LEVERAGE

- Compiled by Sapna Bhupendra Jain; 98112-55704

Leverage means influence of power i.e. utilising the existing resources to attain
something else. Leverage may be defined as meeting of fixed costs or paying a fixed
return for employing resources of funds.
There are 3 measures of leverage 1. Operating leverage.
2. Financial leverage
3. Combined / Total leverage
OPERATING LEVERGAGE
Operating leverage is tendency of EBIT to very disproportionately with sales. This
happens because every enterprises has fixed costs which have to be met regardless of
volume of sales. Fixed cost remains fixed whether sales increases or decreases.
Therefore the percentage change in operating profits on account of change in sales is
greater than the percentage change in sale.
Degree of operating leverage (DOL)

% Change in EBIT
% Change in sales

OR

Contribution
EBIT

FINANCIAL LEVERAGE
Financial leverage can be defined as the tendency of the EBT to vary disproportionately
with net operating income (EBIT). In other words, change in EBIT results in a larger
change in EBT. This happens because of fixed commitments on debentures, loans etc.
hence, if there is a change in EBIT, it will result a larger change in the return of owners
funds. Financial leverage will be higher in case of firms with higher debt equity ratio.
Degree of financial leverage (DFL) = % Change in EBT / EAT / E PS OR EBIT
% Change in EBIT
EBT
TOTAL LEVERAGE
Operating leverage indicates possibility of loss in case of fall in sales, and financial
leverage indicates possibility of bankruptcy in case of fall in EBIT. Total risk involved can
be seen by combining the operating leverage and financial leverage. This combination
is known as total leverage.
Composite leverage (DCL) = % Change in EBT / EPS / EAT
OR
Contribution
% Change in sales
EBT
Note: A firm having high operating leverage and a high financial leverage will be very
risky proposition. Keeping both leverages low will mean that the management is too
conservative in using even the legitimate opportunity for maximising the wealth of
shareholders.

Interpretation of leverage
If DOL is 2, it means for every 1% increase in sales EBIT will be up by 2%
If DFL is 2, it means for every 1% increase in EBIT, EAT/EPS/EBT will go up by 2%.
If DCL is 4, it means for every 1% increase in sales, EBT/EAT /EPS will go up by 4%.
Ques. 1: Calculate DOL, DFL and DCL from following Sales 1,00,000 units @ Rs. 2
Interest Rs. 3668; Variable cost 0.70 per unit
Fixed cost 1,00,000
[Ans. DOL 4.33; DFL 1.14; DCL 4.94]
Ques. 2: Calculate the degree of operating leverage, degree of financial leverage and
the degree of combined leverage for the following firm and interpret the results.
Firm A
Firm B
Firm B
(1) Out put (in units)
60,000
15,000
1,00,000
(2) Fixed cost (Rs.)
7,000
14,000
1,500
(3) Variable cost per unit (Rs)
0.20
1.50
0.02
(4) Interest borrowed funds
4,000
8,000
-(5) Selling price per unit (Rs)
0.60
5.00
0.10
[Ans. DOL-1.41, 1.36, 1.23; DFL-1.31, 1.26, 1.00; DCL- 1.85, 1.72, 1.23]
Ques. 3: The sales revenue of levered (L) company @ Rs. 20 per unit of output is Rs.
20 lakhs and contribution is Rs. 10 lakhs. At the present level of operation, the DOL of
the company is 2.5. The company does not have any preference shares. The number of
ordinary shares in 1 lakh. Applicable corporate income tax is 50% and the rate of
interest on debt capital is 16% p.a. What are the EPS (at sales revenue of Rs. 20 lakh)
and amount of debt capital of the company if a 25% decline in sales will wipe out EPS.
[Ans. 1.25 = EPS, Debt cap 9,37,500]
Ques. 4: The selected financial data for A, B, C companies for the year ended Dec.
1999 are as follows: A
B
C
Variable exp. as a % of sales
66.67
75
50
Interest
200
300
1000
Degree of operating leverage
51
61
21
Degree of financial leverage
31
41
21
Income tax Rate
50%
50%
50%
Prepare income statement of A, B, C.
Ques. 5: A firm has sales of Rs. 10,00,000; variable cost Rs. 7,00,000 and fixed cost
Rs. 2,00,000. Debt of 5,00,000 at the rate of 10% interest. If the firm wants to double
up its EBIT, how much of a rise in sales would be needed on a percentage basis.
[Ans. 33.33%]
Sapna bhupendra jain; 98112-55704

