Lesson 23

Chapter-7
Leverages
Unit 3
Financing decisions

After studying this lesson, you should be able to:

Understand what financial leverage is.

Calculate the operating break-even point for quantity and for dollar revenues
Understand EBIT-EPS break-even, or indifference, analysis.
Describe the elements of total firm risk.
Understand what is involved in determining the appropriate amount of financial
leverage.

Now that you have understood operating leverage, we will be doing financial
leverage in today’s session.

Financial Leverage
An Introduction

Financial leverage involves the use of fixed cost financing. Interestingly, financial leverage is
acquired by choice, but operating leverage sometimes is not. The amount of operating
leverage (the amount of fixed operating costs) employed by a firm is sometimes dictated by
the physical requirements of the firm's operations. For example, a steel mill by way of its
heavy investment in plant and equipment will have a large fixed operating cost component
consisting of depreciation. Financial leverage, on the other hand, is always a choice item. No
firm is required to have any long-term debt or preferred stock financing. Firms can, instead,
finance operations and capital expenditures from internal sources and the issuance of
common stock. Nevertheless, it is a rare firm that has no financial leverage. Why, then, do we
see such reliance on financial leverage?

Financial leverage is employed in the hope of increasing the return of common shareholders.
Favorable or positive leverage is said to occur when the firm uses funds obtained at a fixed
cost (funds obtained by issuing debt with a fixed interest rate or preferred stock with a
constant dividend rate) to earn more that the fixed financing costs paid. Any profits left after
meeting fixed financing costs then belong to common shareholders. Unfavorable or negative
leverage occurs when the firm does not earn as much as the fixed financing costs. The favor
ability of financial leverage, or "trading on the equity" as it is sometimes called, is judged in
terms of the effect that it has on earnings per share to the common shareholders. In effect,
financial leverage is the second step in a two-step profit-magnification process. In step one;
operating leverage magnifies the effect of changes in sales on changes in operating profit. In
step two, the financial manager has the option of using financial leverage to further magnify
the effect of any resulting changes in operating profit on changes in earnings per share. In the
next section we are interested in determining the relationship between earnings per share
(EPS) and operating profit (EBIT) under various financing alternatives and the indifference
points between these alternatives.

EBIT-EPS Break-Even or Indifference Analysis

Calculation of Earnings per Share:

To illustrate an EBIT-EPS break-even analysis of financial leverage, suppose that Cherokee

Tire Company with long-term financing of. $10 million, consisting entirely of common stock
equity, wishes to raise another $5 million for expansion through one of three possible
financing plans.
The company may gain additional financing with a new issue of
(1) All common stock,
(2) All debt at 12 percent interest, or
(3) All preferred stock with an 15 percent dividend. Present annual earnings before
interest and. taxes (EBIT) are $15 million but with expansion are expected to rise to
 $2.7 million. The income tax rate is 40 percent, and 200,000 shares of common stock
are -now outstanding. -Common stock can be sold at $50 per share under the first
financing option, which translates into 100,000 additional shares of stock.

To determine the EBIT-EPS break-even, or indifference, points among the various financing
alternatives, we begin by calculating earnings per share, EPS, for some hypothetical level of
EBIT using the following formula:

EPS = (EBIT - /)(1 - t) – PD / NS

Where I = annual interest paid
PD = annual preferred dividend paid
t = corporate tax rate
NS = number of shares of common stock outstanding
Suppose we wish to know what earnings per share would be under the three alter-
native additional-financing plans if EBIT were $2.7 million. The calculations are shown
Table 16.3
COMMON DEBT PREFERRED
STOCK STOCK
Earning before interest and taxes (EBIT) $2700000 2700000 2700000
Interest (I) ----- 600000 ---
Earnings before taxes (EBT) $2700000 $2100000 $2700000
Income taxes {(EBT) X (t)] 1080000 840000 1080000
Earnings after taxes (EAT) $1620000 $1260000 $1620000
Preferred stock dividends (PD) -------- ---- 550000
Earnings available to common shareholders $1620000 $1260000 $1070000
(EACS)
Number of shares of common stock
outstanding (NS) 30000 200000 200000
Earnings per share (EPS) $5.40 $6.30 $5.35

in Table 16-3. Note that interest on debt is deflected---before taxes, while preferred stock
dividends are deducted after taxes. As a result, earnings available to common shareholders
(EACS) are higher under the debt alternative than they are under the preferred stock
alternative, despite the fact that the interest rate on debt is higher than the preferred stock
dividend rate.

