Leverage

UNIT-4, PART-II
 Leverage- Meaning

Leverage analysis is the technique which is used to

quantify risk –return relationship of different
alternative capital structure.
Leverage means the use of sources of funds bearing
fixed financial payments like debt in the capital
structure.
Risk exists due to uncertainty.
Risk can be classified into Business risk and
Financial Risk.
 Business Risk and Financial Risk

Business Risk can be defined as the variability of Earnings

Before Interest & Tax (EBIT). It results because of internal
and external environment in which the firm has to operate. It
is measured by operating leverage. Its degree does not differ
with the use of different forms of financing.
Financial Risk can be defined as the variability of Earnings
Before Tax (EBT). It results because of use of financial
leverage (i.e. sources of funds bearing fixed financial
payments like debt). It is avoidable risk since the firm can
avoid it by not using financial leverage in the capital
structure. It is measured by calculating financial leverage. Its
degree differs with the use of different forms of financing.
 Types of Leverages

There are three types of leverages:

a) Operating Leverage
b) Financial Leverage
c) Combined Leverage
 Operating leverage

Operating Leverage is a measure of Business Risk. Operating

leverages is defined as the firm’s ability to use fixed operating
cost to magnify the effect of changes in sales on its Earnings
Before Interest and Taxes (EBIT). The percentage change in
EBIT occurring due to a given percentage change in sales is
known as the degree of operating leverage.
It is associated with Capital Budgeting Decisions or Asset
Mix Decision.
Operating Leverage exists if there is fixed costs.
 Formula

Degree of Operating Leverage (DOL)= Percentage Change in EBIT

Percentage Change in Sales
OR
Degree of Operating Leverage (DOL)= Contribution
EBIT
 Interpretation of DOL

If DOL is 2 then it means that if sales increases by 1%

EBIT will increase by 2%. DOL exists if its value is
greater than 1. It also signifies the operating risk
profile (Business risk). DOL does not exist if
operating fixed cost is zero.
Sum No. 1
Installed capacity is 20,000units, actual production
and sales is 75% of installed capacity, selling price per
unit is Rs. 10. Fixed cost is Rs. 30000. Total operating
cost is 80%. Compute DOL.
 Solution 1

Actual Sales (Units) : 20,000 units * 75%= 15,000 units

Actual Sales (Rs.): 15,000 * Rs. 10= Rs. 1,50,000
Total Operating Cost: Rs. 1,50,000*80%= Rs. 1,20,000
Total Variable Operating cost: Total operating Cost – Total Fixed Operating Cost
= Rs. 1,20,000-Rs. 30,000
= Rs. 90,000

Statement showing computation of Degree of Operating Leverage (DOL)

Particulars Amount /Rs.
Sales 1,50,000
Less: Variable Operating Cost 90,000
Contribution 60,000
Less: Fixed Cost 30,000
EBIT 30,000
DOL 2
 Practice Sums

Sum No. 2
A firm sells products for Rs. 100 per unit. Has variable
operating costs of Rs. 50 per unit and fixed operating costs
of Rs. 50000 per year. Show the various levels of EBIT and
DOL for sale of a) 1000 units b) 2000 units and c) 3000
units.
(Ans- 0, 50000, 100000, Undefined, 2, 1.5)
Sum No. 3
Percentage change in sales to double the EBIT is 20%.
Compute DOL.
(Ans- 5)
 Financial leverage

Financial Leverage is the measure of Financial Risk. The

percentage change in Earnings Per Share (EPS) occurring
due to a given percentage change in Earnings before
Interest and Tax (EBIT) it is known as degree of financial
leverage.
Financial leverage is associated with the Capital structure
decision.
Its degree differs with the different forms of financing.
Financial leverage exists if there is use of funds bearing
fixed financial payments.
It is the impact of change in EBIT on EPS.
 Formula

Degree of Financial Leverage(DFL) = Percentage Change in EPS

Percentage Change in EBIT
Or
Degree of Financial Leverage(DFL) = EBIT
EBT
(If preference share capital does not exist)
 
