Outline

What is Leverage?
Leverage Means Risk Operating Leverage

Financial Leverage
Combined or Total Leverage

Business Risk v/s Financial Risk

Business risk refers to Financial risk refers to

the risk of running the business. It is uncertainty about the future operating income(i.e. EBIT) It is generally unavoidable.

the additional risk placed on the firms shareholders as the result of debt use. Financial is the risk associated with the financing activities. It is avoidable if firm does not use fixed charge source of finance.

What is Leverage?
Leverage is used to describe the firms ability to use

fixed costs assets or sources of fund to magnify the potential return to a firm. According to James Home, leverage is, the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return.

OPERATING LEVERAGE
Operating leverage may be defined as the firm ability to use operating costs to magnify the effects of changes in sales on its earnings before interest and tax. A firm with relatively high fixed operating costs will experience more variable operating income if sales change come. OL = Contribution/ Sales

Operating Leverage
Measure of the amount of fixed operating costs used

by a firm Degree of Operating Leverage (DOL) = %age in EBIT (or OI) / %age in Sales a in Sales a larger in EBIT (or OI) Operating Leverage measures the sensitivity of a firms operating income to a in sales

Interpretation of the DOL

DOL is a quantitative measure of the sensitivity of a

firms operating profit to a change in the firms sales. When comparing firms, the firm with the highest DOL is the firm that will be most sensitive to a change in sales.

Financial Leverage
According to Lawrence, financial leverage is the ability

of the firm to use fixed financial charges to magnify the effects of changes in EBIT on the firms earnings per share. Financial leverage = EBIT/EBIT-INT- Po 1-tax

Financial Leverage
Measure of the amount of debt used by a firm
Degree of Financial Leverage (DFL) = %age in EPS /

%age in EBIT (or OI) a in EBIT (or OI) a larger in EPS Financial Leverage measures the sensitivity of a firms earnings per share to a in operating income

Interpretation of the DFL

DFL is a quantitative measure of a firms EPS to a

change in the firms EBIT. Higher the degree of financial leverage leads to high financial risk. Hence the financial manager should take into consideration the level of EBIT and fixed charges while preparing the firms financial plan.

Table showing combination of Operating and Financial Leverage.

OPERATING LEVERAGE HIGH FINANCIAL LEVERAGE HIGH COMBINED EFFECT This combination is very dangerous policy, which should be avoided. This combination is a very cautious policy and not assuming risk. This combination has adverse effects of operating leverage and are taken care of by having low financial leverage This combination is an ideal situation. The company can follow aggressive debt policy.

LOW

LOW

HIGH

LOW

LOW

HIGH

Combined or Total Leverage

The operating leverage has its effects on operating risk

and the financial leverage has its effect on financial risk. Since both these leverages are closely related the firms ability to cover both fixed operating cost and financial cost is measured by combined leverage or total leverage.

Combined or Total Leverage

Represents maximum use of leverage
Degree of Combined or Total Leverage (DCL or DTL) =

%age in EPS / %age in Sales a in Sales a larger in EPS Short-cut formula: DCL or DTL = DOL x DFL

PARTICULARS SALES LESS: VARIABLE COST(0.70) CONTRIBUTION

PLAN A 7000 4900 2100

PLAN B 7000 4900 2100

LESS: FIXED COST

EBIT LESS: INTEREST EBT

1700
400 NIL 400

1700
400 200 200

LESS: TAX@35%
EAT DOL=CONTR/EBIT DFL=EBIT/EBT DCL=DOL*DFL

140
260 5.25 1 5.25

70
130 5.25 2 10.25

INTERPRETATION
THE DCL OF PLAN B IS HIGHER DUE TO HIGHER

FIANCIAL LEVERAGE. THE TOTAL RISK IS THEREFORE HIGHER IN PLAN B. THE DOL OF BOTH THE PLAN IS SAME.

INDIFFERENCE POINT
It is the level of EBIT where

the EPS will be equal under alternative financing plans

COMPUTATION OF

E=EBIT I= Interest on debt

INDIFFERENCE POINT Indifference point can be calculated using the following equation: E(1-t) = (E-I)(1-t) N1 N2

capital t= Corporate tax rate N1= No. of equity shares under 1st alternative financing plan. N2= No. of equity shares under the 2nd alternative financing plan.

 Equity share capital

Alternative financial plan An example of indifference point. A B

200000
Nil 50% 10000& 30000.

100000
100000

( Rs 100 each ) 10% Debt Capital10% Corporate tax EBIT level EPS=(E-I)(1-t) N
When EBIT=Rs.10000 EPS Plan A= Rs. 2.5 Plan B= Rs. 0

When EBIT=Rs.10000 EPS Plan A= Rs. 7.5 Plan B= Rs. 10