CHAPTER 4 LEVERAGE IN BUSINESS Financial Leverage The use of the charges sources such as debt and preference capital

along with the owners equity in the capital structure is described as financial leverage or gearing or trading on equity. The use of the term trading on equity is derived from the fact that it is the owners equity that is used as a basis to raise debt that is traded upon. Financial leverage provides the potential of increasing the shareholders the earnings as well as creating the risk of loss to them. It is a double-edged sword. Measures of Financial Leverage The most commonly measures of financial leverage are: 1. Debt ratio - debt to total capital i.e. L1 = D D = D+S V

Where D is value debt S is value of equity and V is value of total capital D and S may be measured in terms book value or market value. The book value of equity is called net worth. 2. Debt equity ratio the ratio of debt to equity i.e. L2 = D S

3. Interest coverage; the ratio of net operating income (or EBIT) to interest charges i.e. L3 = EBIT Interest

There is no difference between the first two measures of financial leverage in operational terms. These relationships indicate that both these measures of financial leverage will rank companies in the same order. However, the first measure (i.e. D/V) is more specific as its value ranges between zero and one. The value of the second measure (i.e. D/S) may vary from zero to large number. The debt equity, as a measure of financial leverage is more popular in practice.

The first two measures of financial leverage are also measure of capital gearing. They are static in nature as they show the borrowing position of the company at a point of time. These measures, thus fail to reflect the level of financial risk, which is the possible failure of the company to pay interest and replay debt. The third measures of financial leverage commonly known as coverage ratio indicates the capacity of the company to meet fixed financial charges. The reciprocal of interest coverage that is interest divided by EBIT is measure of the firms income earning; income gearing. This measure suffers from certain limitations. First to determine the company ability to meet fixed financial obligation, it is the cash flow information which is relevant, not the reported earning. Second, this ratio when calculated on past earnings does not provide any guide regarding the future riskiness of the company. Third it is only a measure of short term liquidity than of leverage. Financial Leverage and Shareholders Return The primary motive of a company in using financial leverage is to magnify the shareholders return under favorable economic conditions. Based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and other sources or debentures) can be obtained at a cost lower than the firms rate of return on net assets (RONA or ROL) Thus the difference is distributed to the shareholders in earning per share (EPS) or return on equity (ROE). Therefore, EPS, ROE and ROI are the important figures for analyzing the impact of financial leverage. The formula for calculating EPS is as follows: Earnings, per , share = EPS = Pr ofit , after , tax Number , of , shares

PAT ( EBIT INT )(1 T ) = ......................................1 N N

Where; T is the corporate tax rate and N is the number ordinary shares outstanding if the firm does not employ and debt then the formula simply would be: EPS = EBIT (1 T ) ...............( INT = 0, if , D = 0)....................2 N

If a company uses preference capital, then EPS may be calculated as follows: EPS = ( EBIT INT )(1 T ) PDIV N

Notice that PDIV the preference dividend is not deducible ROE is obtained by dividing PAT by equity (S) or net worth (NW). Thus, the formula for calculating ROE is as follows: Re turn, on, equty = ROE = Pr ofit , after , tax Networth(book , value)

( EBIT INT )(1 T ) ..................................3 S

Notice that S is considered as the book value of equity capital in equation (3) therefore ROE is a book value measure. How does the financial leverage affect EPS and ROE? The interest charges are tax deductible and therefore, provide tax shield which increases the earnings of the shareholders: Interest Tax Shield Illustration: A firm wants in invest Br 500,000 and expects a return of 24% (EBIT = 0.24 500,000) It is considering: A. Issuing 50,000 ordinary shares at Br 10 per share B. Issuing 25,000 ordinary shares at Br 10 per share and borrowing Br 250,000 at 15% rate of interest. If tax rate equal 50% what are the effect of the two plans for the investors A. EBIT - Tax = 120,000 - (EBIT 0.5) = 120,000 - 60,000 = 60,000 ( return to investors of A): EPS=60,000/50,000 = 1.20; ROE = 12% B. [(EBIT - INT) ( 1-Tax)] + INT = [(120,000-37,500) 0.5] + 37,500= 78,750 (return to investors of B): EPS = 120,000 37,500 (1-0.5)/ 25,000 = 1.65; ROE = 16.5% = Tax Rate Interest