EBIT-EPS Chart:
Given the information in Table 16-3, we are able to construct an
EBIT-EPS break-even chart is similar to the one for operating leverage. On the horizontal
axis we plot earnings before interest and taxes, and on the vertical axis we plot earnings-per
share. For each financing alternative, we must draw a straight line to reflect EPS for all
possible levels of EBlT. Because two points determine a straight line, we need Two data
points for each financing alternative. The first is the EPS calculated for some hypothetical
level of EBlT. Fat the expected $2.7 million level of EBlT, we see in Table 16-3 that earnings
per share are $5.40, $6.30 and $5.35 for the common stock, debt, and preferred stock
financing .alternatives. We simply plot these earnings per –share levels to correspond with
the $2.7 million level of EBlT. Technically, it does not matter which hypothetical level of
EBlT we choose for calculating EPS. On good graph-paper one EBIT level is as good as the
next. However, it does seem to make common sense to choose the most likely, or expected,
EBlT level ,rather than some level not too likely to occur.

The second data point--chosen chiefly because of its ease of calculation-is where EPS is zero.
This is simply the EBlT necessary to cover all fixed financial costs for a particular financing
plan, and it is plotted on the horizontal axis. We can make use of Eq. (16-10) to determine the
horizontal axis intercept under each alternative. "We simply set the numerator in the equation
equal to zero and solve for EBIT. For the, common stock alternative we have

0 = (E BIT - 1)(1 - t) – PD

= (EBIT - 0)(1 - .40) - 0

= (EBIT)(.60)

EBIT = 0/(.60) = 0

Notice there are no fixed financing costs whatsoever (either on old or new financing).
Therefore, EPS equals zero at zero EBIT.3 For the debt alternative we have

0 = (EBIT- 1)(1 - t) – PD

= (EBIT - $600,000)(1 - .40) - 0

= (EBIT)(.60) - $360,000

=EBIT =$360,000/(.60) = $600,000

Thus, the after-tax interest charge divided by 1 minus the tax rate gives us the EBIT:-
necessary to cover these interest payments. In short, we must have $600,000 to Cover interest
charges, so $600,000 becomes the horizontal a)Jis intercept. Finally, for the preferred stock
alternative we have

0 = (EBIT - 1)(1 - t) – PD

= (EBIT - 0)(1 - .40) - $550,000

= (EBIT)(.60) - $550,000

EBIT = $560,000/(.60) = $916,667

We divide total annual preferred dividends by 1 minus the tax rate to obtain the EBIT
necessary to cover these dividends. Thus, we need $916,667 in EBIT to cover $550,OOO, in
preferred stock dividends, assuming a 40 percent tax rate. Again, preferred dividends are
deducted after taxes, so it takes more in before-tax earnings to cover them J than it does to
cover interest. Given the horizontal axis intercepts and earnings per share for some
hypothetical level of EBIT (like the "expected" EBIT), we draw a straight line through each
set of data points. The break-even or indifference, for Cherokee The Company is shown in
Figure 16-3
We see from Figure 16-3 that the earnings per share indifference point between the debt
and common stock additional-financing alternatives is $1.8 million in EBIT.4 If EBIT is
below that point, the common stock alternative will provide higher earnings per share.
Above that point the debt alternative produces higher earnings per share. The indifference
point between the preferred stock and\the common stock alternatives is $2.75 million in
EBIT. Above that point, the preferred stock alternative produces more favorable earnings
per share. Below that point, the common stock alternative leads to higher earnings per
share. Note that there is no indifference point between the debt and preferred stock
alternatives. The debt alternative dominates for all levels of EBIT and by a constant
amount of earnings per share, namely 95 cents.

