LEVERAGES
Leverage
• MEANING
•Meaning of Leverage
•The term leverage refers to an increased means of accomplishing some purpose.
Leverage is used to lifting heavy objects, which may not be otherwise possible. In
the financial point of view, leverage refers to furnish the ability to use fixed cost
assets or funds to increase the return to its shareholders.
•Definition of Leverage
•James Horne has defined leverage as, “the employment of an asset or fund
for which the firm pays a fixed cost or fixed return.
• Leverage results from using borrowed capital as a funding
source when investing to expand the firm's asset base and
generate returns on risk capital.
• Leverage is an investment strategy of using borrowed
money — specifically, the use of various financial
instruments or borrowed capital — to increase the
potential return of an investment.
Leverage can also refer to the amount of debt a firm
uses to finance assets.
When one refers to a company, property
or investment as "highly leveraged," it means that
item has more debt than equity.
Financial leverage
• Financial leverage which is also known as leverage or trading on
equity, refers to the use of debt to acquire additional assets.
• The use of financial leverage to control a greater amount of
assets (by borrowing money) will cause the returns on the
owner's cash investment to be amplified. That is, with financial
leverage:
Financial leverage
• an increase in the value of the assets will result in
a larger gain on the owner's cash, when the loan
interest rate is less than the rate of increase in the
asset's value
• a decrease in the value of the assets will result in
a larger loss on the owner's cash
Leverages - Types of Leverage
•Leverage can be classified into three major headings according to the
nature of the finance mix of the company.
• Operating Leverage
• Financial Leverage
• Composite Leverage
The company may use financial leverage or operating leverage, to
increase the EBIT and EPS.
OPERATING LEVERAGE
•The leverage associated with operating activities is called as operating
leverage. It is caused due to fixed operating expenses in the company.
•Operating leverage may be defined as the company’s ability to use fixed
operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes. (EBIT)
•Operating leverage consists of two important costs viz., variable cost
and fixed cost.
•When the company is said to have a high degree of operating leverage if it
employs a great amount of fixed cost and smaller amount of variable cost.
OPERATING LEVERAGE
•Thus, the degree of operating leverage depends upon the amount of
various cost structure. Operating leverage can be determined with
the help of a break even analysis.
• Operating leverage can be calculated with the help of the following
formula:
Operating Leverage = Contribution/Op. Profit
• Where,
• OL = Operating Leverage
• C = Contribution (Sales – Variable Cost)
• OP = Operating Profits (Contribution – Fixed Costs)
Degree of Operating Leverage
•The degree of operating leverage may be defined as percentage change
in the profits resulting from a percentage change in the sales. It can be
calculated with the help of the following formula:
•DOL = % change in profits
% change in sales
Operating Leverage
From the following selected operating data, determine the degree of operating
leverage. Which company has the greater amount of business risk? Why?
Company A Company B
Sales 25,00,000 30,00,000
Fixed Costs 7,50,000 15,00,000
Variable expenses as a percentage of sales are 50% for company A and
25% for company B.
Operating Leverage
Company A Company B
Sales 25,00,000 30,00,000
- Variable Cost 12,50,000 7,50,000
Contribution ( S – V) 12,50,000 22,50,000
(-) Fixed Cost 7,50,000 15,00,000
Operating Profit 5,00,000 7,50,000
Operating leverage
Operating Leverage for Co. A
• C/OP = 12,50,000/5,00,000
OL = 2.5
Operating Leverage for Co. B
C/OP = 22,50,000/7,50,000
OL = 3
Leverages
•Operating leverage measures the relationship between
the sales and revenue of the company during a particular
period.
•Operating leverage helps to understand the level of fixed
cost which is invested in the operating expenses of business
activities.
• Operating leverage describes the over all position of the
fixed operating cost.
Operating Leverages
Following is the cost information of a firm;
Fixed cost = Rs. 50,000
Variable Cost = 70% of sales
Sales = Rs 2,00,000 in previous year and Rs. 2,50,000 in current year.
