Financing Decision

In this chapter

Sources of finance Debt, Preference and Equity Capitals Operating and financial Leverage

Sources of Finance

Owned Capital:

Share Capital

Equity Share Capital Preference Share Capital

Retained Earnings.
Debentures. Institutional Loans. Public Deposits.

Debt Capital:

Leverage

Leverage means the action of a lever and mathematical advantage gained by it. Firms ability to use fixed costs assets or sources of funds to magnify the returns to its owners. According to James Home, leverage is the employment of an asset or sources of funds for which the firm has to pay a fixed costs or fixed return.

Types of Leverage

Operating Leverage. Financial Leverage.

Operating Leverage

The firms ability to use operating cost to magnify the effects of changes in sales on its EBIT. The degree of operating leverage may be defined as the change in the percentage of EBIT, for a given change in percentage of sales revenue.

Symbolically
Percentage change in EBIT Degree of Operating Leverage (DOL) = Percentage change in Sales Or

When the data is given only for one year, then we have to compute operating leverage, by the following formula.

Operating Leverage

Contribution Operating Profit (EBIT)

Application of the Operating Leverage

It is helpful to know how operating profit would change with a given change in units produced. It will be helpful in measuring business risk.

Financial Leverage

Ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on firms EPS.
EBIT (Operating profit) Financial Leverage = EBT (Taxable income) Percentage change in EPS Degree of Financial Leverage (DFL) Or

Percentage change in EBIT

Application of the Financial Leverage

It is helpful to know how EPS would change with a operating profit. It is helpful for measuring financial risk.

Combined Leverage

The percentage change in EPS due to the percentage changes in sales.

% Change in EBIT % Change in Sales X % Change in EPS % Change in EBIT = % Change in EPS % Change in Sales

Or
EBIT Contribution

Contribution
EBIT

X
EBT

=
EBT

Effect of Leverage
Operating Leverage High Low High Financial Leverage High Low Low Combined Effect This combination is very dangerous policy, which should be avoided. This combination is very cautious policy and not assuming risk. This combination have adverse effects of operating leverage were taken care of by having low financial leverage. This combination is an ideal situation. The company can follow aggressive debt policy.

Low

High