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2. Literature Review
2.1. Concepts of Risk and Leverage The relationship of operating leverage and financial leverage with the variability of a firms profit has been widely discussed in finance literature. Financial leverage measures a firms exposure to financial risk. Therefore degree of financial leverage indicates the percentage change in EPS emanating from a unit percentage change in EBIT. In general, a firms short term financing needs are influenced by current sales growth and how effectively 23
European Journal of Social Sciences Volume 7, Number 1 (2008) and efficiently the firm manages its net working capital. Note that on-going short term financing needs may reflect a need for permanent long term financing, including an evaluation of the appropriate mix and the use of debt and equity, that is, the capital structure. Financial leverage can accelerate EPS under favourable economic conditions but depresses EPS when the goings are not good for the firm. The unfavourable effect of financial leverage on EPS is more severe with more debt in the capital structure when EBIT is negative. Similarly the firms financial leverage can increase shareholders return and as well could increase their risk. According to Pandey (1999), the financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus (deficit) will increase (or decrease) the return on the owners equity, referred to as a double-edged sword, financial leverage provides the potentials of increasing the shareholders wealth as well as creating the risks of loss to them. Gaius(2007) Opines that operating leverage is created by fixed operating costs, such as general administrative overhead expenses, contractional employees salaries and mortgage or lease payment, these tend to elevate business risk. The impact of operating leverage is evident, when a given percentage changes in net sales results in a greater percentage change in operating income (EBIT). Mandelkar et al (1984) observe that DOL and DFL combine to magnify a given percentage change in sales to a potentially much greater percentage in EBIT. Infact, operating and financial leverages together cause wide fluctuation in EPS for a given change n sales. If a company employs a high level of operating and financial leverage, even a small change in the level of sales, will have dramatic effect on EPS. A company with cyclical sales will have a fluctuating EPS, but the swings in EPS will be more pronounced if the company also uses a high amount of operating and financial leverage. Therefore, there is the need to combine degree of operating and financial leverages to see the effect of total leverage on EPS associated with a given change in turnover as a result of improved purchasing power enabled by capital structure. Measuring Degree(s) of Leverage(s) Degree of Operating Leverage (DOL) Earlier on, we defined the degree of operating leverage (DOL) as the percentage change in EBIT relative to a given change in turnover, i.e: % Change in EBIT DOL = % Change in Turnover DOL = % EBIT/EBIT % Turnover/ Turnover The following equation is also used for calculating DOL: Q(S V) DOL = Q (S V) F Where Q is the unit of output, S is the unit selling price, V is the unit variable cost, and F is the total fixed costs. Degree of Financial Leverage (DFL) From the foregoing the financial leverage affects the EPS, when the economic conditions are good and the firms EBIT is increasing, its EPS increases faster with more debt in the capital structure. DFL is defined as the percentage in EPS due to a given percentage change in EBIT.
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European Journal of Social Sciences Volume 7, Number 1 (2008) DFL = DFL = % Change in EPS % Change in EBIT % EPS/EPS % EBIT/ EBIT Degree of Combined Leverage (DCL) The degrees of operating and financial leverages can be combined to see the effect of total leverage on the wealth of shareholders as demonstrated by EPS associated with a given change in turnover. The degree of combined leverage (DCL) is calculated, given by the following equation: % change in EBIT %change in EPS = % in EPS X % change in Turnover % change in EBIT % in Turnover Another way of expressing the degree of combined leverage is as follows: Q (S V) Q (S V) F Q (S V) DCL = X = Q (S V) F Q (S V) F-INT Q (S V)-f-INT Where Q(S-V) is contribution, and Q(S-V)-F-INT, is the profit after interest but before taxes. 2.2. Optimal Capital Structure Gaius (2007) observes that the optimal capital structure is one, with an equity that minimizes the firms cost of capital and maximizes its stock price. It is important to note here that a non-optimal capital structure may lead to higher financing projects that would have increased shareholders wealth with an optimal financing by the firm. The effect of different capital structure and differing business risk are reflected in a firms income statement. Operating leverage tends to magnify the effect of fluctuating sales and produce a percentage change in operating income (EBIT) larger than the changes in sales (Akintoye, 2007). In practice, firms tend to use target capital structure a mix of debt, preferred stock and common equity with which the enterprise plans to raise needed funds. Since capital structure policy involves a strategic trade-off between risk and expected return, the optimal capital structure policy must seek a prudent and informed balance between risk and return. The firm must consider its business risk, tax positions, financial flexibility and managerial conservatism or aggressiveness. While these factors are crucial in determining the target capital structure, operating conditions may cause the actual capital structure to differ from the optimal capital structure. Therefore the target capital structure should be used as a guide towards an ideal capital structure that minimizes the WACC while maximizing the shareholders wealth (Gaius, 2007).
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Payout Policy
Effect on Return
Effect Risk
Source:
3.Research Methodology
The method of analysis for this study is the use of Degree of Leverage ratios which include: Degree of operating leverage, Degree of financial leverage, Degree of combined leverage, and the percentage change in DPS to the percentage change in EBIT. 26
European Journal of Social Sciences Volume 7, Number 1 (2008) These ratios are presented below: Where; EPS = Earnings per share DPS = Dividend per share EBIT = Earnings before Interest and Tax. We want to establish the responsiveness of EBIT, EPS and DPS as performance indicators to turnover as a measure of the capital structure. We shall make use of secondary data precisely financial statements of the companies under consideration, The Nigerian Stock Exchange Fact Book, Textbooks and other relevant materials. The selected companies are: Cadbury Nigeria Plc, Flour Mills Nig. Plc, Nestle Nig. Plc, Nigerian Bottling Company Plc, and 7up Bottling Co. Plc.