Degree of Financial Leverage(DFL) = EBIT
EBIT-I- Pd
(1-t)
  (If preference share exists in the capital structure)
 Interpretation

If DFL is 2 then it means that if EBIT increases by 1% EPS will

increase by 2%. DFL exists if its value is greater than 1. It also
signifies the financial risk of the company. DFL does not exist if
fixed financial cost is zero.
Effect In case of High degree In case of low degree of
of financial leverage Financial leverage
Variability on Increases Decreases
shareholders’ earnings
Probability of solvency Increases Decreases

EPS will increase if ROI is more than the cost of debt

EPS will decrease if ROI is less than the cost of debt
Sum No. 4
Installed capacity 20,000 units, actual production and
sales 75% of installed capacity. Selling price per unit
Rs. 10, Variable cost 60%. DOL 2, 10% Debt Rs.
1,00,000, 15% Preference share capital Rs. 20,000.
Tax rate 40 %. Compute DFL.
Actual Sales (in units): 75% * 20,000 units= 15,000 units
Actual Sales (in Rs.): 15,000 units * Rs. 10= Rs. 1,50,000
Variable cost: 60% * Rs. 1,50,000= Rs. 90,000
Contribution: Rs. 1,50,000- Rs. 90,000= Rs. 60,000
Degree of Operating Leverage (DOL) = 2
Degree of Operating Leverage: Contribution
EBIT
Therefore; 2= Rs. 60,000
EBIT
EBIT= Rs. 60,000/2
EBIT= Rs. 30,000
Interest= 10% * Rs. 1,00,000= Rs. 10,000
EBT= EBIT- I= Rs. 30,000- Rs. 10,000= Rs. 20,000
Degree of Financial Leverage(DFL= EBIT
EBIT-I- Pd
(1-t)
Rs. 30,000
= Rs. 20,000- (15% of Rs. 20,000)
(1-0.40)
= Rs. 30,000
Rs. 15,000
=2
 Practice sums

 Sum No. 5
Percentage drop in EBIT to make EPS zero is 25%. Compute DFL.
(Ans 4)
 Sum No. 6
Contribution Rs. 20,000, Fixed Costs Rs. 15,000. 10% debt Rs. 37,500, 15% Preference
Share Capital Rs. 3000. Tax rate 40%. Compute DFL.
(Ans 10)
 Sum No. 7

Sales Unit 2000 2800

EBIT Rs. 2400 Rs. 7200
EPS Rs. 9.60 Rs. 38.40

(Ans 1.5)
 Trading on equity

The use of sources of funds with fixed costs such as

debt and preference share capital along with owner’s
equity in the capital structure is known as trading on
equity.
Financial leverage explains the impact on Earnings
per Share (EPS) whereas Trading on equity explains
the impact on Return on Equity (ROE).
Trading on equity helps the company to provide high
rate of return to the equity shareholders than normal
rate of earnings on capital employed.
 Example
 Suppose Infotech Ltd. has total paid up capital of Rs. 50,00,000 and has been
raised by equity shares. In case the company earns a profit of Rs. 5,00,000; which is
10% of the total capital employed, it cannot pay dividend more than Rs. 5,00,000 i.e
10%.
 Now suppose the company goes for Trading on Equity and introduces debentures
and preference shares along with equity shares for raising Rs. 50,00,000 in the
following manner:
6% Debentures Rs. 25,00,000
8% Preference Shares Rs. 10,00,000
Equity Shares Rs. 15,00,000
Rs. 50,00,000
Thus the company have to pay Rs. 1,50,000 as interest on debentures and Rs. 80,000
as preference dividend.
Out of the profit of Rs. 5,00,000; fixed charges amounting to Rs. 2,30,000 is to be paid
to debenture holders and preference share holders.
Rest i.e. (Rs. 5,00,000- Rs. 2,30,000) Rs. 2,70,000 is available for the equity share
holders.
There fore ROE is Rs. 2,70,000/ Rs. 15,00,000*100= 18%
18% >10% (therefore trading on equity helps in increasing ROE)
Sum No. 8
Show the effect of financial leverage on EPS by
considering the following two financial plans if EBIT is
a) Rs. 2,00,000 b) Rs. 1,00,000.
Total Funds required Rs. 10,00,000
Financial Plan A 100% Equity
shares of Rs. 10 each
Financial Plan B 50% Equity shares Rs.
10 each and 50%; 15% Debt
Tax Rate 40%
 Solution
Particulars At EBIT level of Rs. At EBIT level of Rs.
2,00,000 1,00,000

