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Leverage A) Operating B) Financial

C) Combined

Leverage

Leverage: In general leverage may be defined as a


relative change in profits due to change in sales.

Higher the degree of leverage higher will be the


fluctuations in profits due to small changes in sales.

Leverage in business terminology can be either A)


Operating B) Financial .

Combined leverage is the total impact of the two


leverages.

Mathematically combined leverage is multiplication of


operating & financial leverage.

Operating Leverage

Operating leverage is the proportion of fixed assets


in the overall assets of the firm.

Firm with higher proportion of fixed costs has higher


operating leverage.

Firms with higher operating leverage


sensitive to the economic conditions.

Firms with higher operating leverage will see higher


changes in profitability vis--vis it sales.

Generally the firms with higher operating leverage


tend to do well in good economic conditions and vice
versa.

are

more

Degree of Operating Leverage

Degree of operating leverage (DoL) may be defined


as the percentage change in operating profits
resulting from a percentage changes in sales.
DoL = (% Change in Operating Profits )
(% Change in Sales)

i.e. DoL = (% Change in EBIT)


(% Change in Sales)

i.e. DoL = EBIT/EBIT


Sales/Sales

So, if the DoL is 2, then for every 1% change in sales,


then operating profits move (up or down) by 2% in
the same direction.

Formula for Degree of Operating Leverage


Let ,
Q= Number of units
sold
s= Selling price per
unit
v=Variable cost per
unit,
F= Total fixed cost
Then,
DOL= Q*(s-v)
Q*(s-v) F

i.e. DOL= Contribution

However,
Contribution = EBIT +Fixed
Cost
So, DOL= 1+ (F/EBIT)

Example of Operating Leverage


Consider 2 firms B & A with same product but B has a
higher fixed cost.
(All No's in Million unless
stated)

Recession
Normal
Expansion
A
B
A
B
A
B
Units Sold
5
5
6
6
7
7
Price Per Unit (Rs)
4
4
4
4
4
4
Sales(in Mn)
20 20
24
24
28
28
Variable Cost per
unit (Rs)
2
1
2
1
2
1
Total Variable Cost 10
5
12
6
14
7
Conribution
10 15
12
18
14
21
Fixed Cost (Rs. Mn) 10 16
10
16
10
16
EBIT
2
4
5
As (Rs.
one Mn)
can see 0
Firm-1with 2a higher
operating
leverage(i.e. higher fixed cost) tends to do well in
the expansion phase & losses out in the
recessionary environment.

Financial Leverage

Financial Leverage : The use of the fixed-charged


source of funds, such as debt and preference capital
along with the owners equity in the capital structure
is known as Financial Leverage or gearing or trading
on equity.

Trading on equity is used as it is owners equity that


will be used as the basis for raising debt. The supplier
of the debt has limited participation in the companys
profits and hence will insist on protection in earnings
and protection in values represented by owners
equity.

The financial leverage employed by a company is


expected to earn more on fixed charges funds than
the cost of funds.

Meaning of Financial Leverage

For example; If company raises Rs100 at 8% interest


cost and generates 12% on it, the surplus 4% will go
to share holders of the firm. Where as if it earns only
6%, the shareholders returns will suffer by 2%

Hence, financial leverage has the potential to earn


higher returns as well as creating higher risk for the
shareholders.

And hence it is a double edged sword.

Measures of Financial Leverage


Measures of Financial Leverage

Debt Ratio (L1) = D/ (D+E)


Debt to Equity Ratio (L2) = D/ E
Interest Coverage (L3) = EBIT/ Interest

First two measures are similar in nature:

L1 = L2/ (1+L2) and


L2 = L1/ (1-L1). These are called gearing measures
and are static in nature as they give the current
position of the firm at a point of time.

The third measure indicates the capacity of the firm to


service the fixed-charges.

Measures of Financial Leverage


Limitations

To determine the companys ability to meet the fixed


charges, it is the cash flow that is more relevant than
the reported earnings.

The ratio is calculated on the past earning and hence


does not reflect on the future.

It is measure of the short term liquidity than of


leverage.

Financial Leverage & Shareholders returns


The primary purpose of using financial leverage
is to magnify the shareholders returns. For this
to happen, the cost of funds on the leverage
should be less than the returns earned on the
funds.
Thus, when the difference between the fixed
charges funds & and returns generated on the
funds is distributed to shareholders the EPS &
RoE increases.
However, EPS or ROE will fall if the company
obtains the funds at higher rate than it generates
the return on the capital.
So, it must be very clear that, EPS, ROE and ROI
are very important figures when we discuss
financial leverage.

