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LEVERAGES

It is the responsiveness of one financial variable over the other financial variable. It measures how the dependent variable responds to a change in the independent variable. Types of leverage Operating leverage Financial leverage Combined leverage

Operating leverage It refers to the use of fixed costs in the operation of the firm. It implies the proportion of fixed costs in the total cost structure of the firm. Operating leverage will be higher if the proportion of fixed costs is higher. Fixed costs are depreciation, office and administrative costs etc that do not vary with sales. Fixed costs do not include debt interest which is a financial cost.

Operating leverage affects a firms operating profit (EBIT). The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales. Degree of operating leverage (DOL) % change in EBIT = EBIT/EBIT % change in sales Sales/Sales It can also be expressed as Contribution EBIT where EBIT = Earnings before Interest and Tax Sales = Net sales of the firm Contribution = Sales less variable cost

Problem 1 In a company, sales for the year is Rs.30 crores and the variable costs and fixed costs are Rs.18 crores and Rs.4 crores respectively. What is the degree of operating leverage for the firm.
DOL = 12 8 = 1.5 This implies that for a given change in sales, EBIT will change by 1.5 times.

Characteristics of DOL For each level of sales there is a distinct DOL. So, for different levels of sales, the DOL will be different. DOL is undefined at the operating break even point If sales is less than break even point, then DOL will be negative. This has no implication. If sales is more than the break even point, then DOL will be positive. Applications of DOL Measurement of business risk Production planning Break even analysis

1.

Calculate the degree of operating leverage for the following firms and interpret the results Firm I Firm II Firm III Output (units) 60,000 15,000 1,00,000 Fixed costs (Rs) 14,000 28,000 3,000 Variable cost per unit 0.40 3.00 0.10 Selling price per unit 3.20 10.00 1.00 Contribution per unit 2.80 7.00 0.90 Total contribution 1,68,000 1,05,000 90,000 EBIT 1,54,000 77,000 87,000 DOL 1.09 1.36 1.03

Financial leverage It refers to the use of fixed charge sources of funds in the capital structure of a firm. It is also called capital gearing or trading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity. The rate of return on the owners equity is levered above or below the rate of return on total assets. It measures the relationship between EBIT and EPS. It reflects the effect of change in the EBIT on the level of EPS. It is a measure of financial risk. It is called trading on equity since equity is the base that is used to raise debt; the larger the equity the greater is the security to the debt suppliers.

Financial leverage = % change in EPS = EPS/EPS % change in EBIT EBIT/EBIT Where EPS = Profit after tax No. of equity shares
Financial leverage = EBIT EBIT Financial charge = EBIT PBT

1.

Calculate the degree of operating leverage for the following firms and interpret the results Firm I Firm II Firm III Output (units) 60,000 15,000 1,00,000 Fixed costs (Rs) 14,000 28,000 3,000 Variable cost per unit 0.40 3.00 0.10 Selling price per unit 3.20 10.00 1.00 Contribution per unit 2.80 7.00 0.90 Total contribution 1,68,000 1,05,000 90,000 EBIT 1,54,000 77,000 87,000 DOL 1.09 1.36 1.03 Interest on debt 40,000 20,000 -DFL 1.35 1.24 1 CL 1.47 1.69 1.03

Measures of financial leverage Debt ratio Debt Debt + Equity Debt equity ratio Debt Equity Interest coverage ratio EBIT Interest

The first two measures of financial leverage can be expressed either in terms of book values or market values. Debt ratio is more specific as its value will range between zero and one. The debt equity ratio may vary from zero to any number. Usually there is an accepted industry standard to which the companys debt equity ratio is compared. The debt ratio and debt equity ratio are measures of capital gearing. They are static in nature. They do not show the level of financial risk. The reciprocal of the interest coverage ratio is a measure of the firms income gearing.