The difference in earnings to investors of A and B is 78,750 60,000 = 18,750 or the Interest Tax Shield i.e. Tax Interest: (0.5 37,500 = 18,750) Suppose that the management considers alternative C in which they want to use 75% debt and 25% equity. In option C, 12,500 shares will be sold at Br 10 each and debt of Br 375,000 at 15% used. EPS and ROE will be: EPS = ROE = ( EBIT INT )(1 T ) (120,000 56,250)(1 0.50) 31,875 = = = Br 2.55 N 12,500 12,500 ( EBIT INT )(1 T ) 31,875 = = 25.5% S 125,000

Under the third alternative financial plan of 75 per cent debt, EPS and ROE are more than double as compared with all-equity no leverage financial plan. Suppose that, for some reason the from may not be able to earn 24 percent before tax return on its total capital rather it can earn only 12 per cent return (i.e. EBIT = Br 60,000) what would be the impact on EPS and ROE we can use equation 1 and 3 calculate EPS and ROE. No debt plan: EPS = ROE = (60,000 0)(1 0.5) 30,000 = = Br 0.60 50,000 50,000 30,000 = 6% 500,000 (60,000 37,500)(1 0.5) 11,250 = = Br 0.45 25,000 25,000 11,250 = 4.5% 250,000 (60,000 56,250)(1 0.5) 1,875 = = Br 0.15 12,500 12,500 1,875 = 1.5% 125,000

50% debt plan: EPS = ROE = 75% debt plan: EPS = ROE =

Why is the effect of financial leverage unfavorable? It is unfavorable because the firms rate of return is less than the cost of debt. The firm is paying 15 per cent on debt and earning a return of 12 per cent on funds employed. We are thus led to an important conclusion: The financial leverage will have a favorable impact on EPS and ROE only when the firms return on investment (ROI) exceeds the interest or cost of debt. The impact will be unfavorable if the return on investment is less than the interest cost. It is in this that the financial leverage is said to be a double-edged sword. Effect of Leverage Favorable if, ROI > Cost of the debt Unfavorable if, ROI < Cost of debt Neutral if, ROI = Cost of debt Financial leverage works both ways. It accelerates EPS and ROE under favorable economic conditions but depresses EPS (and ROE) when the going is not good for the firm. The unfavorable effect of EPS (and ROE) is more with higher debt levels, in the capital structure, if EBIT is declining or negative The higher the financial leverage the wide the range over which EPS varies with fluctuating EBIT. The indiscriminate use of financial leverage without taking in to account the uncertainly surrounding EBIT can lead a firm in to financial difficulties. Relationship between EBIT and EPS (a) EBIT-EPS Chart As noted earlier the formula for calculating EPS is: EPS = ( EBIT INT )(1 T ) (1 T ) = ( EBIT INT ).................................4 N N

We assume that the level of debt the cost of debt and the tax rate are constant. Therefore (1 T ) (1 T ) (1 T ) (1 T ) EBIT INT = INT + EBIT .............5 N N N N Thus the EPS formula can be rewritten as: EPS = a + b (EBIT) 6 EPS =

Where; a = b=

(1 T ) INT N

(1 T ) N Equation 6 clearly indicates that EPS is a linear function of EBIT From one provious example: (A) Under no debt; a = (1 T ) 0.5 INT = (0) = 0 N 50,000

(1 T ) 0.5 = = 0.00001 N 50,000 (1 T ) 0.5 INT = (37,500) = 0.75 (B) Under 50% debt; a = N 50,000 (1 T ) 0.5 b= = = 0.00002 N 25,000 b=

EPS

50% debt

Indifference Point 0

No debt

EBIT

If we identify any two points of EPS for two given levels of EBIT and join them in a straight line we obtain EPS-line for a particular financial plan. The line relating EBIT and EPS becomes steeper with more debt in the capital structure and the steeper the line the more the profit potential to the shareholders with increasing EBIT. If EBIT is declining the 6

loss to the shareholders will be magnified. The point of intersection of the EBIT-EPS lines is the indifference point (also called the break even point) at which EPS is same regardless of the level of the financial leverage. Calculation of Indifference Point To find out break-even level of EBIT we may set the EPS formulae of two plans equal. The EPS formula the under all equity plan is: EPS = EBIT (1 T ) ...............( where, D = 0) N1

Where N1 is number of ordinary shares under first plan and since the firm has no debt, no interest charges exist. The EPS formula under debt equity plan is: ( EBIT INT )(1 T ) N2 Where INT is the interest charges on debt N2 is the number of ordinary shares under second EPS = plan. Setting the two formulae equal, we have: EBIT (1 T ) ( EBIT INT )(1 T ) = ..................7 N1 N2 Using the values for financial plans A and B given in the example, we can determine EBIT as follows: EBIT (1 0.5) EBIT 18,750(1 0.5) = 50,000 37,500 0.5 EBIT 37,500 = 0.5EBIT 9,375 50,000

