Financial And Operation Leverage

By Group -7
D.V. R.K. Raju (1225111311) Pratyusha .L (1225111328)

Priyanka Pradip(1225111339)
Rajesh .T (1225111343) Anusha.S(1225111347)

Out line
Concept of Leverages Operating leverages DOL Operating risk Financial leverages DFL Financial Risk Combines Leverages

Concept
Leverage is very scientific tool in the hand of finance manager . Financial structure is just mix of debt and equity and with help of leverage. Main aim of leverage testing is maximize the earning of shareholder and reduce the risk of company. Type of leverage : Operation Financial Combined

Leverage and The income statement

Sales Fixed costs Variable costs EBIT Interest EBT Taxes EAT
Operating Leverage Total Leverage

Financial Leverage

Operating
It is caused due to fixed operating expenses in a firm. Tells the EBIT will greater than sale because due to increasing sale of fixed cost per unit will decrease and it will increase EBIT higher than sale . Operating Leverage = % change in EBIT % change in Sale

Example
(Q) A firm sells products for 100 /unit, has variable operating cost of
Rs 50/unit and fixed operating cost of Rs 50,000/yr. Show the various levels of EBTI that would result from sales of 1000units, 2000units, 3000units. Solution: The sales level of 200 units used as a base for comparison.
Case-2
(-50%)

base 2000 units

200,000.00 100,000.00 100,000.00 50,000.00

case-1
(+50%)

Sales in units
sales revenue (-)Variable operating cost contribution (-)Fixed operating cost

1000 units
100,000.00 50,000.00 50,000.00 50,000.00

3000 units
300,000.00 150,000.00 150,000.00 50,000.00

EBIT

50,000.00

100,000.00

Key to Symbols Used

Note: The symbols used in the notes differ somewhat from the symbols used in the text. P = price per unit Q = sales in units V = variable cost per unit F = fixed costs VC = total variable costs TC = F + VC = total costs S = PQ = sales dollars EBIT = S - TC

Degree of operating leverage (dol)

Dol measures quantitative terms .
% in EBIT DOL % in Sales Q( P V ) S VC = Q ( P V ) F S VC F S VC = EBIT

Example
Sales (100000 units@ 8) (-) Variable cost (100000@ Rs 4) Contribution (-)Fixed costs EBIT 800,000 400,000 400,000 280,000 120,000

100,000 ( Rs 8 Rs 4) DOL 3.33 100,000 ( Rs 8 Rs 4) Rs 280,000

DOL = 3.33

Operating risk
Risk of not able to cover fixed operating cost by firm.
The larger the magnitude, the larger the volume of sales required to cover all fixed cost.

Financial leverages
Caused due to the fixed financial costs (interest) in firm.
Defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share.

PAT ( EBIT INT )(1 T ) EPS N N

 Where T is the corporate tax rate and N is the number of ordinary shares outstanding. If the firm does not employ any debt, then the formula is
EPS EBIT (1 - T) N

Measures of financial leverage

Debt ratio

D DE L D E

Debt equity ratio

Interest coverage L EBIT

Interest

Example
A company has Rs 100000, 10% debentures and 5000 equity shares outstanding. It is in the 35 %tax bracket. Assuming three levels of EBIT (i) Rs 50,000, (ii) Rs 30,000, and (iii) Rs 70,000 calculate the change in EPS. (base level of EBIT = Rs 50,000).
EBIT (-)Interest EBT (-) Taxes EAT EPS Case-2 -40% 30000 10000 20000 7000 13000 2.6 -50% Base 50000 10000 40000 14000 26000 5.2 Case -1 40% 70000 10000 60000 21000 39000 7.8 50%

Degree of financial leverage

Financial leverage can be more precisely expressed in terms of the DFL.

% in EPS DFL % in EBIT EBIT = EBIT - I

Example
50% Case 1 1.25 40% - 50% Case 2 1.25 - 40%
Rs 50,000 1.25 Rs 50,000 - Rs 10,000

DFL =1.25

Financial Risk
The risk of not being able to cover fixed financial costs by a firm. Degree of variability of EBIT, the variability of EPS increase with more financial leverages.
Financial risk can be avoidable risk if the firm decides not to use any debt in its capital structure

Combined leverage
Product of Operating leverage and Financial leverage DCL = DOL x DFL
%change in EPS DCL % change in sales

S VC DCL EBIT I

Example
DCL = DOL x DFL DOL = 3.33 DFL = 1.25

DCL= 4.1625
Total risk : Is the risk associated with combined leverage