CHAPTER 14 FINANCIAL AND OPERATING LEVERAGE Q.1 Explain the concept of financial leverage.

Show the impact of financial leverage on the earnings per share. A.1 The use of fixed-charges sources of funds, such as debt and preference capital, along with owners equity in the capital structure is known as financial leverage (or gearing or trading on equity). The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus will increase the return on the owners equity. The role of financial leverage in magnifying the return of the shareholders is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and other sources or debentures or bonds) can be obtained at a cost lower than the firms rate of return on net assets. So, when the difference between the earnings generated by assets financed by the fixed-charges funds and costs of these funds is distributed to the shareholders, the earnings per share (EPS) (or return on equity, ROE) increases. EPS is calculated by dividing profits after tax (PAT) (net of preference dividend) by the number of shares outstanding. Example: All-equity Debt-equity 500,000 500,000 500,000 250,000 0 250,000 120,000 120,000 0 37,500 120,000 82,500 60,000 41,250 ------------8. PAT 60,000 41,250 9. No. of equity shares 50,000 25,000 10. EPS (5 6) 1.20 1.65 This indicates that EPS increases as debt in introduced in the capital structure. 1. 2. 3. 4 5. 6. 7. Investment Equity capital Debt capital @ 15% EBIT Less: Interest PBT Less: Taxes @ 50% Q.2 Does financial leverage always increase the earnings per share? Illustrate your answer.

Q.2

The earnings per share will increase if return on assets is higher than the interest cost, and EPS will reduce if return on assets is lower than the interest cost. The EPS will not be affected by the level of leverage if return on assets just equal to the interest cost. Example: No Debt 50% Debt 75% Debt (Rs.) plan (Rs.) plan (Rs.) Investment 500,000 500,000 500,000 Equity capital 500,000 250,000 125,000 Debt capital @ 15% 0 250,000 375,000 EBIT 120,000 120,000 120,000 Interest 0 37,500 56,250 PBT 120,000 82,500 63,750 Taxes @ 50% 60,000 41,250 31,875 PAT 60,000 41,250 31,875 No. of equity shares 50,000 25,000 12,500 EPS (8 9) 1.20 1.65 2.55 ROI 24% 24% 24% ROE 12% 16.5% 25.5%

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11 12 Q.3

What is financial risk? How does it differ from business risk? How does the use of financial leverage result in increased financial risk?

A.3

The variability of EBIT and EPS distinguish between two types of risk - operating risk and financial risk. Operating risk or business risk can be defined as the variability of EBIT on account of variability of sales and expenses. The fluctuation of sales happens on account of general economic conditions, events in related product lines, and boom or recession in industry. The variability of expenses may include variability in prices of factors of production, technological changes, etc. For a given degree of variability of EBIT, the variability of EPS (or ROE) increases with more financial leverage. The variability of EPS caused by the use of financial leverage is called financial risk. Firms exposed to same degree of operating risk can differ with respect to financial risk when they finance their assets differently. A totally equity financed firm will have no financial risk. But when debt is used, the firm adds financial risk. The operating risk is unavoidable, while financial risk is avoidable.

Financial leverage magnifies the shareholders earnings. The variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure. That is, with more debt, EPS rises and falls faster than the rise and fall in EBIT. Example: Situation 1 Situation 2 Situation 3 Rs Rs Rs 1. EBIT 100,000 120,000 80,000 2. Less Interest 40,000 40,000 40,000 3. EBT (PBT) 60,000 80,000 40,000 4. Taxes @ 50% 30,000 40,000 20,000 5. PAT 30,000 40,000 20,000 6. No. of equity shares 50,000 50,000 50,000 7. EPS 0.60 0.80 0.40 Above example indicates that at the same level of debt-equity ratio in the capital structure of the firm, the EPS rises by increases in EBIT, and falls by decreases in EBIT.

Q.4

If the use of financial leverage magnifies the earnings per share under favorable economic conditions, why companies do not employ very large amount of debt in their capital structures?