Plan A Plan B Plan A Plan B

EBIT 2,00,000 2,00,000 1,00,000 1,00,000

Less: Long-Term Debt (15% on Rs. - 75,000 - 75,000

5,00,000)

EBT 2,00,000 1,25,000 1,00,000 25,000

Less: Tax @40% 80,000 50,000 40,000 10,000

EAT or EAES (as there is no preference 1,20,000 75,000 60,000 15,000

share)

No. of Equity shares 1,00,000 50,000 1,00,000 50,000

EPS Rs. 1.20 Rs. 1.50 Rs. 0.60 Rs. 0.30

ROE ( * 100) 12% 15% 6% 3%

 Interpretation
If ROI >Cost of Debt If ROI <Cost of Debt
Effect on EPS Effect on Effect on EPS Effect on
Financial Risk Financial
Risk
1. Use of more debt Increases Increases Decreases Increases the
in the capital threat of
structure insolvency
2. Use of less debt Relatively less Relatively less Relatively less Relatively
in the capital increase increase decrease less increase
structure
 Combined Leverage

Combined leverage is a measure to total risk. The

percentage change in EPS occurring due to a given
percentage change in sales is known as the degree of
combined leverage
It is associated with capital budgeting decision and
capital structure decision.
Combined leverage exists if there are either fixed
costs or funds bearing fixed financial payments or
both.
 Formula

Degree of Combined Leverage (DCL) = DOL * DFL

Or

Degree of Combined Leverage (DCL) = Contribution

EBIT-I- Pd
(1-t)
Or

Degree of Combined Leverage (DCL) = Percentage Change in EPS

Percentage Change in Sales
 Interpretation

 If DCL is 2 then it indicates that if sales increases by 1% EPS will

increase by 2%. It denotes the combined risk profile of the
organisation.
 Combined leverage indicates the total risk associated with the
enterprise.
 This ratio should be as low as possible.
 This can be done if either of DOL or DFL is kept low.
 However it is preferable if DFL is higher than DOL provided the Rate of
Return Investment is higher than the cost of debt.
Degree of Operating Degree of Financial Nature of the Situation
Leverage Leverage
High High Risky
High Low Normal
Low High Normal
Low Low Ideal
Sum No. 9
Calculate DCL from operating cost Rs. 18000, Variable
cost Rs. 10000, EBT Rs. 500, 10% Debt Rs. 15000.
Solution
EBIT= EBT+ Interest= Rs. 500+10% of Rs. 15,000=,Rs. 2,000
Contribution= EBIT+ Fixed Costs= Rs. 2,000+ (Rs. 18,000-Rs. 10,000)
= Rs. 10,000
Degree of Combined Leverage (DCL)= Contribution
EBT
= Rs. 10,000
Rs. 500
= 20
 Practice sums

Sum No. 10
A firm has sales of Rs. 10,00,000, variable cost of Rs.
7,00,000 and fixed cost of Rs. 2,00,000 and debt of Rs.
5,00,000 at 10% rate of interest. What are the
operating, financial and combined leverages?

If the firm wants to double up its EBIT, how much of

the rise in sales would be needed on a percentage basis?