Ques. 6: Calculate operating leverage and financial leverage under situation A, B and C
financial plans I, II, and III from the following
Production and Sales
800 units
Selling price per unit
Rs. 15
Variable cost per unit
Rs. 10
Fixed cost: A situation
Rs. 1000
B situation
Rs. 2000
C situation
Rs. 3000
Capital Structure
Financial plans
I
II
III
Equity
5,000
7,500
2,500
Debt
5,000
2,500
7,500
Cost of debt
12%
12%
12%
Find out the combination of operating and financial leverage, which gives the highest
value and the least value.
I
II
III
I
II
III
Ans. A
DOL 1.33 1.33 1.33 B.
DOL
2
2
2
DFL 1.25 1.11 1.43
DFL 1.43 1.18 1.82
DCL 1.66 1.48 1.90
DCL 2.86 2.36 3.64
C
DOL
4
4
4
DFL 2.5
1.43 10
DCL 10
5.72 40
Ques. 7: Operating leverage 2.5; Financial leverage 3; EPS 30; Market price per
share 225; Capital 20,000 shares. It is proposed to raise a loan of Rs. 50,00,000 @
18%, sales will increase by 25% and Fixed cost by Rs. 3,00,000. Estimate MPS after
expansion assuming Tax @ 50%.
[Ans. 421.88]
Sapna bhupendra jain; 98112-55704

EBIT EPS ANALYSIS

INDIFFERENCE POINT
- Compiled by Sapna Bhupendra Jain; 98112-55704
This concept is relevant when we have to make a choice. Out of two proposed capital
structures. One capital structure may have no financial leverage i.e. no debt and other
may have financial leverage i.e. other may have debt or higher degree of financial
leverage. Our decision criteria are EPS.
Indifference point is that level of EBIT at which EPS is the same under both capital
structures. If company is likely to have EBIT higher then the indifference point, it should
go for the capital structure with higher degree of financial leverage. If its EBIT is likely to
be less than indifference point, it should opt for the capital structure with lower degree of
financial leverage. If its EBIT is likely to be equal to indifference point, it may go for
either or the two capital structure as both will result same EPS.
Indifference point =
(EBIT Intt) (1 tax)
=
(EBIT Intt) (I tax)
no of equity shares in plan I
No. of equity shares in plan II
It can also be identified graphically by plotting the EBIT EPS lying for various plans.
Take EBIT on x axis and EPS on Y axis. Intersection point of plans is indifference
point of both plans is indifference point.
Plan I
EPS

Plan II
BEP
EBIT

Ques. 1: A Co. has the choice for raising an additional sum of Rs. 50 lakh either by sale
or 10% debentures or by issue of additional equity shares by Rs. 50 per share. The
current Capitalisation structure of the company consists of 10 lakh equity shares of Rs.
50 each and no debt. Determine the indifference point. Also determine the level of EBIT
at which uncommitted earning per shares would be same, either by issuing share or by
issuing debentures, if sinking fund obligation of Rs. 5,00,000 per year. Tax @ 50%.
[Ans. (i) 55,00,000 (ii) 1,65,00,000]
Ques. 2: ABC corporation plans to expend assets by 50% to finance the expansion, it is
choosing between 12% debt issue and equity shares. Its Balance sheet and Profit and
loss A/c as follows.
Balance Sheet As on 31-12- 01
11% Deb.
40,000
Assets
2,00,00,000
10,00,000 equity Shares
1,00,00,000
Retained Earnings.
60,00,000
2,00,00,000
2,00,00,000