Find out the percentage change in sales and operating profits when:
1. Fixed costs are not there. (No Leverage)
2. Fixed costs are there (Leveraged Situation)
Operating Leverages
1. No Leverage
Particulars Previous. Year Current Year. % Change
Rs Rs
Sales 200000 250000 25%
(-) Variable Cost(70% of sales) 140000 175000 25%
Profit from Operations- 60000 75000 25%
Contribution
Operating Leverages
2. Leveraged Firm
Particulars Pr. Year Current Ye. % Change
Rs Rs
Sales 200000 250000 25
(-) Variable Cost(70% of sales) 140000 175000 25
Contribution 60000 75000 25
(-) Fixed Cost 50000 50000
Profit from Operations 10000 25000 150 %
Operating Leverages
Following information is taken from the records of a company
Installed capacity 1000 units
Operating Capacity 800 units
Selling price per unit Rs. 10
Variable cost per unit Rs. 7
Calculate Operating leverage under the following situations
Fixed Cost
Situation A Rs. 800
Situation B Rs. 1200
Situation C Rs. 1500
Operating Leverage
• A=1.5
B=2
c=2.66
Financial Leverages
•Leverage activities with financing activities is called financial
leverage. Financial leverage represents the relationship between the
company’s earnings before interest and taxes (EBIT) or operating
profit and the earning available to equity shareholders.
•Financial leverage is 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”.
•It involves the use of funds obtained at a fixed cost in the hope of
increasing the return to the shareholders.
•“The use of long-term fixed interest bearing debt and preference
share capital along with share capital is called financial leverage
Financial Leverages
•Financial leverage may be favourable or unfavourable
depends upon the use of fixed cost funds.
•Favourable financial leverage occurs when the company
earns more on the assets purchased with the funds, then the
fixed cost of their use. Hence, it is also called as positive
financial leverage.
•Unfavourable financial leverage occurs when the company
does not earn as much as the funds cost. Hence, it is also
called as negative financial leverage.
Financial Leverages
Financial leverage can be calculated with the help of the following formula:
FL = Operating Profit / Profit Before Taxes
• FL = Financial leverage
•OP = Operating profit (EBIT)
• PBT = Profit before tax. (EBIT – I)
Financial Leverages
•Degree of Financial Leverage
•Degree of financial leverage may be defined as the percentage change in taxable
profit as a result of percentage change in earning before interest and tax (EBIT).
This can be calculated by the following formula:
•DFL = Percentage change in EPS
• Percentage change in EBIT OR
• EBIT
EBT (EBIT – I)
Financial Leverages
A firm is considering two financial plans with a view to examine the impact
on EPS. Total funds required for investment in assets are Rs. 5,00,000.
The earnings before interest and tax are assumed Rs. 50,000, Rs. 75,000 and
Rs. 1,25,000 respectively. The rate of tax is 50%.
Financial Plans
Plan I Plan II
Debt – Int. @ 10% p.a 400000 100000
Eq. Shares @ Rs. 10 100000 400000
each
Total finances required 500000 500000
No. of equity shares 10000 40000
Financial Leverages
(1) EBIT – 50,000
Plan I Plan II
EBIT 50000 50000
Less: Interest @ 10% 40000 10000
Earnings before Tax 10000 40000
Less: Tax @ 50 % 5000 20000
Earnings after Int. & Tax 5000 20000
available to Eq. shareholders
No. of Eq. Shares 10000 40000
EPS = 5000/10000 = 0.50 P 20000/40000 = 0.50 P
Financial Leverages
(2) EBIT – 75,000
Plan I Plan II
EBIT 75000 75000
Less: Interest @ 10% 40000 10000
Earnings before Tax 35000 65000
Less: Tax @ 50 % 17500 32500
Earnings after Int. & Tax 17500 32500
No. of Eq. Shares 10000 40000
EPS = 17500/10000 = 1.75 32500/40000 = 0.81
Financial Leverages
(3) EBIT – 1,25,000
Plan I Plan II
EBIT 125000 125000
Less: Interest @ 10% 40000 10000
Earnings before Tax 85000 115000
Less: Tax @ 50 % 42500 57500
Earnings after Int. & Tax 42500 57500
No. of Eq. Shares 10000 40000
EPS = 42,500/10000 = 4.25 57,500/40000 = 1.438
Financial Leverage
• A Co. has equity share capital of Rs.5,00,000 divided into shares of Rs. 100
each. It wishes to raise further Rs. 3,00,000. The Co. plans the following
financing schemes:
• 1. All common stock
• 2. Rs. 1,00,000 in common stock and Rs. 2,00,000 in 10% debentures.
• 3. All debt @ 10% p.a.
• 4. Rs. 1,00,000 in common stock and Rs. 2,00,000 in 8% preference
capital.
• The Co. expected earnings before Interest & Tax (EBIT) are Rs. 1,50,000.
The corporate tax rate is 50%.
• Calculate EPS and comment on the implication of financial leverage.
