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Leverage

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Published in: Financial Management | MBA
14,279 Views

The concept of Financial Leverage and Operating Leverage. 

Dr.Amit G / Delhi

22 years of teaching experience

Qualification: Ph.D ( - 2012), M.Com ( - 2002), MBA/PGDM ( - 2010), B.Com ( - 2000)

Teaches: Accountancy, Economics, Costing, Financial Management, Statistics, BBA Subjects, Management Subjects

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  1. Financial Leverage, Operating Leverage , Combined Leverage 1 Dr. Amit Gupta 1/10/2018
  2. Leverage Leverage has been defined as "the action of a lever is , and mechanical advantage gained by it", Leverage is the means which a business firm can increase the profits, The force will be applied on debt, the benefit of this reflected in the form of higher returns to equity shareholders, Dr. Amit Gupta 1/10/2018
  3. Master table to calculate the leverage Particulars Sales less: variable cost Contribution Less: Fixed cost Earning before Interest and tax Less: interest Earning before tax Less: tax Earning after tax Less: Preference dividends Earning available for equity share holder Amount(Rs) xxx Dr. Amit Gupta 1/10/2018
  4. Financial leverage Financial leverage is a tool with which a financial manager can maximize the returns to the equity shareholders. Financial leverage signifies the relationship between the earning power on equity capital and rate interest on borrowed capital. Financial leverage helps the finance manager to select an appropriate mix of capital structure. Capital is required for the purpose of meeting both long-term & short-term financial requirement of a business unit. This could be raised through long term as well as short term sources, namely, Equity shares, debentures, preference shares, public deposits. 4 Dr. Amit Gupta 1/10/2018
  5. Formula for calculating Financial leverage Financial Leverage= EBIT EBT Degree of Financial Leverage = % change in EPS 0/0 change in EBIT Dr. Amit Gupta 1/10/2018
  6. Illustration A firm has a choice of the following three financial plans. Compute the financial leverage in each situation and interpret it: Particulars Equity Capital Debt Operating Profit (EBIT) 4,000 4,000 800 2,000 6,000 800 C 6,000 2,000 800 Interest @ 10% on debt in all situations. Dr. Amit Gupta 1/10/2018
  7. Illustration A firm's capital structure comprises the following securities: 10% Preference Share Capital Equity Share Capital (Rs. 10 shares) Rs. The operating profit of the firm is Rs. 80,000 and the firm is in 50% tax bracket. Compute the financial leverage of the firm. What would be the new financial leverage in case the operating profit enhances to Rs. I and interpret your results? Dr. Amit Gupta 1/10/2018
  8. Illustration Capital Structure 1 0,000 equity shares of Rs. 10 each 1 00/0 500, Debentures of Rs. 100 each EBIT Compute DEL. Rs. 50,000 Rs. 40,000 Dr. Amit Gupta 1/10/2018
  9. Illustration The capital structure of a firm -is as under: 20,000 equity shares of Rs. 10 each 4,000 10% Preference shares of Rs. 1 00 each Rs. 4,000 10% Debentures of Rs. 100 each Rs. 400,000 Compute the EPS for each of the following levels of the EBIT: (ii) (iii) The firm is in 50% tax bracket. Compute also the financial leverage taking EBIT level under (i) base. Dr. Amit Gupta 1/10/2018
  10. Operating Leverage The operating leverage has a bearing on fixed costs. There is a tendency of the profits to change, if the firm employs more of fixed cost in its production process, greater will be the operating cost irrespective of the size in its production. The operating leverage will be at a low degree when fixed costs are less in the production process. Operating leverage show the ability of a firm to use fixed operating cost to increase the effect of change in sales on its operating profits. 10 Dr. Amit Gupta 1/10/2018
  11. Formulas Cost Operating leverage I- 11 Cost - Flied Cost Dr. Amit Gupta Cost Operating Illcome 1/10/2018
  12. Degree of Operating leverage= % Change in profits % change in sales Dr. Amit Gupta 1/10/2018 12
