the DOL of a firm is say 2, then a 10% increase in level of output will increase operating income by 20%. A large DOL indicates that small fluctuations in level of output will produce large fluctuations in the level of operating income

Two firms with different cost structures are compared.

Bell
Units produced & Sold Q 10000 20000 30000 40000 50000 60000 70000 80000 Unit SP FC VC EBITBEP

Metal
Sales

works
Total op costs EBIT

Fibre

Glass Ltd
Total op costs EBIT

Sales Units produced & Sold Q PQ 100000 200000 300000 400000 500000 600000 700000 800000 Rs.10 190000 Rs.5 38000 units

PQ 100000 200000 300000 400000 500000 600000 700000 800000 Rs.10 90000 Rs.7 30000 units 160000 230000 300000 370000 440000 510000 580000 650000 (60000) (30000) 0 30000 60000 90000 120000 150000

10000 20000 30000 40000 50000 60000 70000 80000 Unit SP FC VC EBITBEP

240000 290000 340000 390000 440000 490000 540000 590000

(140000) (90000) (40000) 10000 60000 110000 160000 210000

Let us calculate the DOL at an output of 50000 units for both firms
DOL of Bell Metal: = [50000 (10-7) ] / [50000 (10-7) 90000] = 2.5 DOL of Fibre glass Ltd =[50000(10 -5)]/ [50000 (10 -5 )-190000] = 4.17 Thus, Fibreglasss DOL is greater than Bell metals, and its EBIT fluctuates far greater than Bell Metals.

Measurement of Business risk

Greater the DOL, the more sensitive is EBIT to a given change in unit sales. DOL is therefore a measure of firms business risk. Business risk refers to the uncertainty or variability of firms EBIT. SO, EVERYTHING BEING EQUAL, A HIGHER DOL MEANS A HIGHER BUSINESS RISK AND VICE VERSA.

Production planning
DOL is also important in production planning. A firm may have opportunity to change its cost structure by introducing labor saving machinery, thereby reducing variable cost while increasing Fixed cost. Such an exercise will increase DOL. Any method of production which increases DOL is justified only if the sales are high and certain and firm can enjoy increased earnings.

Problem

AMC co Ltd provide the following information and requested you to calculate a. Operating Leverage with 4000 and 6000 quantity of sales. B. Operating BEP. Selling Price Rs. 300 per unit, Variable cost Rs. 200 per unit Fixed cost Rs. 240000.

Solution
Calculation of EBIT Particulars 4000 units 6000 units

1800000 1200000 Sales revenue 1200000 800000 Less: VC 600000 400000 Contribution 240000 240000 Less: FC 360000 160000 EBIT Op Leverage = Contribution/EBIT OL 4000 Units = 400000/160000 = 2.5 OL 6000 units = 600000/360000 = 1.66 b. Operating BEP = FC/Contribution = 240000/300 = 2400 units

FINANCIAL LEVERAGE
While Operating Leverage measures the changes in the EBIT of a company to a particular change in output, the Financial Leverage measures the effect of the change in EBIT on the EPS of the company. Financial leverage refers to the mix of debt and Equity in the capital structure of the company

DFL
The measure of financial leverage is the Degree of Financial Leverage DFL and it is calculated as follows; DFL=(percentage change in EPS)/ (percentage change in EBIT) DFL= (EPS/EPS / EBIT/ EBIT ) Substituting Eq.2 for EPS, we get DFL = . EBIT .

EBIT-I [Dp)/(1-t)]

Take the example of XYZ co Ltd which has EBIT of Rs.600000 at 5000 level of production. Capital structure is given below and we will calculate the DFL
Capital structure 500000 Equity shares @Rs.10 15% Debentures 10% Pref shares (5000 nos) @ Rs. 100 each Total Solution: Let us calculate the DFL of XYZ Co Ltd. Amt 5000000 500000 500000 6000000

Earnings before Interest and Tax (EBIT)= 600000 Interest on Long term Debt (I) = 75000 Preference dividend (Dp) = 50000 Corporate tax (T) = 50% 600000 . DFL = 600000 75000 (50000 / 0.50) = 1.41

Application and Utility of Financial Leverage

FL when measured for various levels of EBIT will aid in understanding the behavior of DFL and explain its utility in financial decision making. Let us consider case of XYZ and measure DFL for different EBIT
EBIT 50000 100000 175000 600000 700000 750000 DFL -0.40 -1.33 UNDEFINED 1.41 1.33 1.30

Application and utility contd.. DFL at EBIT level of 175000 is undefined and this point is the financial breakeven point. It can be defined as: EBIT= I + Dp /(1-T) Following observations can be made: Each level of EBIT has a distinct DFL DFL is undefined at Financial BEP DFL will be negative when the EBIT level goes below Financial BEP DFL will be positive for all values of EBIT that are above the financial BEP. This will start to decline as EBIT increases will reach a limit of 1.

Impact of Financial leverage on Investors rate of return / EBIT-EPS analysis EBIT EPS analysis.doc

Financial Leverage and Risk

Although FL increases EPS, it also increases the financial risk which leads to: 1. Increased fluctuations in the return on equity. 2. Increase in the interest rate on debt.

TOTAL LEVERAGE
A Combination of Operating and Financial leverages is the total or Combined 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 calculated as: DTL = %change in EPS/%Change in output = (EPS/EPS) / (Q / Q)

DTL Contd..

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)]

problem

Calculate the DTL for XYZ Ltd given the following information: Equity earnings : 162500 Quantity produced : 5000 units Variable cost per unit : Rs.200 Selling price per unit : Rs. 500 Number of Equity shareholders: 5,00,000 Fixed expenses : Rs. 900000 Interest : Rs. 75000 Preference dividend : Rs. 50000 Corporate tax rate : 50%

Soln.
DTL= 5000 ( 500 200) . 5000(500-200)-900000-75000- [50000/(1-0.50)] = 3.53 DTL = DOL x DFL 2.5 X 1.41 = 3.53

Overall Breakeven point

The overall breakeven point is that level of output at which the DTL will be undefined and EPS is equal to Zero. This level of output can be calculated as follows: F + I +Dp Q= . (1-t) . (S V)

Problem
F= Rs. 800000 I = Rs. 80000 Dp=Rs. 60000 S= Rs. 1000 V= Rs. 600 Calculate the Overall breakeven point.

.
Ans: Q= [800000+80000+60000/(1-0.50)]/ (1000-600) =2500 units.

Application of DTL
DTL measures the changes in EPS to a percentage change in Q. Thus the Percentage change in EPS can be assessed as the product of DTL and the percentage change in Q. For example, if DTL for Q of 3000 units is 6 and there is a 10% increase in Q, the effect on EPS is 60%. Percentage change in EPS = DTL (Q=3000)x percentage change in Q = 6 x 10% = 60%