Particulars Plan I Plan II Plan III Plan IV
Earnings before Interest and Tax 150000 150000 150000 150000
Less: Interest on debt 20000 30000
EBT 150000 130000 120000 150000
Less: Tax @ 50% 75000 65000 60000 75000
Earnings After Tax 75000 65000 60000 75000
Less: Pref. Dividend @ 8% 16000
75000 65000 60000 59000
Earnings Available to Eq.
Shareholders 75000 65000 60000 59000
No. of Eq. Shares 8000** 6000** 5000 6000**
Earnings Per Share 75000/8000 65000/6000 60000/5000 59000/6000
EPS 9.375 10.83 12 9.83
• A co. has currently an equity share capital of Rs. 40 lakhs consisting of 40,000
equity shares of Rs. 100 each. The management is planning to raise another
30 lakhs through one of the four possible financial plans.
• 1. Entirely through Equity Shares.
• 2. Rs. 15 lakhs in equity shares of Rs. 100 each and the balance in 8%
Debentures.
• 3. Rs. 10 lakhs in equity shares of Rs. 100 each and the balance through long
term borrowing at 9% Interest p.a.
• 4. Rs. 15 lakhs in equity shares of Rs. 100 each and the balance through Pref.
shares with 5% dividend.
• The Co’s EBIT will be Rs. 15,00,000. Tax rate 50%
• Calculate EPS & Degree of Financial Leverage and Comment.
Plan I Plan II Plan III Plan IV
Earnings before Interest and
Tax 15,00,000 15,00,000 15,00,000 15,00,000
Less: Interest 120000 180000
EBT 1500000 1380000 1320000 1500000
Less: Tax @ 50% 750000 690000 660000 750000
EAT 750000 690000 660000 750000
Less: Pref. Dividend @ 8% - - - 75000
750000 690000 660000 675000
Earnings Available to Eq. 750000 690000 660000 675000
Shareholders
No. of Eq. Shares 70000** 55000** 50000** 55000**
750000/70000 690000/55000 660000/50000 675000/55000
Earnings Per Share
EPS 10.71 12.55 13.20 12.27
• DFL = EBIT/EBT (EBIT – I)
EBIT 1500000 1500000 1500000 1500000
EBT 1500000 1380000 1320000 1500000
DFL 1500000/1500000 1500000/13800
00
1500000/132 1500000/150
0000 0000
DFL 1.00 1.087 1.136 1.00
Financial Leverage
• A Co. has the following Capital Structure
• Eq Sh. capital Rs. 100000 (Rs. 100 each)
• 10% Pref. Share Capital Rs. 100000
• 8 % Debentures Rs. 125000
The present EBIT is Rs. 50,000. Calculate the financial leverage & EPS
assuring that the company is in 50% tax bracket.
EBIT 50000
Less: Int. on Debt. @ 8% 10000
Earnings Before Tax 40000
Less: Tax @ 50% 20000
Earnings After Tax 20000
Less: Preference Dividend 10000
Earnings Available to 10000
Equity Shareholders
EPS = 10000/1000 =Rs. 10 No. of Eq. Shares = 100000/100 = 1,000
EBIT /Profit Before Taxes = 50000/40000 = 1.25
Financial Leverage = 1.25
Operating
Operating Leverage
v/s Financial Leverage
Financial Leverage
1. Operating leverage is associated with investment 1. Financial leverage is associated with financing activities of
activities of the company. the company.
2. Operating leverage consists of fixed operating 2. Financial leverage consists of operating profit of the
expenses of the company. company.
3. It represents the ability to use fixed operating cost. 3. It represents the relationship between EBIT and EPS.
4. Operating leverage can be calculated by 4. Financial leverage can be calculated by
OL = C / OP . FL = O P / PBT .
5. A percentage change in the profits resulting from a 5. A percentage change in taxable profit is the result of
percentage change in the sales is called as degree of percentage change in EBIT.
operating leverage.
6. Trading on equity is not possible while the company is 6. Trading on equity is possible only when the company
operating leverage. uses financial leverage.
7. Operating leverage depends upon fixed cost and 7. Financial leverage depends upon the operating
variable cost. profits.
8. Tax rate and interest rate will not affect the operating 8. Financial leverage will change due to tax rate and interest
leverage. rate.
COMBINED/COMPOSITE LEVERAGE
•When the company uses both financial and operating leverage to magnification
of any change in sales into a larger relative changes in earning per share.
Combined leverage is also called as composite leverage or total leverage.