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European Journal of Social Sciences Volume 7, Number 1 (2008) 4.1. Data Analysis Our summarized table presents the degree of operating leverage derived by using the ratio % EBIT % Turnover the degree of financial leverage; % in EPS % in EBIT Degree of calculated leverage; % in DPS % in Turnover, and we also adopt % DPS % EBIT The table reveals that for each of the food and beverages companies considered in our study, the responsiveness of the EBIT, EPS and DPS to capital structure which is measured by turnover, is significant, except for a change in the pattern in year 2004 for Nigerian Bottling Company Plc where an increase in turnover does not result in a corresponding increase in EBIT. However, Flour Mills Nigeria Plc, experienced a sharp fall in its turnover in 2003 and this result, in corresponding fall in its EBIT, which also affects the EPS and DPS. However, in the case of Nigerian Bottling company Plc, there was an increase in turnover though this increment does not reflect a corresponding increase in EBIT, we found out that EBIT is not sensitive to turnover, we therefore consider another performance indicator which is the DPS to establish if the DPS as a performance indicator, is sensitive to turnover, we discovered that the DPS for the year in question is not also sensitive to the turnover following the analysis and given the available details, we conclude that irrespective of the dividend policy adopted by an organization (either dividend supremacy or irrelevance) the RATE OF CHANGE IN CAPITAL STRUCTURE, is a major influence on what organizations behaviour is likely to be. For Nestle Nig. Plc, we found out that an increase in turnover for all the years considered, results in an increase in EBIT although at a lesser rate which invariably implies that EBIT is also sensitive to turnover, the EPS from the data available to us is also sensitive to EBIT, but the DPS in 2004, reveals no sensitivity to EBIT this situation is attributable to the form of dividend policy adopted by the organization, the increase (or decrease) in EBIT further reveals that the rate of change in EBIT (earnings) goes a long way in determining the behaviour of companies managers towards the dividend policy to adopt at a particular point in time. For year 2004, Nestle Nig. Plc, recorded no increase in is DPS. Furthermore, Cadbury Nig. Plc with increased turnover throughout the period under consideration reveals that EBIT, EPS and DPS are sensitive to Turnover, infact the company presents a fascinating financials, depicted by the percentage increase in DPS to a relative increase in EBIT of 1,466 for the year 2004. Similarly 7-up Bottling Co Plc, possesses similar result, with the analysis of Cadbury Nig Plc, an increase in turnover reflects sensitivity of EPS, DPS and EBIT to same. 4.2. Summary Of Findings Having analysed our data, for each of the food beverages companies considered, we found out that EBIT, EPS and DPS are sensitive to capital structure. The largest effects of leverage are obtained when we combined the operating leverages with financial leverages. For Cadbury Nig Ltd, the combination results in an EPS increase of 1.87, 1.71, 0.68 & 0.65 times, than increase in turnover, respectively, for each of the years considered. 7-Up Bottling Co. Plc, given the combination of DOL and DFL has increase of 1.33, 0.25, 0.41 and 1 times respectively, than increase in turnover.
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European Journal of Social Sciences Volume 7, Number 1 (2008) Flour Mills Nig. Plc, also has 7.2, 16.15, 0.28 increase in EPS than increase in turnover for the years 2002, 2004 and 2005 respectively with an exception of 2003 when the company record a fall in its turnover, EBIT and EPS. Similarly, Nestle Nig Plc, reveals an increase in EPS 1.15, 0.07 and 0.05, for the years 2001, 2002 and 2004, with the exception of 2003 when the companys DFL is negative due to the fall in EPS of the firm from 7.51 to 7.20 for that particular year. Lastly, Nig Bottling Company Plc, has its EPS increased by more than 4.33, 2.22 and 0.71 times its turnover for the years 2001, 2002 and 2003, apart from 2004, when the companys EBIT fell drastically from 6,045,057 to 3,330,594. However, few of the companies experience sharp change in trend for some of the years, especially year 2004, thereby revealing that irrespective of the dividend policy adopted by an organization (either dividend supremacy or irrelevance) the rate of change in capital structure is a major influence on what organizations behaviour towards dividend policy could be, as to embracing retention or supporting dividend payout.
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References
[1] [2] [3] [4] [5] [6] [7] [8] Akintoye, I.R. (2006) Akintoye I.R. (2007) Optimising Firm Performance: A Closer Look at The Capital Structure Brenner M and Smidt, S. (1978) Asset Characteristics and Systematic Risks Financial Management (Winter): 33-39. Gahlon, J and Gentry, J (1982) Relationship between Systematic Risk and the Degree of Operating and Financial Leverage. Financial Management (Summer): 15-23 Hite, G.L (1977) Leverage, output effects and he M.M. Theory, Journal of Financial Economics March 177. Mandelker, G and Rhee, S. (1984). The Impact of the Degrees of Operating and Financial Leverage an Systematic Risk of Common Stock. Journal of Financial and Quantitative Analysis. March, 45-50. Pandey (1999) Yang H, and Kwansa, H (1994) Effect of operating and Financing Leverage on firms risk. Journal of International Academy of Hospital Research. Issue 8.
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