0.375 EBIT 0.5 EBIT = 9,375 EBIT = 9,375 = Br 75,000 0.125

We can simplify equation (7) as follows EPS = N1 ( INT )........................................8 N1 N 2

Thus, in the example:

EPS =

50,000 37,500 = 2 37,500 = Br 75,000 50,0000 25,000

Sometimes a firm may like to make a choice a between two levels of debt of debt. Then, the indifference point formulae will be: ( EBIT INT1 )(1 T ) ( EBIT INT2 )(1 T ) = ............9 N1 N2 Where INT1 and INT2 represent the interest charges under the alternatives financial plans After simplifying equation (9) we obtain: EBIT = N 2 ( INT1 ) N1 ( INT2 ) ................................10 N1 N 2

Many other combination of the method of financial may be compared. The firm may compare between a common share plan and a preference share plan. Then the indifference point formula will be: EBIT (1 T ) EBIT DIVP(1 T ) = .......................11 N1 N2 Equation (11) can be simplified as follows: N1 DIVP ....................................12 N1 N 2 1 T

EBIT =

Operating Leverage This is the use of fixed costs in the operation of a firm. A firm will not have operating leverage if its ratio of fixed costs to total costs it nil. Such a firm will produce the same EBIT for any measure in sales. A firm with fixed costs will have operating leverage and produce proportionally higher EBIT with increase in sales. Thus, operating leverage increases with increase in fixed costs. If sales fall a firm with high operating leverage will suffer more than the one with low operating leverage (doubleedged sword). A break even chart can be constructed to illustrate to illustrate the relationship between costs sales (volume) and profit as shown in the graph below.

Profit area BEP Costs & Revenue TC FC Sales Sales

Alternatives BEP can be given as; BEP = FC Selling , price Variable, cos ts

BEP =

FC ..................................13 Contribution

Illustration: Suppose the price out previous example has the following data: Sales volume = 100,000 units, selling price = Br 8 per unit, variables cost = Br 4 per unit and fixed costs = Br 280,000 The BEP would be; BEP = 280,000 = 70,000Units 84

Degree of Operating Leverage (DOL) DOL is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales. Thus: DOL = %changeinEBIT %Changeinsales

DOL =

EBIT / EBIT ....................................14 sales / sales

The following equation is also used for calculating DOL: DOL = Q( s v) ....................................15 Q( s v) F

Where Q is the unit of output s, is the unit selling price v is the unit variables cost and F is the total fixed costs equation (15) can also be written as follows: DOL = DOL = Contribution ..................................16 EBIT EBIT + Fixed cos t FC = 1+ .......17 EBIT EBIT

Applying equation (15), DOL for our previous examples is: DOL = 100,000(8 4) 400,000 = = 3.33 100,000(8 4) 280,000 120,000

DOL of 3.33 implies that for a given charge in the companys sales EBIT will changes by 3.33 times Let us suppose in the case of the company in our example that a technical expert appointed by the management tells them that can choose more automate production processes which will reduce unit variables cost to 2 Br but will increase fixed costs to Br 480,000. If the management accepts the experts advice then the income statement will look as follows: DOL = 100,000(8 2) 600,000 = =5 100,000(8 2) 480,000 120,000

If the firm chooses high automated technology and if its actual sales happen to be more than expected its EBIT will increase greatly: an increase of 100 per cent in sales will lead to a 500 per cent increase in EBIT. Degree of Financial Leverage

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The degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage in EBIT: DFL = DFL = %changeinEPS Or %ChangeinEBIT

EPS / EPS ....................................18 EBIT / EBIT

In the case of our example when EBIT increases form Br 120,000 to Br 60,000, EPS increase from Br 1.65 to Br 2.45, when it employees 50 per cent debt and pays interest charges of Br 37,500. Applying equation (18) DFL at EBIT of Br 120,000 is: DFL = (2.45 1.65) / 1.65 0.485 = = 1.456 (160,000 120,000) / 120,000 0.333

The implies that for a given change in EBIT, EPS will change by 1.456 times The following equation can also be used to calculate DFL. DFL = EBIT EBIT EBIT = = 1+ ....................................19 EBIT INT PBT PBT

