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Leverage
Study Note - 4
LEVERAGE
Analysis of Operating and Financial Leverages
This Section includes :
l Concept and Nature of leverages operating risk and financial risk and
combined leverage.
l Operating leverages and CVP analysis and EPS, indifference point.
INTRODUCTION :
The concept of leverage has its origin in science. It means influence of one force over another.
Since financial items are inter-related change in one causes change in profit. In the context of
financial management, the term ‘leverage’ means sensitiveness of one financial variable to
change in another. The measure of this sensitiveness is expressed as a ratio and is called
degree of leverage.
Algebrically, the leverage may be defined as,
= SQ – VQ
= Q (S–V)
Total Contribution
Contribution per unit =
Units sold
Q (S − V )
= =S−V=C
Q
Financial Leverage
The Financial leverage may be defined as a % increase in EPS in associated with a given
percentage increase in the level of EBIT. Financial leverage emerges as a result of fixed financial
charge against the operating profits of the firm. The fixed financial charge appears in case
the funds requirement of the firm are partly financed by the debt financing. By using this
relatively cheaper source of finance, in the debt financing, the firm is able to magnify the
effect of change in EBIT on the level of EPS.
The significnace of DFL may be interpreted as follows :
l Other things remaining constant, higher the DFL, higher will be the change in EPS for
same change in EBIT. In other words, if firm K has higher DFL than firm L, EPS of firm K
increase at faster rate than that of firm L for same increase in EBIT. However, EPS of firm
K falls at a faster rate than that of firm K for same fall in EBIT. This means, higher the DFL
more is the risk.
l Higher the interst burden higher the DFL, which means more a firm borrows more is its
risk.
l Since DFL depends on interest burden, it indicates risk inherent in a particular capital mix,
and hence the name financial leverage.
There is an unique DFL for each amount of EBIT.
While operating leverage measures the change in the EBIT of a company to a particular
change is the output, the financial leverage measures the effect of the change in EBIT on the
EPS of the company.
Thus the degree of financial leverage (DEL) is ratio between proportionate change in EPS
and proportionate change in EBIT.
(EBIT − I) (I − T ) − D
Here, EPS =
N
Where I = Interest
t = Tax rate
D = Preference Dividend
N = No of equity shares.
ΔEPS / EPS
DFL =
ΔEBIT / EBIT
Substituting the value of EPS above, we have
EBIT (1 - t)
DEL =
(EBIT - I) (I - t) - D
It there is no preference share capital,
EBIT
then DEL =
EBIT − I
Earning before interest and tax
=
Earning after interest
Combined Leverage
The operating leverage explains the business risk of the firm whereas the financial leverage
deals with the financial risk of the firm. But a firm has to look into the overall risk or total of
the firm, which is busines risk plus the financial risk.
One can draw the following general conclusion about DCL.
l Other things remaining constant, higher the DCL higher will be the change in EPS for
same change in Q (Deamand).
l Higher the DCL, more is the overall risk, and higher the fixed cost and interest burden in
lower the earning after interest, higher is the DCL.
l There is an unique DCL, for each level of Q.
A combintation of the operating and financial leverages is the total or combination leverage.
The operating leverage causes a magnified effect of the change in sales level on the EBIT level
and if the financial leverage combined simultaneously, then the change in EBIT will, in turn,
have a magnified effect on the EPS. A firm will have wide fluctuations in the EPS for even a
small change in the sales level. Thus effect of change in sales level on the EPS is known as
combined leverage.
Thus Degree of Combined leverage may be calculated as follows :
ΔEPS / EPS
in DCL =
ΔQ / Q
= DFL × DOL
EBIT CQ CQ
= × =
EBIT − T EBIT EBIT − I
Degree of Combined leverage
Contribution C
DOL = =
Earning before Interest and Tax EBIT
Contribution C
DCL = =
Earning after Interest EBIT − I
Fixed Cost
Q1 = ⇒ OperatingBEP.
Contribution
Contribution
Whereas, DOL =
EBIT
l Thus EBIT is negative below operating BEP, thus DOL is negative below that point.
l EBIT is positive above operating BEP, DOL is positive above that point.
l EBIT = 0 at operating BEP. DOL is undefined at operating BEP.
l DFL = 0 at operating BEP, as at operating BEP, EBIT = 0.
Earning per Share
If interest = I
Tax per Rs. of taxable income = t
Preference Dividend = D
No of equity shares = E
(EBIT − I) (I − t ) − D
EPS =
N
EBIT – EPS Indifference Point
The amount of EBIT, at whcih EPS under two capital mixes are equal, is called the
EBIT – EPS indifference point.
To explain this, we may use the following equation :
(EBIT − I) (1 − t ) − D
EPS =
N
Putting two different values of I, D and N in the above eqution, we can find two equation
representing EPS in terms of EBIT under two proposed mixes.
Equating these two equations, and solving for EBIT, we can find the indifference point.
The linear relationship developed between EBIT and EPS using above equation for two capital
mixes can be plotted on a graph paper in the form of two straight lines. In the following
figure, the indifference point is shown at point G.
EPS
Mix 1
Mix 2
O
G
EBIT
ILLUSTRATIONS
Illustration 1
Calculate the degree of operating leverage (DOL), degree of financial leverage (DFL) and the
degree of combined leverage (DCL) for the following firms and interpret the results.