Indifference Point Determined Mathematically:

The indifference point between two alternative financing methods can be determined
mathematically by first using
Eq. (16-10) to express EPS for each alternative and then setting these expressions equal
to each other as follows:

(EBIT1,2 - I1) (1 - t) – PD) /NS1 = (EBIT1,2 - I2)(1 - t) - PD2) / NS2

where EBITI,2 = EBIT indifference point between the two alternative financing methods
that we are concerned with-in this case, methods 1 and 2

I1,I2 = annual interest paid under financing methods 1 and 2

PD1, PD2 = annual preferred stock dividend paid under financing methods 1 and
2

t = corporate tax rate

NS1, NS2 = number of shares of common stock to be outstanding under financing

methods 1 and 2

Suppose that we wish to determine the indifference point between the common stock and
debt-financing alternatives in our example. We would have

Common Stock Debt

(EBIT1.2 - 0)(1 - .40) – 0) / 300,000 = (EBIT1,2 - $600,000)(1 - .40) – 0)/ 200,000

Cross-multiplying and rearranging, we obtain

(EBIT12)(.60)(200,000) = (EBIT1,2)(.60)(300,000) - (.60)($600,000)(300,000)

(EBIT12)(60,000) = $108,000,000,000

EBIT12 = $1,800,000
 The EBIT-EPS indifference point, where earnings per share for the two methods
of financing are the same, is $1.8 million. This amount can be verified graphically in
Figure 16-3. Thus, indifference points can be determined both graphically and
mathematically.

Effect on risk

So far our concern with EBIT-EPS analysis has been only with what happens to the
return to common shareholders as measured by earnings per share.

We have seen in our example that if EBIT is above $1.8 million, debt financing is the
preferred alternative fro_ the standpoint of earnings per share. We know from our earlier
discussion, however, that the impact on expected return is only one side of the coin. The
other side is the effect that financial leverage has on risk. An EBIT-EPS chart does not
permit a precise analysis of risk. Nevertheless, certain generalizations are possible. For
one thing, the financial manager should compare the indifference point between two
alternatives, like debt financing versus common stock financing, with the most likely
level of EBIT. The higher the expected level of E13IT, assuming that it exceeds the
indifference point, the stronger the case that can be made for debt financing, all other"
things the same.

In addition, the financial manager should assess the likelihood of future EBITs I
actually falling below the indifference point. As before, Our estimate of expected! EBIT
is $2.7 million. Given the business risk of the company and the resulting possible
fluctuations in EBIT, the financial manager should assess the probability of EBITs falling
below $1.8 million. If the probability is negligible the use of the debt alternative will be
supported. On the other hand, if EBIT is presently only slightly above the indifference
In summary, the greater the level of expected EBIT above the indifference point and the
lower the probability of downside fluctuation, the stronger the case that can be made for
the use of debt financing. EBIT-EPS break-even analysis is but one of several methods
used for determining the appropriate amount of debt a firm might carry. No one method
of analysis is satisfactory by itself. When several methods of
analysis are undertaken simultaneously, however, generalizations are possible.

The indifference between the two alternatives methods:

(EBIT - I1) (1-T) (EBIT- I2) (1 – T)

E1 = E2

Where EBIT = Earning before interest and taxes

I1 = Interest charge in alternative 1.
I2 = interest charges in alternative 2.
T = rate of tax
E1 = Equity share in alternative 1.
E2 = Equity share in alternative 2.

Sanjay Manufacturing Ltd. wanted to finance a project, which has an outlay of Rs

60,00,000. It has the following two alternatives in financing the project cost.

Alternative1: 100% equity finance.

Alternative2: debt equity ratio 2:1.
The rate of interest payable on the debt is 18% p.a. The corporate orate of tax is 40%.
Calculate the indifference point between two alternative methods of financing.

Solution
Alternatives in financing and its financial charges:

(i) By issue of 6,00,000 equity shares of RS 10 each amounting Rs 60,00,000. No

financial charges involved.

(ii) By raising the funds in the following way:

Debt Rs. 40 lakhs.