We know that EBIT = Q (p-v) F (and EBIT INT = PBT). Thus equation (19) can also be written as follows: DFL = Q( s v) F .......................................................20 Q( s v) F INT

The numerator of equation (19) or (20) is earning before interest and taxes and the denominator is profit before taxes. Combined Effect of Operating and Financial Leverage Operating and financial leverage together causes wide fluctuations in EPS for a given change in sales. If a company employs a high level of operating and financial leverage even a small change in the level of sales will have dramatic effect on EPS. A company with

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cyclical sales will have a fluctuating EPS but the swings in EPS will be more pronounced if the company also uses a high amount of operating and financial leverage. The degree of operating and financial leverage can be combined to see the effect of total leverage on EPS associated with a given change in sales. The degree of combined leverage (DCL) is given by the following equation: DCL = %changeinEBIT %changeinEPS %changeinEPS = ..................21 %Changeinsales %ChangeinEBIT %Changeinsales Q( s v) Q( s v) F Q( s v) = .....................22 Q( s v ) F Q( s v ) F INT Q( s v ) F INT

Yet another way of expressing the degree of combined leverage is as follows: DCL =

Since Q (s v) is contribution and Q(s-v)-F INT is the profit but before taxes, equation (22) can also be written as follows: DCL = = Contribution Pr ofit , before, taxes EBIT + Fixed cos ts PBT + INT + FC INT + FC = =1+ .................23 PBT PBT PBT

For our example when it used less automated production processes the combined leverage effect at a sales of Br 800,000 (100,000 units at Br 8) and 50 per cent debt level is: DOL = 100,000(8 4) 400,000 = = 4.85 100,000(8 4) 280,000 37,500 82,500

This means the combined effect of leverage is to increase EPS by 4.85 times for one unit increase in sales when it chooses less automated production process and employs 50 per cent debt. Thus if the firms sales increase by 10 per cent from Br 800,000 to Br 880,000 then EPS will increase by 10% 4.85 = 48.5% EPS at the sales of 800,000 is 1.65 then the new EPS will be 1.65 1.485 = 2.45 The right combination of operating and financial leverage will differ among companies it would generally by governed by the behavior of sales. Public utilities such as electricity companies can afford to combine high operating leverage with high financial leverage since they generally have stable or rising sales. A company whose sales fluctuate widely

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and erratically should avoid use high leverage since it will be exposed to a very high degree of risk. Financial Leverage and the Shareholders Risk We have seen that financial leverage magnifies the shareholders earning. We also find that the variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure. That is with more debt; EPS rises and fall faster than the rise and fall in EBIT. Thus financial leverage not only magnifies EPS but also increase its variability. The variabilities of EBIT and EPS may be distinguished between two types of risk: operating risk and financial risk. Operating Risk Operating risk can be defined as the variability of EBIT (or return on to total assets). The environment; Internal and external in which a firm operates determined the variability of EBIT so long as the environment is given to the firm operating risk is an unavoidable risk. A firm is better placed to face such risk if it can predict it with a fair degree of accuracy. The variability of EBIT has two components variability of sales and variability of expenses. Variability of Sales The variability of sales revenue is in fact a major determinant of operating risk sales of a company may fluctuate because of three reasons. First the changes in general economics conditions may affect the level of business activity. Business cycle is an economic phenomenon which affects sales of all companies. Second certain events affects sales of companies belonging to a particular industry for example the general economic conditions may be good but a particular industry may be hit by recession. Other factors may include availability of materials, technological changes actions of competitors, industrial relations, shifts in consumers or reference and so on. Third sales may also be affected by the factors which are internal to the company. The change in management the product market decisions of the company and its investment policy of strike in the company have a great influence on the company sales.

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Variability of Expenses Given the variability of sales the variability of EBIT is further affected by the composition of fixed and variable expenses. The higher the proportion of fixed expenses relative to variable expenses the higher the degree of operating leverage. High operating leverage leads to faster increase in EBIT when sales are rising in bad times when sales are failing. EBIT declines at a greater rate than fall in sales. Thus operating leverage causes wide fluctuations in EBIT with varying sales Financial Risk For a given degree of variability of EBIT the variability of EPS and ROE increase with more financial leverage. The variability of EPS caused by the use of financial leverage is called financial risk. Firms exposed to same degree of operating risk can differ with respect to financial risk when they finance their assets differently. A totally equity financed firm will have no financial risk. But when debt is used the firm adds financial risk. Financial risk is thus an available risk if the firm decides not to use debt in its capital structure.

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