CHAPTER 6

LONG- TERM FINANCING

LEVERAGES

It is the duty of the finance manager in every firm to estimate the requirements of funds and
procure them, at economic cost. There are various alternative sources to raise the funds. Sources
are many and so costs are also different. In respect of some funds, firm has to pay fixed costs like
interest on debentures while the return to shareholders varies, if the same amount is raised in the
form of share capital. The finance manager has to determine the best mix of such funds or decide
about the capital structure of the concern. The structure, finally chosen influences the risk and
return to the firm.

Leverage analysis is the technique used by the business firms to quantify the risk return
relationship of different alternative capital structures.

Meaning: the dictionary meaning of the term leverage refers to an increased means of
accomplishing some purpose. Leverage allows the organization to achieve certain objectives
which are other wise not possible i.e. lifting of heavy objects with the help of leverage. This
concept of leverage is also applicable for the business. In Fm the term leverage is used to
describe the firm’s ability to use fixed cost assets or funds to increase the return to its equity
share holders.

Definition: James Horene has defined leverage as” the employment of an asset or sources of
funds for which the firm has to pay a fixed cost or a fixed return .the fixed cost cost indicate
fixed operating cost, and fixed return indicate financial cost it should remain constant
irrespective of changes in the volume of out put or sales.

James Horne –has defined leverage as “ the employment of an asset or funds for which the firm
pays a fixed cost or fixed return.”

Concept of leverage

The term leverage, in general, refers to the relation ship b/n two interrelated variables. In
financial matters, one financial variable influence another variable. Those financial variables
may be cost , sales, revenue, EBIT, out put, EPS etc. In this analysis the emphasis on the
measurement of the relationship of the two variables, rather than on measuring the variables.

Leverage= % of change in dependent variable(sales)/ % of change in independent variable(sales

promotion).

The term leverage is used to describe the firm’s ability to use fixed cost assets or funds to
increase the return to its owners; i.e. equity shareholders. Higher is the degree of leverage, higher
is the risk as well as return to the owners. There are basically three types of leverages.
 1. Operating leverage
2. Financial leverage.
3. Composite leverage

The leverage associated with the employment of fixed cost assets is referred to as operating
leverage. While the leverage resulting from the use of fixed cost/return source of funds is known
as financial leverage. In addition to these two kinds of leverage, one could always compute
‘composite leverage’ to determine the combined effect of the leverages.

FINANCIAL LEVERAGE OR TRADING ON EQUITY:

The use of long-term fixed interest bearing debt and preference share capital along with equity
share capital is called financial leverage or trading on equity. The fixed cost funds are employed
in such a way that the earnings available for common stockholders are increased. The aim of
financial leverage is to increase the revenue available for equity shareholders using the fixed cost
funds. A firm is known to have a favorable leverage if its earnings are more than what debt
would cost. On the contrary, if it does not earn as much as the debt costs then it will be known as
an unfavorable leverage.

When the debt is relatively large in relation to capital stock, a company is said to be trading on
their equity. On the other hand if the amount of debt is comparatively low in relation to capital
stock, the company is said to be trading on thick equity.

Financial leverage:-
The use of long term interest/ fixed dividend bearing securities such as debt and preference share
capital along with equity share capital is called financial leverage.

Purpose of financial leverage:-this employed by a company to earn more on the fixed charges
funds than their costs.

Degree of Financial leverage(DFL)= % of changes in EPS/% of changes in EBIT

Master table for leverage calculation

IMPACT OF FINANCIAL LEVERAGE:

The financial leverage is used to magnify the shareholders earnings. It is based on the
assumption that the fixed charges/cost funds can be obtained at a cost lower than the firm’s rate
of return on its assets. When the difference between the earnings from assets financed by fixed
cost funds and the costs of these funds are distributed to the equity shareholders, they will get
additional earnings without increasing their own investment. Consequently, the earnings per
share and the rate of return on equity share capital will go up. The impact of financial leverage
can be analyzed while looking at earnings per share and return on equity capital.

OPERATING LEVERAGE:

Operating leverage results from the presence of fixed costs that help in magnifying net operating
income fluctuations flowing from small variations in revenue. The fixed cost is treated as
fulcrum of leverage. The changes in sales, fixed costs remaining the same, will magnify the
operating revenue. The operating leverage occurs when a firm has fixed costs which must be
recovered irrespective of sales volume. The fixed costs remaining same, the percentage change
in operating revenue will be more than the percentage change in sales. The occurrence is known
as operating leverage. If a firm does not have fixed costs then there will be no operating
leverage.
Degree of operating leverage= % of changes in profit/% of changes sales.

Contribution= sales-variable cost

Operating profit= sales-variable cost-fixed cost

BEP= fixed cost/P/v ratio

P/V ratio= contribution/sales.