A.4

Financial leverage works both ways. It accelerates EPS (and ROE) under favorable economic conditions, but depresses EPS (and ROE) when the going are not good for the firm. The favorable effect of the increasing financial leverage during normal and good years is on account of the fact that the rates of return on assets exceed the cost of debt. From, the table explained in A. 3 above, it is clear that favorable economic condition (i.e., increase in EBIT in situation 2) accelerated EPS, while unfavorable economic condition (i.e., decrease in EBIT in situation 3) depressed EPS. Generally, companies do not employ very large amount of debt on account of business risk i.e., variability in sales and expenses, which is unpredictable with accuracy.

Q.5 A.5

What is an EBIT-EPS analysis? Illustrate your answer. In practice, EBIT for any firm is subject to various influences on account of fluctuations in the economic conditions, sales, expenses, etc. The EBIT-EPS

analysis helps to find out the impact of financial leverage on EPS (and ROE) for possible fluctuations in EBIT. Example: (A) Debt 60%, Equity 40% Situation 1 (poor) 50,000 500,000 300,000 45,000 5,000 2,500 2,500 20,000 0.125 .10.0% Situation 2 (Normal) 75,000 500,000 300,000 45,000 30,000 15,000 15,000 20,000 0.75 15.0% Situation 3 (Good) 100,000 500,000 300,000 45,000 55,000 27,500 27,500 20,000 1.375 20.0%

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

EBIT Capital Employed Debt Capital @ 15% Interest P.B.T (1-4) Taxes @ 50% PAT No. of equity shares EPS (7 8) R.O.I (EBIT/CE)

B: Assume Debt 90%, and Equity 10% 1. EBIT 50,000 75,000 2. Interest @ 15% 67,500 67,500 3. PBT (17,500) 67,500 4. Taxes @ 50% 8,750* 3,750 5. PAT (8,750) 3,750 6. No. of equity shares 5,000 5,000 7. E.P.S. (1.75) 0.75 8. R.O.I (EBIT/CE) 10.0% 15.0% *Assumed that losses will be set off against other profits

100,000 67,500 32,500 16,250 16,250 5,000 3.25 20.0%

Above two financial plans, indicates that higher financial leverage works adversely when firm face the unfavorable economic conditions.

Q.6

What is an indifference point in the EBIT-EPS analysis? How would you compute it?

A.6

The relationship between EBIT and EPS for the alternative financial plans can be depicted in graphical way, in the form of EBIT-EPS chart. The chart is easy to prepare since, for any given level of financial leverage, EPS is linearly related to EBIT. In the chart, EBIT is shown on a horizontal line and EPS on vertical line. We can draw EBIT-EPS line for all different financial plans. The point of intersection of all financial plans lines in short indicates the Indifference point at which EPS is same regardless of the level of financial leverage.

The firm wants to know the level of EBIT at which EPS would be same under two alternative plans. It can be worked out by using following formula:
EBIT(1 T) (EBIT INT)(1 T) = N1 N2

where N1 is the number of equity share under first plan and N2 is the number of equity shares under second plan. Example: The firm is considering two financial plans, viz. an all equity plan, and a plan with 1:3 debt-equity ratio. Assume total finance need is Rs. 500,000 and debt interest @ 10%. Using the above values, we can determine the level of EBIT at which EPS of both plan is same. Also, assume tax rate 50% and FV of share Rs. 10. EBIT (1 0.50) (EBIT 12500)(1 0.50) = 50,000 37,500
37500 0.50EBIT = 0.50EBIT 6250 50000
0.375EBIT 0.50EBIT = 6,250 EBIT = 50,000 Verify: At EBIT of Rs. 50,000. The EPS of each plan: 50,000(1 0.50) (50,000 12500)(1 0.50) = 50,000 37,500 0.50 = 0.50

Q.7 A.7

Explain the merits and demerits of the various measures of financial leverage. The most commonly used measures of financial leverage are: 1. Debt ratio: The ratio of debt to total capital, i.e.,
L1 = D D = D+E V