Firm K Firm L Firm M
1. Output (Units) 60,000 15,000 1,00,000
2. Fixed costs (Rs.) 7,000 14,000 1,500
3. Variable cost per unit (Rs.) 0.20 1.50 0.02
4. Interest on borrowed funds (Rs.) 4,000 8,000 —
5. Selling price per unit (Rs.) 0.60 5.00 0.10
Solution :
Firm K Firm L Firm M
Output (Units) 60,000 15,000 1,00,000
Selling Price per unit (Rs.) 0.60 5.00 0.10
Variable Cost per unit 0.20 1.50 0.02
Contribution per unit (Rs.) 0.40 3.50 0.08
Illustration 4.
The following information is available for ABC & Co.
EBIT Rs. 11,20,000
Profit before Tax 3,20,000
Fixed costs 7,00,000
Calculate % change EPS if the sales are expected to increase by 5%.
Solution :
In order to find out the % change in EPS as a result of % change in sales, the combined
leverage should be calculated as follows :
Operating Leverage = Contribution/EBIT
= Rs. 11,20,000+Rs. 7,00,000/11,20,000
= 1.625
Financial Leverage = EBIT/Profit before Tax
= Rs 11,20,000/3,20,000
= 3.5
Combined Leverage = Contribution/Profit before tax = OL×FL
= 1.625×3.5 = 5.69.
The combined leverage of 5.69 implies that for 1% change in sales level, the % change in EPS
would be 5.69%. So, if the sales are expected to increase by 5%, then the % increase in EPS
would be 5×5 = 28.45%.
Illustration 5.
XYZ and Co. has three financial plans before it, Plan I, Plan II and Plan III. Calculate operating
and financial leverage for the firm on the basis of the following information and also find out
the highest and lowest value of combined leverage :
Production 800 Units
Selling Price per unit Rs. 15
Variable cost per unit Rs. 10
Fixed Cost : Situation A Rs. 1,000
Situation B Rs. 2,000
Situation C Rs. 3,000
Capital Structure Plan I Plan II Plan III
Equity Capital Rs. 5,000 Rs. 7,500 Rs. 2,500
12% Debt 5,000 2,500 7,500
Solution :
Calculation of Operating Leverage :
Situation A Situation B Situation C
Number of unit sold 800 800 800
Sales @ Rs. 15 12,000 12,000 12,000
and lowest value of combined leverage is attained when financial Plan II is implemented in
situation A.
Illustration 6.
The folowing data relates to two companies A Ltd. and B Ltd.
A Ltd. B Ltd.
Capital Employed :
Equity share capital (in Rs. 10 shares) 5,00,000 2,50,000
9% Debentures — 2,50,000
Earnings before interest and tax 1,00,000 1,00,000
Return on capital employed 20% 20%
The equity shareholders of A Ltd. find to their dismay that in spite of same return earned by
their company on the total capital employed, their earning per share is much less as compared
to B Ltd.
You are required to state for the satisfaction of the shareholders of A Ltd., the reasons for
such lower earnings per share on their capital. Assume the tax at 50%.
Solution :
In order to find out the reasons for a higher rate of earning for the shareholders of B Ltd., the
earning per share for both the companies have to be calculated :
If EBIT increase by 6%, the taxable income will increase by 1.15×6 = 6.9% and it may be
verified as follows :
EBIT (after 6% increase) Rs. 42,400
Less : Interest 5,000
Profit before Tax 37,400
Increase in taxable income in Rs. 2,400 i.e., 6.9% of Rs. 35,000
(ii) Degree of operating leverage :
DOL = Contribution/EBIT = 1,40,000/40,000 = 3.50
If Sales increase by 10%, the EBIT will increase by 3.50×10 = 35% and it may be verified as
follows :
Sales (after 10% increase) Rs. 2,20,000
Less : Variable Expenses @30% 66,000
Contribution 1,54,000
Less : Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is Rs. 14,000 i.e., 35% of Rs. 40,000.
(iii) Degree of combined leverage :
DCL = Contribution/Profit before Tax = 1,40,000/35,000
=4
If Sales increases by 6%, the profit before tax will increase by 4×6 = 24% and it may be
verified as follows :
Sales (after 6% increase) Rs. 2,12,000
Less : Variable Expenses @ 30% 63,600
Contribution 1,48,400
Less : Fixed cost 1,00,000
EBIT 48,400
Less : Interest 5,000
Profit before Tax 43,400
Increase in Profit before tax is Rs. 8,400 i.e., 24% of Rs. 35,000.
Illustration 9.
(i) Find out operating leverage from the following data :
Sales Rs. 50,000
Variable Costs 60%
Fixed Costs Rs. 12,000
(ii) Find out of financial leverage from the following data :
Net Worth Rs. 25,00,000
Debt/Equity 3:1
Solution :
EBIT 3
Firm A Financial Leverage = = or EBIT = 3 × EBT .... (1)
EBT 1
Again EBIT–Interest = EBT
or EBIT-200 = EBT .... (2)
Taking (1) and (2) we get 3 EBT–200 = EBT
or 2 EBT=200 or EBT = Rs. 100
Hence EBIT=3EBT = Rs.300
Interpretation
The financial position of firm C can be regarded better than that of other firm A and B
because of the following reasons :
(i) Financial leverage is the measure of financial risk. Firm C has the least financial risk as
it has minimum degree of financial leverge. No doubt it is true that there will be a
more magnified impact on earnings per share on A and B firms that that of C due to
change in EBIT but their EBIT level due to low sales is very low suggesting that such
an advantage is not great.
(ii) Degree of combined leverage is maximum in firm B i.e., 20, against firm A i.e., 12 and
firm C i.e., 6. Clearly, the total risk (business and financial) complexion of firm C is the
lowest, while that of other firms are very high.
(iii) The ability of firm C to meet interest liability is better than that of firms A and B as
follows :
EBIT/Interest ratio for three firms :
A = 300/200 = 15
B = 400/300 = 1.33
C = 2,000/1,000 = 2