Equity Rs. 20 lakhs (2,00,000 equity shares of Rs. 10 each)

Interest payable on debt = Rs. 40,00,000 X (18/100) = Rs. 7,20,000

We can calculated the break even or difference point as following ways:

(EBIT-0) (1-0.40) = (EBIT-7, 20,000) (1-0.40)

6,00,000 2,00,000

(EBIT-0) (0.60) = (EBIT-7,20,000) (0.60)

6,00,000 2,00,000

(in lakhs)
(EBIT-0) (0.60) = (EBIT-7.2) (0.60)
6 2
0.60 EBIT X 2 = (0.6EBIT X 6) – [(0.62 X 7.2) X 6]
0.60 X 7.2 X6 = (0.60 EBIT X 6) – (6.60 EBT X 2)
25.92 = 3.6 EBIT – 1.2 EBIT
2.4 EBIT = 25.92
 Preference dividend (Dp) = Rs.50000
What is the degree of financial leverage when the earning before interest and tax EBIT
are Rs.400000? What percentage change would occur in the earning per share of Sylex if
EBIT increases by 10 percent?

Solution
EBIT
DFL = ------------------
EBIT – I – Dp/ 1-t
400000
DFL(EBIT = 400000) = --------------------------------------- = 2
400000 – 100000 –50000/ 1- .05
percentage change in EPS if EBIT increases by 5 percent = DFL* 5 percent = 10 %

Example to measure Impact of financial leverage on investor’s

Rate of return
Let us see with the help of a very simple example, how financial leverage affects return
on equity. A company needs a capital of Rs.10000 to operate. This money may be
brought in by the share holders of the company. Alternatively, a part of this money may
also be brought in through debt financing. If the management raises Rs.10000 from
shareholders, the company is not financial leveraged and would have the following
balance sheet.

Liabilities Rs. Assets Rs.

Equity capital 10000 cash 10000

The company commences operations, which leads to the preparations of the following
simplified version of its income statement.
 Rs.
Sales 10000
Expenses 7000
EBIT 3000
Tax @ 50% 1500
Net profit 1500

What is the return the company has earned on the owner investment? We see that the
return on equity is 15%. The net profit of Rs.1500 may be paid fully or partly to
shareholders as dividends or may be retained to finance future activities of the company.
Either way the return on equity is 15%.
What happens to the owner’s rate of the return if the management decides to finance a
part of the required total investment of Rs.10,000 through debt financing? The answer to
this question depends on,
• The proportion of total investment, which the management decides to finance
through debt and the interest rate on, borrowed funds.
• The interest rate on the borrowed funds.
If the management has decided on a Debt equity Ratio of 2:1, total borrowings will
amount to 10000*2/3 = Rs.6667. assuming that the company is able to raise this amount
at an interest of say , 15%, the company’s balance sheet will appear as follow;

liabilities Rs. Assets Rs.

Equity capital 3333 cash 10000
Debt capital 6667
Total 10000 10000

The company now has an added financial burden of payment of interest on the amount he
has borrowed. The income statement will now show as follows;
 Rs.
Sales 10000
Expenses 7000
EBIT 3000
Interest charges 1000
Profit before tax(PBT) 2000
Tax @ 50% 1000
Net profit 1000

The use of debt in the company’s capital structure has caused the net profit to decline
from Rs.1500 to Rs.1000. But has the return on owner’s capital declined? Return on
equity now works out to 30%, as the owner have invested only Rs.3333 now which
earned them Rs.1000. what were the factors which contributed to this additional return.
• Though the company has to pay interest at 15% on borrowed capital, the
company’s operations have been able to generate more than 15%, which is being
transferred to the owners.
• The reduction in PBT has brought about a reduction in the amount of tax paid, as
interest is a tax deductible expenses, to the extent of interest (1-tax rate) i.e,
Rs500. the greater the tax rate, the more is the tax shield available to a company
which is financially leveraged.
As was seen in the above example, a company may increase the return on the equity by
use of the debt i.e., the use of financial leverage. by increasing the portion of debt in the
pattern of financing i.e., by increasing the debt equity ratio, the company should be able
to increase the return on equity.

Example of financial leverage and risk;

If Increased financial leverage leads to increased return on the equity, why do companies
not resort to even increasing amount of debt financing? Why do financial and other term
lending institution insist on norms for debt equity ratio? The answer is that as the
company come more financial leveraged, it become riskier, i.e., increased use of debt
financing will lead to increased financial risk which leads to;
 • Increased fluctuations in the return on equity.
• Increase in the interest rate on debts.