2. Debtequity ratio: The ratio of debt to equity, i.e.,

L2 = D E

3. Interest coverage: The ratio of net operating income to interest charges,

L3 =

EBIT Interest

The first two measures of financial leverage can be expressed either in terms of book values or market values. The market value to financial leverage is theoretically more appropriate because market values reflect the current attitude of investors. But it is difficult to get reliable information on market values in practice. The market values of securities fluctuate quite frequently. There is no difference between the first two measures of financial leverage in operational terms. These relationships indicate that both these measures of financial leverage will rank companies in the same order. However, the first measure (i.e. D/V) is more specific as its value will range between zero to one. The value of the second measure (i.e. D/E) may vary from zero to any large number. The debt-equity ratio, as a measure of financial leverage, is more popular in practice. There is usually an accepted industry standard to which the companys debtequity ratio is compared. The first two measures of financial leverage are also measures of capital gearing. They are static in nature as they show the borrowing position of the company at a point of time. These measures, thus, fail to reflect the level of financial risk, which is inherent in the possible failure of the company to pay interest and repay debt. The third measure of financial leverage, commonly known as coverage ratio, indicates the capacity of the company to meet fixed financial charges. The reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of the firms income gearing. Again by comparing the companys coverage ratio with an accepted industry standard, investors can get an idea of financial risk. However, this measure suffers from certain limitations. First, to determine the companys ability to meet fixed financial obligations; it is the cash flow information, which is relevant, not the reported earnings. During recessionary economic conditions, there can be wide disparity between the earnings and the net cash flows generated from operations. Second, this ratio, when calculated on past

earnings, does not provide any guide regarding the future riskiness of the company. Third, it is only a measure of short-term liquidity than of leverage.

Q.8

Define operating and financial leverage. How can you measure the degree of operating and financial leverage? Illustrate with an example.

A.8

Operating leverage refers to the use of fixed costs in the operation of a firm, and it accentuates fluctuations in the firms operating profit due to changes in sales. Thus, the degree of operating leverage may be defined as the percentage change in operating profit (EBIT) on account of change in sales.

DOL =

EBIT Sales EBIT Sales Or

DOL =

Contribution EBIT

The financial leverage refers to the use of fixed charges capital like debt with equity capital in the capital structure. The main reason for using financial leverage is to increase the shareholders wealth/return. The percentage of change in EPS occurring due to a given percentage change in EBIT is referred to as degree of financial leverage (DFL). % Change in EPS DFL = ------------------% change in EBIT = EPS EBIT EPS EBIT EBIT EBIT INT

DFL =

For example, the expected sales volume of firm is 100,000 units. The selling price Rs 8 per unit, the variable cost per unit Rs. 4; fixed operating charges Rs. 280,000 and fixed financial charges Rs. 50,000.

DOL =

Contribution -----------EBIT Sales Volume (S.P. V.C) ---------------------------------------Contribution Fixed Operating Charges 1,00,000(8 4) 4,00,000 = = 3.33 4,00,000 2,80,000 1,20,000

This indicates that EBIT will change by 3.33 times, for given change in sales. DFL = = EBIT EBIT INT

1,20,000 1,20,000 = = 1.71 1,20,000 50,000 70,000

This indicates that EPS will change by 1.71 times, for given change in EBIT. Q.9 What is the degree of combined leverage? What do you think is the appropriate combination of operating and financial leverage? A.9 The degrees of operating and financial leverages can be combined to see the effects of total leverage on EPS associated with a given change in sales. The degree of combined leverage can be calculated as under: DCL = % of change in EBIT % of change in EPS ---------------------- --------------------% of change in Sales % of change in EBIT

% of change in EPS = --------------------= DFL DOL % of change in Sales Operating leverage and financial leverage together cause wide fluctuation in EPS for a given change in sales. If a company employs a high level of operating leverage and financial leverage, even a small change in the level of sales will have dramatic effect on EPS. The appropriate combination should be governed by the behaviour of sales. The public utilities such as Electricity Companies can afford to combine high operating leverage with high financial leverage since they generally have stable or

rising sales. A company whose sales fluctuate widely and erratically should avoid use of high financial leverage since it will be exposed to a very high degree of risk.