•Combined leverage express the relationship between the revenue in the
account of sales and the taxable income.
• Combined leverage can be calculated with the help of the following
formulas:
Combined Leverage = Op. Leverage X Fin. Leverage
COMBINED LEVERAGE
CL = Operating Leverage X Financial Leverage
• Degree of Composite Leverage = DCL
• DCL = Percentage change in EPS
Percentage change in Sales
COMBINED LEVERAGE
• A company has sales of Rs. 5,00,000, variable cost
Rs. 3,00,000, fixed cost of Rs. 1,00,000 & long term
loan of Rs. 4,00,000 at 10% rate of Interest.
• Calculate Composite Leverage.
1. OL = Contribution / Operating Profit
C = Sales – VC = 500000 – 300000 = 200000
Op Profit = C – FC = 200000 -100000 = 100000
OL = C / OP = 200000 / 100000 = 2/1
COMBINED LEVERAGE
• FL = OP / EBT
• OP = 100000
• EBT = EBIT – I = 100000 – 40000 = 60000
• OP / EBT = 100000 / 60000 = 5/3
• CL = OL X FL
• CL = 2 X 5 = 10/3
1 3
COMBINED LEVERAGE
• Calculate and interpret the degree of operating.
Financial and combined leverage.
• Sales: 10,50,000
• Variable Cost 767000
• Fixed Cost 75000
• Interest 110000
• Taxes 30%
COMBINED LEVERAGE
• OL = C/OP = 1.36
• FL = OP/EBT = 2.12
• CL = OL X FL
• 1.36 X 2.12 = 2.88
COMBINED LEVERAGE
• Calculate the operating, financial and combined leverage under situations 1 and 2
and the financial plans for X and Y respectively from the following information.
• Installed capacity is 5000 units.
• Annual Production and sales at 60% of installed capacity.
• Selling price per unit Rs. 25
• Variable cost per unit Rs. 15
• Fixed cost:
• Situation 1 : Rs. 10,000
• Situation 2 : Rs. 12,000
Capital Structure X
Y
Equity 25000
50000
Debt (@10 %) 50000
• SALES – 3000 Units
• Sale Price = 25/ unit, VC = 15/unit
• Total Sales = 3000 * 25 = 75000
• Less : Variable Cost =45000
• Contribution = 30000
PLAN-X
COMBINED LEVERAGE PLAN-Y
Situation 1 Situation 2 Situation 1 Situation 2
Contribution (Sales – V.C.) 30000 30000 30000 30000
Less: Fixed cost 10000 12000 10000 12000
Operating profit (or) EBIT 20000 18000 20000 18000
Interest on Debts:
10% of 50,000 5000 5000 2500 2500
10% of 25,000
Earnings before Tax 15500
15000 13000 17500
(i) Operating Leverage
Contribution 30000 30000 30000 30000
Op. Profit 20000 18000 20000 18000
Operating Leverage = 1.5 1.67 1.5 1.67
(ii) Financial Leverage
Operating Profit (op) 20000 18000 20000 18000
Profit Before Tax (PBT) 15000 13000 17500 15500
Financial Leverage = 1.33 1.38 1.14 1.16
(iii) Combined leverage OL × 1.5 × 1.33 1.67 × 1.38 1.5 × 1.14 1.67 × 1.16
FL =
COMBINED LEVERAGE
• Annual production and sales 60% of 5,000 = 3000 Units
Selling Price / Unit = Rs. 25
Variable Price / Unit = Rs. 15
Contribution = Rs. 10 per unit
Total Contribution = Rs. 10 X 3000 units = Rs 30,000
Leverages
•Uses of Operating Leverage
•Operating leverage is one of the techniques to measure the impact
of changes in sales which lead for change in the profits of the
company.
• If any change in the sales, it will lead to corresponding changes
in profit. Operating leverage helps to identify the position of
fixed cost and variable cost.
Leverages
•Uses of Financial Leverage
•Financial leverage helps to examine the relationship between EBIT and EPS.
• Financial leverage measures the percentage of change in taxable income to
the percentage change in EBIT.
• Financial leverage locates the correct profitable financial decision regarding
capital structure of the company.
• Financial leverage is one of the important devices which is used to measure
the fixed cost proportion with the total capital of the company.
• If the firm acquires fixed cost funds at a higher cost, then the earnings
from those assets, the earning per share and return on equity capital will
decrease.
Leverages
•Financial BEP
• It is the level of EBIT which covers all fixed financing costs of the
company. It is the level of EBIT at which EPS is zero