  13. Illustration The installed capacity of a manufacturing concern is 1200 units. Actual capacity used is 800 units. Selling price per unit is Rs. 10. Variable cost is Rs. 7 per unit. Compute the operating leverage in the following situations: l. 2. 3. 13 When Fixed cost is Rs. 300 When Fixed cost is Rs. 800 When Fixed cost is Rs. 1 200 Dr. Amit Gupta 1/10/2018
  14. Particulars Fixed cost Variable Costs per unit Selling Price 14 Illustration Rs. 6 Rs. 10 x Companies Rs. 10 Dr. Amit Gupta z Rs. 4, 75,000 Rs. 10 1/10/2018
  15. Compute: BEP (Break- Even Points) to all the companies Profits earned by the companies if each of them sells units What will be the effect of profit in case: Sales increase by 30% Sales decrease by 30% 15 Dr. Amit Gupta 1/10/2018
  16. Combined leverage This leverage shows the relationship between a change in sale & the corresponding variation in taxable income, 16 Dr. Amit Gupta 1/10/2018
  17. Formulas Represents maximum use of leverage Degree of Combined or Total Leverage (DCL or DTL) = O/oage in EPS / O/oage in Sales Short-cut formula: DCL or DTL = DOLx DFL Dr. Amit Gupta 1/10/2018
  18. Exam ple : The following figures relate to two companies: Particulars Sales Variable cost Fixed cost I nterest Kabutaru Ltd. Rutabuka Ltd. Rs.500 Rs.200 Rs. 1 50 Rs.50 Values given above are in lakhs. 18 Rs.300 Rs.400 Dr. Amit Gupta 1/10/2018
  19. You are required to calculate — (a) operating, financial and combined leverages of the two companies, and (b) comment on the relative position of the companies in respect of the risk. 19 Dr. Amit Gupta 1/10/2018
  20. Operating Leverage: Kabutaru Ltd.= 2; Rutabuka Ltd.= 2.33 Financial Leverage: Kabutaru Ltd.= 1.5; Rutabuka Ltd.= 1 5 Combined Leverage: Kabutaru Ltd.= 3; 20 Rutabuka Ltd.= 3 5 Dr. Amit Gupta 1/10/2018
  21. The operating leverage is higher for Rutabuka Ltd. and therefore -it is subject to greater degree of business risk (operating risk) than Kabutaru Ltd. The EBIT will tend to vary more with sales in Rutabuka Ltd. The financial leverage of both the companies stand at 1.5 times. It conveys that interest burden is proportionately same, and also financial risk is similar for both the companies. The combined leverage of Rutabuka Ltd. is higher and its overall risk is more as compared to Kabutaru Ltd. 21 Dr. Amit Gupta 1/10/2018
  22. Exam ple: Consider the following information for ROG Ltd. EBIT l, lakhs EBT Rs.320 lakhs Fixed cost Rs.700 lakhs Calculate the % change in EPS, if sales increased by 5%. 22 Dr. Amit Gupta 1/10/2018
  23. Contribution = EBIT + Fixed cost = Rs. ,820 lakhs Operating Leverage = Contribution/EBlT = 1.625 Financial Leverage = EBIT / EBT = 3.5 Combined Leverage = OL x FL = 5.687 Combined Leverage = % change in EPS / % change in Sales 5.687 = 0/0 change in EPS / 5 0/0 change in EPS = 5.687 x 5 = 28.44 23 Dr. Amit Gupta 1/10/2018
  24. Exam ple : The following figures are available for Success Ltd. : Net sales: Rs. 15 crores (08-09); Rs.20 crores (09-10) EBIT as 0/0 of net sales: 140/0 (08-09); 160/0 (09-10) Debt @ 150/0 Rs. 5 crores (08-09); Rs.8 crores (09-10) I I %Preference share capital: Rs.2 crores The applicable Income-tax rate to be taken at 40% Number of equity shares outstanding: 8 lakhs Calculate: DOL, DFL & DCL 24 Dr. Amit Gupta 1/10/2018
  25. Net sales EBIT I nterest EBT Tax EAT Pref. Div. EAt0ESH No. of Eq. EPS 25 shares 08-09 15.00 2.10 0.75 I .35 0.54 0.81 0.22 0.59 0.08 7.375 Dr. Amit Gupta 09-10 20.00 3.20 I .20 2.00 0.80 I .20 0.22 0.98 0.08 12.25 1/10/2018
  26. % change in net sales = ((20- 15)/ 15) x = 33.33 0/0 change in EBIT = ((3.2 - 2.1) / 2.1 ) x 100 = 52.38 0/0 change in EPS 12.25- 7.375) / 7.375) x 26 = 66.10 Dr. Amit Gupta 1/10/2018
  27. DOL 52038/33.33 DEL 66010/ 1.262 DCL 66010 / 33.33 1.983 27 Dr. Amit Gupta 1/10/2018
  28. Effect of Leverage on Firm Operating Leverage High Low High Low Financial Leverage High Low Low High 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.
  29. Leverage Means Risk Leverage is a double-edged sword It magnifies profits as well as losses An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point) A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point) Many Japanese firms tend to be highly leveraged 29 Dr. Amit Gupta 1/10/2018

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