Favorable & unfavorable operating leverage:-

Operating leverage may be favorable or unfavorable.

In case, contribution exceeds the fixed costs, there is favourable operating leverage. In the
reverse situation, when fixed costs exceeds contribution, the operating leverage is termed as
unfavourable leverage.
Operating leverage is a double edged sword:-

Operating profit of a highly leveraged firm would increase at a faster rate for any given increase
in sales. However, if sales fall, the firm with a higher operating leverage would suffer more loss
than the firm with no or low operating leverage. This is very risky situation.

Typical example:-

A retail firm and an airline are typical examples of low and high operating leverage. Proportion
of fixed costs in the total cost structure is low in a retail firm, as the amount of investment is
more on inventory, with a small investment in future and other fixed assets to support the
business. So, to a retail firm, a small increases in sales does not produce a bigger increase in
operating profit, due to low proportion of fixed cost in the cost structure.

To an air line, amount of fixed costs in the total cost structure is very high. Firm with high
degree of operating leverage is more vulnerable to change in sales. So. Profit is highly sensitive
to the increase in revenue and passengers carried in an airline. Percentage of increase in revenue
to an airline firm produces a higher % of operating profit. This is reason why unsold tickets are
sold at a cheap rate when the flight is about to depart to increase the operating profit. A retail
firm and an airline are typical examples of low and high operating leverage, respectively.

Option of higher operating leverage or higher operating profit:-

If choice is to be made b/n higher these two, it is better to chose for a firm to have higher
operating profit rather than having higher operating leverage. Reason is firm having higher
operating leverage is vulnerable, in case sales fall due to high fixed costs. The firm suffers more
loss, in case of decline in sales.

(Operating leverage tells the impact of sales on income.

COMPOSITE LEVERAGE:

Both financial leverage and operating leverage magnify the revenue of the firm. Operating
leverage affects the income which is the result of production. On the other hand, the financial
leverage is the result of financial decisions. The composite leverage focuses attention on the
entire income of the concern. The risk factor should be properly assessed by the management
before using the composite leverage. The high financial leverage may be offset against low
operating leverage or vice-versa.

F.L*O.L=C/EBT

Degree of composite leverage= % change in EPS/% change in sales.

Q1. XYZ Company has currently an equity share capital of $ 4,000,000 consisting of 40,000
equity shares of $100 each. The management is planning to raise another $3,000,000 to finance a
major programme of expansion through one of the four possible financing plans. The options
are:

(i) Entirely through equity shares.

(ii) $1,500,000 in equity shares of $100 each and the balance in 8% debt.
(iii) $1,000,000 in equity shares of $100 each and the balance through long-term
borrowing at 9% interest p.a.
(iv) $1,500,000 in equity shares of $100 each and the balance through preference share
with 5% dividend.

The company’s expected earnings before interest and taxes (EBIT) will be 1,500,000.
Assuming corporate tax rate of 50%, you are required to determine the EPS and comment
on the financial leverage that will be authorized under each of the above scheme of
financing.

Q2. Following is the cost information of a firm:

Fixed cost =$50,000

Variable cost=70% of sales

Sales=200,000 in previous year and $250,000 in current year.

Find out percentage change in sales and operating profits when:

(i) Fixed costs are not there (no leverage)

(ii) Fixed cost are there (leveraged situation)

Q3. A simplified income statement of Zenith Ltd. is given below. Calculate and interpret its
degree of operating leverage, degree of financial leverage and degree of combined leverage.
$

Sales 1,050,000

Variable cost 767,000

Fixed cost 75,000

___________

EBIT 208,000

Interest 110,000

Taxes (30%) 29,400

___________

Net Income 68,600

____________
Case lets

4. A firm is considering the financial plans with a view to examining their impact on
earnings per share (EPS). The total funds required for investment in assets are $500,000
Financial plans
Particulars plan-I Plan-II
Debt (interest @10% p.a) 400,000 100,000
Equity shares ($10each) 100,000 400,000
Total finances required 500,000 500,000
No.of equity shares 10,000 40,000
The earnings before interest and tax are assumed as $ 50, 000, $ 75,000 and $125,000.
The rate of tax be taken at 50. Comment.

5. A Ltd .company has equity share capital of $500,000 divided in to shares of $100 each.
It wishes to rise further $300,000 for expansion cum modernization plans. The company
plans the following financing schemes.
a. All common stock
b. $100,000 in common stock and $200,000 in 10% debentures.
c. All debt at 10% p.a
d. $100,000 in common stock and $200,000 in preference capital with rate of dividend
at 8%.
The company’s existing earnings before interest and tax are $150,000. The corporate
rate of tax is 50%.
You required to determine the EPS in each plan and comment on the implications of
financial leverage.