The document discusses weighted average cost of capital (WACC) and leverage. It defines WACC and the steps to calculate it. It also defines operating leverage and financial leverage, explaining how firms use fixed costs to increase profitability. An example problem calculates EPS under different levels of EBIT to demonstrate the effects of leverage.
The document discusses weighted average cost of capital (WACC) and leverage. It defines WACC and the steps to calculate it. It also defines operating leverage and financial leverage, explaining how firms use fixed costs to increase profitability. An example problem calculates EPS under different levels of EBIT to demonstrate the effects of leverage.
The document discusses weighted average cost of capital (WACC) and leverage. It defines WACC and the steps to calculate it. It also defines operating leverage and financial leverage, explaining how firms use fixed costs to increase profitability. An example problem calculates EPS under different levels of EBIT to demonstrate the effects of leverage.
The document discusses weighted average cost of capital (WACC) and leverage. It defines WACC and the steps to calculate it. It also defines operating leverage and financial leverage, explaining how firms use fixed costs to increase profitability. An example problem calculates EPS under different levels of EBIT to demonstrate the effects of leverage.
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Cost of Capital and Leverage
Weighted Average Cost of Capital or Overall
Cost of Capital • The term Cost of Capital is used to denote composite or weighted average or overall cost of capital. • Once the component costs have been calculated, they are multiplied by the proportions of the respective source of capital to obtain the WACC. • Here weighted average concept is used not the simple average. The simple average Cost of Capital is not appropriate to use because firms hardly use various sources of funds equally in the Capital Structure. • The main reason behind the computation of overall Cost of Capital is to use this rate as the decision criterion in Capital Budgeting or Investment Decision. • Generally, it may be stated that this Cost of Capital is taken to be the cut-off rate for determining the profitability of proposed projects. Steps for calculation of WACC Step 1: Compute the specific cost of each source of capital. Step 2: Calculate the proportion (or %) of each source of capital to the total capital (weight). Step 3: Multiply the cost of each source by its proportion in the Capital Structure. Step 4: Add the weighted component cost to get the WACC. • WACC may change due to change in the cost of each component; change in the relative importance of each company, i.e. the change in proportion or weight; or change in both. • Weighted average Cost of Capital can be computed by using the following three types of weight: 1. Book value weight 2. Market value weight 3. Marginal book value weight Leverage • Leverage refers to the use of fixed costs in an attempt to increase (or lever up) profitability. • According to James Horne, leverage is “the employment of assets or funds for which the firm pays a fixed cost or fixed return”. Operating Leverage
• Operating leverage refers to the use of fixed
costs in the operation of a firm. • If a firm’s ratio of fixed costs to total cost is nil, it should not have operating leverage. • The operating leverage may be defined as the tendency of the operating profit to vary disproportionately with sales. • Thus operating leverage appears from the existence of fixed operating expenses. • Operating leverage is the firm’s ability to use fixed operating costs to magnify the effect of change in sales on its earnings before interest and tax (EBIT). • High operating Leverage refers to greater risk because in this situation a small sales decline will cause a big Operating Profit decline. • =
• = • Degree of Operating Leverage implies that by using Fixed Operating Costs, a small change in sales is magnified into a larger change in operating income. • A value of DOL = 3 implies that a 1% increase in sales will result in 3% increase in operating income (EBIT). Financial Leverage • Financial Leverage results from the use of fixed financing costs by the firm. Financial Leverage is acquired by choice. • It is used as a means of increasing the return to common shareholders. • The British expression of financial leverage is gearing. Thus the use of fixed interest/dividend bearing securities such as debt and preference capital along with the owner’s equity in the total capital structure of the company is described as financial leverage. • Sometimes, financial leverage is also known as trading on equity. But the term trading on equity is used for the term financial leverage only when the financial leverage is favourable. • The leverage is said to be favourable so long as the company earns more on assets purchased with the funds than the fixed costs of their use. • Negative or unfavourable leverage occurs when the firm does not earn as much as the funds cost. • The company resorts to trading on equity for providing the equity shareholders, a higher rate of return than the general rate of earning on its capital employed. • For instance, in case a company borrows a sum of Rs. 1 lakh at 10% interest per annum, and earns a return of 15%, the balance of Rs. 5,000 per annum after payment of interest belongs to the shareholders. • But if the company can earn a return of only 8% on Rs. 1 lakh employed by it, the loss of equity shareholders’ is Rs. 2,000 per annum. Thus it is clear that although financial leverage creates additional risk to equity shareholders, it has at the same time the potentiality to enhancing their return. That is why the financial leverage is sometimes called a double-edged sword. • =
• = Example Problem • The capital structure of a firm is as under: Rs 20,000 Equity Shares of Rs. 10 each: 2,00,000 4,000 10% Preference Shares of Rs. 100 each: 4,00,000 4,000 10% Debentures of Rs. 100 each: 4,00,000 Compute the EPS for each of the following levels of EBIT: (i) 1,50,000 (ii) 1,20,000 and (iii) 2,00,000 The firm is in 50% tax bracket. Compute also the financial leverage taking EBIT level under (i) as the base EBIT-EPS Analysis • The EBIT-EPS analysis, is a method to study the effect of leverage, essentially involves the comparison of alternative methods of financing under various assumptions of EBIT. • A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. • For instance, it can (i) exclusively use equity capital (ii) exclusively use debt, (iii) exclusively use preference capital, (iv) use a combination of (i) and (ii) in different proportions; (v) a combination of (i), (ii) and (iii) in different proportions, (vi) a combination of (i) and (iii) in different proportions, and so on. The choice of the combination of the various sources would be one which, given the level of earnings before interest and taxes, would ensure the largest EPS. Example • Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to ₹ 10,00,000. The firm now wishes to raise additional ₹ 10,00,000 for expansion. • The firm has four alternative financial plans: • (A) It can raise the entire amount in the form of equity capital. • (B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures. • (C) It can raise the entire amount as 6% debentures. • (D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital. • Further assume that the existing EBIT are ₹ 1,20,000, the tax rate is 35 per cent, outstanding ordinary shares 10,000 and the market price per share is ₹ 100 under all the four alternatives. Which financing plan should the firm select? Combined Leverage • Operating leverage explains the degree of operating risk as it measures the relationship between quantity produced and sold and EBIT. • Financial leverage explains the degree of financial risk as it measures the relationship between EPS and EBIT. • Both these leverages are closely related to the firm’s capacity to meet its fixed costs (both, operating and financial). • If both these leverages are combined, a composite leverage should be obtained. Composite leverage, therefore, expresses the relationship between quantity produced and sold and EPS. Composite leverage = OL x FL CL = CL =
