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LEVERAGE
Employment of assets or source of finance for which firm pays fixed cost or fixed return is
known as leverage.
Favorable Leverage ------- If the earning > fixed costs
Types of Leverage
There are two types of leverages
Operating leverage
Financial leverage
OPERATING LEVERAGE
To magnify the sensitivity of EBIT to changes in Sales
The firm’s ability to used fixed operating costs to magnify the effects of changes in sales on
its operating profit (EBIT) is termed as operating leverage.
%∆inEBIT CM
DOL =
% ∆inSales
OR DOL =
EBIT
Existence of OL
Operating leverage exists only when fixed costs present in the cost structure.
It exists if percentage change in EBIT is more than the percentage change in sales.
It means if DOL = 1 ------operating leverage is not exist.
So it must be > 1 i.e. DOL > 1
Example:
Examine the following partial income statement of ABC ltd. and determine (a) DOL
(b) What is the new EBIT if changes in sales by (i) 20% increases (ii) 50% Increases
(iii) 10 % decreases.
Rs.
(000)
Sales 2000
Variable Cost 1000
CM 1000
Fixed Cost 500
EBIT 500
Solution
CM 1000
(a) DOL = DOL = DOL = 2
EBIT 500
(b) New EBIT
If 20% Increase in sales:
EBIT = 2 x 20% =>EBIT = 40% (increase)
EBIT = 500 x 140% EBIT = Rs.700 (thousands)
If 50% Increase in sales :
EBIT = 2 x 50% =>EBIT = 100% (increase)
EBIT = 500 x 200% =>EBIT = Rs.1000 (thousands)
If 10% decrease in sales :
EBIT = 2 x 10% => EBIT = 20% (decrease)
EBIT = 500 x 80% => EBIT = Rs.400 (thousands)
FINANCIAL LEVERAGE
To magnify the sensitivity of NI to changes in NOI
The ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT
on the EPS is termed as financial leverage.
It is based on the assumption that the firm is to earn more on the assets that are acquired by the use of
funds on which fixed rate is to be paid. The difference between the earning from the assets and fixed
cost paid on the use of those funds goes to shareholders wealth maximization.
Formula
It is measure as degree of financial leverage. DFL measures the % change in net income
(EPS) for a given percentage change in net operating income (EBIT).
High fixed financial costs increase the financial leverage and, thus, financial risk. The financial
risk refers to the risk of the firm not being able to cover its fixed financial costs. With the
increase in financial charges, the firm is also required to raise the level of EBIT necessary to
meet financial charges. If the firm cannot cover these financial payments, it can be technically
forced into liquidation.
Example
Examine the following partial income statement of ABC ltd. and determine (a) DFL
(b) What is the impact on NI if changes in EBIT by (i) 20% increases (ii) 50% Increases
(iii) 10 % decreases.
Rs.(000)
EBIT 10000
Interest 2000
EBT 8000
Tax 35% 2800
EAT/NI 5200
Pref Dividend 2200
Available for SH 3200
Shares 1000
EPS 3.2
Solution
EBIT 10000
(a) DFL = DFL = DFL = 1.25
EBIT − I 10000 − 2000
COMBINED LEVERAGE
To magnify the sensitivity of NI to changes in Sales
Formula
% ∆inNI CM
D
CL =
DO
L ×
DF
L
OR DCL =
% ∆inSales
OR DCL =
EBIT − I
If a firm invests in more risky assets than usual, the operating leverage of the firm increases result is
increase in total risk. To keep the total risk constant, the firm must to have lowered its financial risk by
starting new investments which are financed with more equity than the usual.
EBIT-EPS ANAYLYSIS
What will happen in EPS, if EBIT changes?
Pr ef .Dividend
F .BE .Po int =Interest +
(1 −t )
INDIFFERENCE POINT
Level of EBIT at which EPS under two or more alternative capital structures is equal is
known as Indifference point.