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Leverage SFM

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.

 Operating leverage is associated with the investment decision.


 It results from the existence of fixed operating expenses in the firm’s income stream.
 It is determined by the relationship between the firm’s sale and its EBIT (operating
profit).
 The greater the amount of fixed costs in the total cost structure the higher the
operating leverage (higher the magnifying power to see the effect).
Formula
It is measured in terms of Degree of Operating leverage (DOL). The DOL at a particular
production level Q measures the percentage change in NOI (EBIT) for a given percentage
change in sales.

%∆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

From the desk of M. Azam 1


Leverage SFM

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)

Operating leverage (magnifying the effects of change in sales) can be favorable or


unfavorable, higher levels of risks are attached to high degree of operating leverage. Since
DOL depends on fixed operating costs, it logically follows that the larger fixed costs the
higher the DOL and higher level of operating risks. High DOL is good when revenues are
rising and bad when they are falling.
 OL measures the extent to which a firm uses fixed production costs in its operations. The
higher the ratio of fixed cost to net operating income, the higher the operating leverage and higher
the operating risk.
 Operating risk is the risk of the firm not being able to cover its fixed operating costs. The
larger the magnitude of DOL means the larger the volume of sales required to cover all fixed costs.

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 associated with the financing decision.


 It results from the presence of fixed financial charges in the firm’s income stream.
These fixed charges independent to the EBIT (operating profit). It means it always
incurred even no profit is made by the firm.
 The use of fixed interest sources of funds provides increased return on equity
investment without additional requirement of funds from the shareholders. It means it
involves the use of funds obtained at a fixed cost in the hope of increasing the return
of the shareholders. So, it is also called as trading on equity.
 It represents the relationship between the firm’s EBIT and earning available for
ordinary shareholders.
 Favorable or positive leverage occurs when the firm earns more on the assets
purchased with the funds, than the fixed cost of their use. Unfavorable leverage
occurs when the firm does not earn as much as the fund cost.

From the desk of M. Azam 2


Leverage SFM

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).

% ∆inEPS %∆inNI EBIT


DFL =
%∆inEBIT
OR DFL =
%∆inNOI
OR DFL =
EBIT − I

 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

(b) New Net Income


If 20% Increase in EBIT :
NI = 1.25 x 20% =>NI = 25% (increase)
NI = 5200 x 125% =>NI = Rs.6500 (thousands)
If 50% Increase in EBIT :
NI = 1.25 x 50% =>NI = 62.5% (increase)
NI = 5200 x 162.5% =>NI = Rs.8450 (thousands)

If 10% decrease in EBIT :


NI = 1.25 x 10% =>NI = 12.5% (decrease)
NI = 5200 x 87.5% =>NI = Rs.4550 (thousands)

From the desk of M. Azam 3


Leverage SFM

COMBINED LEVERAGE
To magnify the sensitivity of NI to changes in Sales

 Combined leverage is the product of operating leverage and financial leverage.


 Both OL and FL are closely concerned with ascertaining the ability to cover fixed
charges, if they are combined, the result is total (combined) leverage and the risk
associated with combined leverage is known as total risk.
 The usefulness of DCL lies in the fact that it indicates the impact of changing in sales on
net income.
 The combined leverage work in either direction, it will be favorable if sales increases and
unfavorable when sales decreases.

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?

Goal---------Shareholders wealth maximization


In other words EPS maximization

 In EBIT-EPS analysis, we analyze the impact of changes of EBIT on EPS.


 This relation is evaluated by taking different combination of capital structure.
In this analysis, we read two concepts
 Financial Break-even point
 Indifference point

FINANCIAL BREAK-EVEN POINT


When all financial cost is covered at a particular level of EBIT is called as Financial Break-
even point.

Financial cost may be interest cost and fixed preference dividend.

Pr ef .Dividend
F .BE .Po int =Interest +
(1 −t )

From the desk of M. Azam 4


Leverage SFM

INDIFFERENCE POINT
Level of EBIT at which EPS under two or more alternative capital structures is equal is
known as Indifference point.

 If expected level of EBIT >Indifference Point, the advantage of EPS would be


available from the use of debt source of finance.
 If expected level of EBIT < Indifference Point, the advantage of EPS would be
available from the use of capital equity.

Favorable Capital Structure:


Expected EBIT > Indifference level of EBIT-------Geared Capital Structure
Expected EBIT < Indifference level of EBIT-------Un-geared Capital Structure

Comparison of EPS of Different Financing Plan

Equity Shares Vs Debentures


EBIT (1 −t ) ( EBIT −I )(1 −t )
=
N1 N2

Equity Shares Vs Preference Shares


EBIT (1 −t ) EBIT (1 −t ) −Dp
=
N1 N2

Equity Shares Vs Preference Shares with tax on preference dividends


EBIT (1 −t ) EBIT (1 −t ) −Dp (1 +Dt )
=
N1 N2

Equity Shares Vs Preference Shares and Debentures


EBIT (1 −t ) ( EBIT −I )(1 −t ) −Dp
=
N1 N2

From the desk of M. Azam 5

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