Profit & Loss A/C for the year ended 31-12-01

Sales
6,00,00,000
Total cost (excluding Intt)
5,40,00,000
EBIT
60,00,000
Interest
4,40,000
EBT
55,60,000
Tax @ 50%
27,80,000
EAT
27,80,000
Price Earning Ratio
7.5
If the expansion is financed by debt, Price Earning Ratio will be 5. If the company
decides to issue equity shares, the issue would be at 20% premium
(i)
Assuming EBIT is 10% of sales, calculate earning per share (EPS) at sales level
of 8 crore and 10 crore, when financing with (i) debt and (ii) equity
(ii)
Market price per share (MPS) for each sales level for both equity and debt
financing.
(iii)
Indifference point.
(iv)
Indifference point (on the basis of uncommitted earnings) if sinking fund
obligations of Rs. 5,00,000 per year.
Ques. 3: A Ltd. is considering 3 financial plans. The Key information is as follows
Assume 50% Tax.
I Plan
II Plan
III Plan
Common stock Rs.2,00,000 8% Bonds
Rs. 1,00,000 Pref. stock 8% Rs.1,00,000
Common stock Rs. 1,00,000 common stock Rs.1,00,000
Common stock will be sold @ Rs. 20. Expected EBIT Rs. 80,000 determine
(a) EPS for each plan
(b) Financial BEP for each plan.
[Ans. (a) I 4, II 7.20, III 6.40; (b) I 0, II 8000, III 16000]
Ques. 4: X Ltd. is planning an expansion programme which will require Rs. 30 crores
and can be funded through one of three following options (i)
Issue further equity shares of Rs. 100 each at par.
(ii)
Raise a 15% loan
(iii)
Issue 12% preference shares.
The present paid up capital is 60 crores and the annual EBIT is Rs. 12 crores. The tax
may be taken at 50%. After the expansion plan is adopted, the EBIT is expected to be
15 crores.
Calculate the EPS under all the three financing options indicating the alternative giving
the highest return to the equity shareholders. Also determine the indifference point
between the equity share capital and the debt financing.
[Ans. EPS - 8.33, 8.75, 6.50]
Ques. 5: ABC Ltd. has 6% debt of Rs. 10,00,000 and 4,00,000 equity shares of Rs. 10
each. market price of share Rs 10. Ignore tax. Find out
(i)
Financial BEP
(ii)
What is the minimum EBIT to be able to pay dividend of Rs. 1.00 per share.

(iii)

For what range of EBIT is leverage positive? And whenever

[Ans. (i) 60,000, (ii) 4,60,000, (iii) +Ve if EBIT > 3,00,000 -Ve if EBIT < 3,00,000]

Ques. 6: A company is considering 2 financial plans to finance en expansion plan of Rs.

1.00 crore. I plan equity shares @ Rs. 12.50 II plan 14% debentures. Tax 40%. Its
present capital structure consists of 20,00,000 equity shares & 8% debentures of Rs.
50,00,000. Expected price earning ratio in case of I Plan 14 and in case of II Plan 12.
Calculate indifference point at which market price of share will be same.
Ques. 7: A new company has to raise Rs. 60,00,000 from the market. It can issue
equity shares @ Rs. 25, 15% debentures at par and 12% preference shares at par. Tax
50%. The four possible financial plans.
Plan
Debenture
Pref. Sharers
equity
1
NIL
NIL
100%
2
20%
NIL
80%
3
40%
NIL
60%
4
45%
15%
40%
Determine indifference point
-Compiled By Sapna Bhupendra Jain; 98112-55704

Ques. 15: The abridged Balance sheet as at 31st March 1999 of a company is as under
LIABILITIES
AMOUNT
ASSETS
AMOUNT
Share capital equity
Fixed Assets
1,80,000
Shares of Rs. of 10 each 1,00,000
Current Assets
Reserves & surplus
1,50,000
Stock
70,000
Trade creditors
50,000
Debtors
50,000 1,20,000
3,00,000
3,00,000
The company in the next year plans to undertake a major capital investment which will
be 31st March 2000, increased the fixed assets by Rs. 70,000./ turnover for the year is
expected to go up by 50% and the profits before interest and taxes also are anticipated
to increase by the same percentage, as will the creditors, stock and debtors.
The earning before tax for the year ended 31 st March 1999 were Rs. 60,000 and the
rate of Rs 1 per share were paid at the end of that year. Dividends per share for the
year 1999 2000 will be at the same rate per share. Tax rate is not expected to change.
The co. needs large funds for the expansion programme and the finance division is
examining the following alternatives for implementation: (a) Issue of 10% convertible debentures for 2 lakhs; each Rs. 1000 debentures is
convertible into so equity shares.
(b) Issue of debentures for Rs 2 lakhs with interest warrants attached. Interest rate is to
be fixed at 13% p.a. and each Rs 1000 debenture will enable the holder to purchase
50 equity shares at Rs. 15 each.
(c) Making a right issue, which would allow shareholders to buy 8 new shares at Rs.
15.50 each for every five shares presently held.
You are required to consider each of the alternatives separately. You are requested to
indicate the effect of each financing method on the B/sheet as at 31 st March, 2000 and
also indicate the underlying earnings per share (earning per share based on the number
of shares that have been issued as at 31st March, 1999)
You are to assume that the debentures and rights issue will be made on 1sat April 1999.
In the case of convertible debentures, assume that all the debentures are converted on
1st Oct, 1999. If funds are raised in excess of the needs of the company for 1999-2000,
you can assume that they will be held in the form of cash.