Increased fluctuations in returns

In the previous example, let us assume that sales decline by 10%(fromRs.10000 to
Rs.9000), expenses remaining the same. What happens to return on equity? The income
statements for the financially unleveraged and leveraged firms will appear as follows.

Unleveraged firm Leveraged firm

(0 Debt) (Debt Equity ratio 2:1)
Sales 9000 9000
Expenses 7000 7000
EBIT 2000 2000
Interest charges - 1000
(6667*0.5)
PBT 2000 1000
Tax @ 50% 1000 500
Net profit 1000 500
Net profit @ sales of 1500 1000
Of Rs.10000
ROE @ sales of Rs.10000 15% 30%
ROE@ sales of Rs.9000 10% 15%

We see that a 10% decline in sales produces substantial declines in earnings and the rates
of return on owner’s equity in both cases. But the decline is greater for financially
leveraged firm than for the financially unleveraged firm. Why is this so? The reason can
be traced to the fact that once a firm borrows capital, interest payments become
obligatory and hence fixed in nature. The same interest payment, which was the cause for
increase in owner’s equity when sales decline. Hence, the greater the use of financial
leverages, the greater the potential fluctuation in return on equity.
Increase in interest rates
Firms that are highly financially leveraged are perceived by lenders of debt as risky.
Creditors may refuse to lend to a highly leveraged firm or may do so only at higher rates
of interest or more stringent loan conditions. As the interest rate increases, the return on
equity decrease. However, even though the rate of return diminishes, it might still exceed
the rate of return obtained when no debt was used, in which case financial leverage would
still be favorable.

Implications
Let us again refer to our earlier example. In the first situation, the company was
unleveraged, in the second situation the debt – equity ratio was 2:1. The balance sheet
and income statements are reproduced below.

Balance sheets
--------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------
liabilities Assets Liabilities Assets
Equity Equity Cash 10000
capital 10000 cash 10000 capital 3333
------- -------- Debt 6667
10000 10000 ------- -------
-------- -------- 10000 10000
-----------------------------------------------------------------------------------------------
Income statements

unleveraged Leveraged
sales 10000 10000
Expenses 7000 7000
EBIT 3000 3000
Interest - 1000
PBT 3000 2000
tax@ 50% 1500 1000
Net profit 1500 1000
The degree of financial leverage(DFL) in each case is calculated as follows;
EBIT
DFL = -----------------------
EBIT – I – Dp/1-t
3000
Unleveraged = -------- = 1
3000
3000
leveraged = -------------------- = 1.5
3000 - 1000
What do these imply? This implies that if EBIT is changed by 1%, EPS will also change
by 1% when the company uses no debt and by 1.5% when it uses debt in the ratio of
2:1(66.67% of total capital). This proof of what we have stated earlier. The greater the
leverage, the wider are the fluctuations in the return on equity and the greater is the
financial risk the company is exposed to. Through an EBIT-EPS analysis, we can
evaluate various financing plans or degree of financing plans or financial leverage with
respect to their effect on EPS.

Combined or Total Leverage

Combined leverage is the measure of the total leverage due to both operating and fixed
financial cost. This is then equal to the product of the firm’s DOL and DFL and indicates
the responsiveness of EPS to Q.
Degree of total leverage( DTL) = DOL* DFL
= % change in EPS/ % change in Q
change in EPS/ EPS
= -------------------------
change in Q/ Q
Q(P-V)
= -------------------
Q(P-V) –F – I- Dp/1-t
Implications
A greater DOL or DFL will raise DTL. DTL is a measure of the overall risk ness or
uncertainty associated with shareholder’s earnings that arises because of operating and
financial leverage can be combined in a number of different ways(high business risk
being set off by a low financial risk and vice versa) to obtain a desirable degree of total
leverage and acceptable level of total risk.

Exercise.
The following data are available for the Broadway and Midway companies:

Broadway co. Midway co.