DFL =

EBIT PBT (PD / 1- t)

For eg, if EBIT is Rs.5,00,000 and interest charges are Rs.40,000. The company has 10% preference shares for Rs.3,00,000 and 1,00,000 equity shares of Rs.10 each. The applicable tax rate is 40% and corporate dividend tax is 20%. Profit before tax would be Rs.4,60,000 Preference dividend including corporate dividend tax would be Rs.36,000 DFL = 5,00,000 = 5,00,000 = 1.25 4,60,000 36,000 /( 1- 0.4) 4,00,000

If the EBIT increases by 40% to Rs.7,00,000. Existing level EBIT 5,00,000 Interest 40,000 Profit before tax 4,60,000 Tax @ 40% 1,84,000 Profit after tax 2,76,000 Preference dividend plus corporate dvd tax 36,000 Profit available for equity 2,40,000 EPS 2.4 DFL x % change in EBIT = % change in EPS 1.25 x 40% = 50%

New level 7,00,000 40,000 6,60,000 2,64,000 3,96,000 36,000 3,60,000 3.6

The formulation of DFL is static in nature and is ascertained for a particular level of EBIT. So, for different levels of EBIT, the DFL will be different. When EBIT is just equal to the fixed financial charges, the DFL is undefined. This is also known as the Financial Break even point. When the rate of return of the firm is less than the interest on debt financing, it will result in an unfavourable financial leverage. That is, the EPS will decrease even if the EBIT increases.

Analysis of Financial leverage is a very important tool for a finance manager. Having an all-equity capital structure completely reduces financial risk. But if there are benefits in debt financing, then the returns to the equity shareholders will increase. If the firm is able to generate a return on investment that is more than the rate paid on debt, then it makes obvious sense to use debt and trade on equity. Use of debt, however, increases the financial risk to the firm. So, the finance manager is required to trade off between risk and return. With increased leverage, the expected return is higher, but there is a risk that returns will be lower if EBIT is low. If EBIT decreases because of reduced sales or increased costs, then financial insolvency is possible.

Comparison between Operating and Financial Leverage Operating leverage appears if the firm has fixed operating costs, while financial leverage appears if the firm has fixed financial charges. The fixed cost has an impact on EBIT, while the fixed financial charge has an impact on EPS. Analysing the OL helps in determining a reasonable level of fixed costs. Analysing FL helps in determining a reasonable level of debt financing. The FL takes off where the OL leaves. Taken together, they magnify the effect of the change in sales on the EPS. The OL is called the leverage of first order or first stage leverage, while FL is the second stage leverage.

ROI
If ROI is equal to the cost of debt the firm is earning just what is being paid as interest. So it is better not to borrow since there is no benefit to the equity shareholders. If ROI is less than the cost of debt the firm will incur losses or EPS will decline if it borrows funds. If ROI is more than the cost of debt now the firm can employ debt financing. As more funds are borrowed, the return to the equity shareholders will increase. This is situation of favourable financial leverage.

Calculation of ROE EPS = Profit after tax No. of equity shares = (EBIT Interest) (1- t) Number of equity shares
ROE = Profit after tax Value of equity

FINANCIAL BREAK EVEN


Financial break even is the level of EBIT at which only the fixed financial charges of the firm are covered and so EPS is zero. Financial Break even EBIT = Interest charges Financial Break even EBIT =Interest charges + Preference Dividend/(1-t)

The EBIT at which EPS is the same regardless of the financial plans or the level of financial leverage is called the Indifference point or the EBIT EPS break even point. The break even or indifference point between two alternative methods of financing can be determined by a formula.

Ordinary shares vs. ordinary shares and debt _EBIT(1-t)_ = (EBIT Interest)(1-t) N1 N2 OR

EBIT =

N1 x Interest N1 N2 Where N1 = Number of equity shares in 1st plan N2 = Number of equity shares in 2nd plan Interest = interest on debt

Ordinary shares vs. ordinary shares and preference shares EBIT(1-t) = EBIT(1-t) Preference dividend N1 N2 OR EBIT = N1 x Preference dividend ____ ____ N1 N2 (1-t) Ordinary shares vs. shares, preference shares and debt EBIT(1-t) = (EBIT-Interest)(1-t) Preference dividend N1 N2 OR EBIT = N1__ X Interest + Preference Dividend N1-N2 1-t

Ordinary shares, debt vs. shares, preference shares and debt (EBIT-Interest1) (1-t) = (EBIT-Interest2)(1-t) Pref Div N1 N2 OR EBIT = N1__ X Interest2 + Preference Dividend N1-N2 1-t

N2__ X Interest1 N1-N2

Ordinary shares, preference shares vs. shares, preference shares and debt EBIT (1-t)- PD1 = (EBIT-Interest)(1-t) PD2 N1 N2 OR EBIT = N1__ X Interest + N1__ X PD2 N1-N2 N1-N2 1-t - N2__ X PD1 N1-N2 1-t