(Ans: DOL: 3; DFL: 2; DCL: 6; 33.33%)

 Formula for margin of safety

Margin of safety (M/S)= EBIT

P/V Ratio
Or
Margin of safety M/S= Actual Sales – Breakeven sales
(BES)
Margin of safety M/S= 1
DOL
P/V Ratio= Contribution
Sales
Sum No. 11
Installed capacity of Alpha limited is 5,000 units
Units manufactured and sold 3,000 units
Selling price per unit Rs. 20
Variable cost per unit Rs. 15
Calculate the operating leverage, break-even point and margin
of safety Ratio in each of the following three situations:
I. When fixed costs are Rs. 5,000
II. When fixed costs are Rs. 7,000
III. When fixed costs are Rs. 12,000
 Solution
Particulars I II III

Total sales 60,000 60,000 60,000

Less: Total variable cost 45,000 45,000 45,000
Contribution 15,000 15,000 15,000
Less: Operating fixed costs 5,000 7,000 12,000
EBIT 10,000 8,000 3,000
P/V Ratio 25% 25% 25%
Break even point 20,000 28,000 48,000
DOL 1.50 1.88 5.00
M/S 66.67% 53% 20%

M/S sales in units 40,000 31,800 12,000

Percentage of break-even sales to total 33.33% 47% 80%

sales
Sum No. 12
Consider the following information of Strong Ltd:
EBIT Rs. 1,120 lakhs
EBT Rs. 320 lakhs
Fixed Cost Rs. 700 lakhs
Calculate the percentage of change in earnings per
share, if sales increased by 5%.
 Solution
Particulars Old (Rs. in New (Rs. in
lakhs) lakhs)
Contribution (EBIT + Fixed cost) 1,820 1,911

Less: Fixed Cost 700 700

EBIT 1,120 1,211

Less: Interest 800 800

EBT 320 411

Percentage change in EPS = DCL * Percentage change in sales

= Contribution * % Change in sales
EBT
= 1,820/320 * 5%= 28.43%
Sum No. 13
T Ltd provides the following information:
Total funds required: Rs. 10,00,000
Financial Plan I 100% Equity shares of Rs. 10each. Current market price Rs. 25

Financial Plan II 40% Equity shares of Rs. 10each , current market price Rs. 20
60%, 10% Debentures of Rs. 100 each

Financial Plan III 40% Equity shares of Rs. 10 each. Premium in market 100%.
40%, 10% Debentures of Rs. 100 each
20%, 15% Preference Shares of Rs. 100 each

Tax rate 40%

EBIT 5% on Capital Employed

Which financial plan would you recommend and why?

 Solution
Particulars Plan I Plan II Plan III

EBIT (5% on 10,00,000) 50,000 50,000 50,000

Less: Interest - 60,000 40,000
EBT 50,000 (10,000) 10,000

Less: Tax @ 40% 20,000 4,000

EAT 30,000 (10,000) 6,000

Less: Preference dividend - - 30,000

EAES 30,000 (10,000) (24,000)

No. of Equity shares 1,00,000 40,000 40,000

EPS 0.30 (0.25) (0.60)

Financial Plan I is accepted as EPS is positive and higher.

Sum No. 14
Calculate DOL, DFL and DCL and comment which financial plan will be acceptable.

Installed capacity 4000 units

Actual Production75%
Selling Price Rs. 30 per unit
Variable cost Rs. 15 per unit
Fixed cost:
Situation I Rs. 15000
Situation II Rs. 20000

Financial Plans A B
Equity Rs. 10000 Rs. 15000
20% Debt Rs. 10000 Rs. 5000
Total Rs. 20000 Rs. 20000
Tax 40%
 Solution
Particulars Situation I Situation II
Plan A Plan B Plan A Plan B
Sales Value (75% * 4,000) *Rs. 30 90,000 90,000 90,000 90,000

Less: Variable Cost (3,000 *Rs. 15) 45,000 45,000 45,000 45,000

Contribution 45,000 45,000 45,000 45,000

Less: Operating Fixed Cost 15,000 15,000 20,000 20,000

EBIT 30,000 30,000 25,000 25,000

Less; Interest 2,000 1,000 2,000 1,000

EBT 28,000 29,000 23,000 24,000

DOL 1.50 1.50 1.80 1.80

DFL 1.07 1.03 1.08 1.04

DCL 1.60 1.55 1.95 1.87

Financial Plan B under situation I would be preferred as DCL is lower under it and there is financial leverage
existing.