Sales volume 10000 units 10000 units

Selling price per unit of output Rs.200 Rs.200
Variable cost per unit of output Rs.120 Rs.150
Fixed operating cost per unit of output Rs.60 Rs.30
Equity Rs.300000 Rs.600000
Preference shares Rs.100000 --
Debt Rs.600000 Rs.400000
Interest rate on debt 16.25% 15%
Dividend rate on preference share 13% --
Tax rate 60% 60%

Required:
1. Calculate the ROE, DOL, DFL, DTL, operating break-even point ,financial break-
even point for each company.
2. As a financial analyst which of two companies would you describe as more risky?
Give reasons.

Solution:
Broadway co. Midway co.
Rs. Rs.
1. Selling price per unit 200 200
2. Less: variable cost per unit 120 150
3. Contribution 80 50
4. Operating fixed costs at 6,00,000 3,00,000
Sales volume of 10000 units
5.operating breakeven point = 6,00,000/80 3,00,000/50
Operating fixed cost/contribution per unit= 7500 units 6000 units
6. DOL=total contribution
------------------- 800000/200000 500000/200000
Total contribution- total operating
fixed cost =4 2.5
7. Profit before interest& tax 200000 200000
8. Less; interest 97500 60000
9.profit before tax 102500 140000
10. Tax @ 60% 61500 84000
11. profit after tax 41000 56000
12. less: preference dividend 13000 --
(100000*13/100)
13.profit available to equity shareholders 28000 56000

14. ROE 28000*100 56000*100

-------------- =9.3% ------------- =9.3%

300000 600000

15. DFL 200000 200000

----------------=2.86 ----------- =1.43
102500-32500 140000
16. DTL=DOL*DFL = 4*2.86= 11.44 =2.5*1.43=3.575
17. Financial breakeven point = Rs.130000 =Rs. 60000
(Level of PBIT at which ROE is zero)
18. Overall breakeven point = 73000/80 = 360000/50
(Operating fixed cost+ interest+
Dp/1-t/contribution per unit) = 9125units = 7200 units

Working notes: Broadway co. Midway co.

1. Profit before interest and taxes;
Total contribution 800000 800000
Less; fixed operating cost 600000 300000
---------- -----------
200000 200000
2. Interest
Broadway company- 600000*16.25/100 = Rs. 97500
Midway company- 400000*15/100 = Rs.60000

Solution
Through ROE is the same for both the companies; Broadway Company is exposed to
greater risk than Midway company. This is also reflected in the breakeven points
calculated. Midway company is therefore better managed.
True/False Exercise

1. A DOL must be greater than or equal to zero.

2. The EBIT-EPS break-even analysis does not consider differences in risk.

3. The judgments of investment analysts are important for the firm to consider since
they understand and influence the financial markets.

4. The debt ratio is a perfect measure to examine financial risk.

5. A business that has some fixed operating costs but has no debt of any type and no
preferred stock can be considered risk-free.

1. FALSE

2. TRUE

3. TRUE

4. FALSE

5. FALSE
(Level of PBIT at which ROE is zero)
18. Overall breakeven point = 73000/80 = 360000/50
(Operating fixed cost+ interest+
Dp/1-t/contribution per unit) = 9125units = 7200 units

Working notes: Broadway co. Midway co.

1. Profit before interest and taxes;
Total contribution 800000 800000
Less; fixed operating cost 600000 300000
---------- -----------
200000 200000
2. Interest
Broadway company- 600000*16.25/100 = Rs. 97500
Midway company- 400000*15/100 = Rs.60000

Solution
Through ROE is the same for both the companies; Broadway Company is exposed to
greater risk than Midway company. This is also reflected in the breakeven points
calculated. Midway company is therefore better managed.
True/False Exercise

1. A DOL must be greater than or equal to zero.

2. The EBIT-EPS break-even analysis does not consider differences in risk.

3. The judgments of investment analysts are important for the firm to consider since
they understand and influence the financial markets.

4. The debt ratio is a perfect measure to examine financial risk.

5. A business that has some fixed operating costs but has no debt of any type and no
preferred stock can be considered risk-free.

1. FALSE

2. TRUE

3. TRUE

4. FALSE

5. FALSE