Financial Leverage & Shareholders returns


Effects of Leverage
Favorable

RoI > Interest Rate

Unfavorable

RoI < Interest Rate

Neutral

RoI = Interest Rate

RoE = [r + (r-i)*D/E]* (1-t)


Where,
- r is pre-tax return on investment or
assets

Financial Leverage & Shareholders returns


Conclusions:
The equation in previous slide clearly shows that
RoE is more by
(r-i)*D/E *(1-t) factor when the firm uses debt.
It is also seen that if return on assets exceeds the
interest rate (r>i), RoE will increase linearly with
increase in the financial leverage i.e. D/E. The effect
of leverage depends on both D/E and spread between
r & i.
If, r=i , no benefits of the financial leverage will be
seen.
The leverage effect will be unfavorable if r<i.
With a given financial leverage, tax rate & interest

Degree of Financial Leverage


As we have seen, Financial leverage affects the
earning per share of the Company.
The degree of financial leverage (DFL) is defined as
the percentage changes in EPS due to given
percentage change in EBIT.
DFL =

% Change in EPS
% Change in EBIT

DFL = EPS /EPS


EBIT/EBIT
So, if the DFL is 2, then for every 1% change in EBIT,
then profits move (up or down) by 2% in the same
direction.

Formula for Degree of Financial Leverage


Let ,
Q= Number of units
sold
s= Selling price per
unit
v=Variable cost per
unit,
F= Total fixed cost
However,
Then,
EBIT= Q *(s-v)-F
DFL= EBIT
(EBIT-INT)
i.e. DFL= EBIT
PBT

So, DFL= Q *(s-v)-F


Q*(s-v)-F-INT

Example of Financial Leverage


Equity
Debt
Total Investment
Equity
Debt
No of Shares@
Rs.10

100%
0%

50%
50%

25%
75%

1000000 1000000 1000000


1000000 500000 250000
0 500000 750000
100000

50000

25000

Debt@ 15%
I rate

15%

EBIT Margin
Case 1
EBIT
Interest
PBT
Tax @ 50%
PAT
EPS
ROE

24%
240000 240000 240000
0
75000 112500
240000 165000 127500
120000
82500
63750
120000
82500
63750
1.2
1.65
2.55
12.0%
16.5%
25.5%

Case 1 : EBIT
Margin (i.e.
ROI) > Rate of
Interest

Example of Financial Leverage


Equity
Debt

100%
0%

50%
50%

25%
75%

100000 100000 100000


Total Investment
0
0
0
100000
Equity
0 500000 250000
Debt
0 500000 750000
No of Shares@ Rs.10 100000 50000 25000

Debt@ 15%
I rate

15%

EBIT Margin
Case 2
EBIT
Interest
PBT
Tax @ 50%

15%
150000 150000 150000
0 75000 112500
150000 75000 37500
75000 37500 18750

Case 2 : EBIT
Margin (i.e.
ROI) = Rate of
Interest

Example of Financial Leverage


Equity
Debt

Total Investment
Equity
Debt
No of Shares@
Rs.10

100%
0%

50%
50%

25%
75%

100000 100000 100000


0
0
0
100000
0 500000 250000
0 500000 750000
100000

50000

25000

Debt@ 15%
I rate

15%

EBIT Margin
Case 3
EBIT
Interest
PBT

12%
120000 120000 120000
0 75000 112500
120000 45000
7500

Case 3 : EBIT
Margin (i.e.
ROI) < Rate of
Interest

Combined Leverage
Combined leverage in the impact of change of sales
on the EPS.
Higher the combined leverage higher will be the
sensitivity of EPS with respect to sales.
Combined leverage is nothing but the combined
impact of operating & financial leverages.

Degree of Combined Leverage


The degree of combined leverage (DCL) is defined as
the percentage changes in EPS due to given
percentage change in Sales.
DCL =

% Change in EPS
% Change in Sales

Multiplying both numerator & denominator by %


change in EBIT we get,
DCL =

DoL * DFL

As we know, DFL =

% Change in EPS
% Change in EBIT

DoL = (% Change in EBIT)


(% Change in Sales)