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Unit 6
Structure
6.1 Introduction 6.2 Operating Leverage
6.2.1 Application of Operating Leverage 6.3 Financial Leverage
6.3.1 Uses of Financial Leverage 6.4 Combined Leverage
6.4.1 Uses of Combined Leverage 6.5 Summary
Solved Problems Terminal Questions Answers to SAQs and TQs 6.1 Introduction
Leverage
A company uses different sources of financing to fund its activities. These sources can be classified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable.
There are two types of leverage – operating leverage and financial leverage. Leverage
associated with the asset purchase activities is known as operating leverage, while those associated with financing activities is called as financial leverage.
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Learning Objectives:
After studying this unit, you should be able to understand the following.
1. Explain the meaning of leverage. 2. Mention the different types of leverage. 3. Discuss the advantages of leverage.
6.2 Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows. A company’s operating costs can be categorized into three main sections:
· Fixed costs are those which do not vary with an increase in production or sales activities for a
particular period of time. These are incurred irrespective of the income and volume of sales and generally cannot be reduced.
· Variable costs are those which vary in direct proportion to output and sales. An increase or
decrease in production or sales activity will have a direct effect on such types of costs incurred. · Semivariable costs are those which are partly fixed and partly variable in nature. These costs
are typically of fixed nature up to a certain level beyond which they vary with the firm’s activities. The operating leverage is the firm’s ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume. Example:
A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses amount to R. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000 units and 3000 units. Solution Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost 1000 10000 5000 5000 5000 2000 20000 10000 10000 5000 3000 30000 15000 15000 5000Sikkim Manipal University
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EBIT 000 5000 10000 If we take 2000 units as the normal course of sales, the results can be summed as under: · A 50% increase in sales from 2000 units to 3000 units results in a 100% increase in EBIT. · A 50% decrease in sales from 2000 units to 1000 units results in a 100% decrease in EBIT. The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in EBIT and vice versa. The former is a favourable operating leverage and the latter is unfavourable.
Another way of explaining this phenomenon is examining the effect of the degree of operating leverage DOL. The DOL is a more precise measurement. It examines the effect of the change in the quantity produced on EBIT.
DOL=% change in EBIT / % change in output To put in a different way, (ΔEBIT/EBIT) (ΔQ/Q)
EBIT is Q(S—V)—F where Q is quantity, S is sales, V is variable cost and F is fixed cost. Substituting this we get, {Q(S—V)} {Q(S—V)—F}
Example:
Calculate the DOL of Guptha enterprises. Quantity produced and sold – 1000 units Variable cost Selling price per unit Fixed expenses Solution DOL={Q(S—V)} {Q(S—V)—F} =1000(300—200) 1000(300—200)—20000 =100000/80000 DOL=1.25
If the company does not incur any fixed operating costs, there is no operating leverage.
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– Rs. 100 per unit’ – Rs. 300 per unit – Rs. 20000
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Example: Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT Solution: DOL={Q(S—V)} {Q(S—V)—F}
{1000(5000)} / {1000(5000) – 0} =5000000/5000000 =DOL=1
As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards.
6.2.1 Application of Operating Leverage
Measurement of business risk: Risk refers to the uncertain conditions in which a company performs. Greater the DOL, more sensitive is the EBIT to a given change in unit sales. A high DOL is a measure of high business risk and vice versa.
Production planning: A change in production method increases or decreases DOL. A firm can change its cost structure by mechanizing its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.
1000 10000 5000 5000 0 5000 Sikkim Manipal University
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6.3 Financial Leverage
Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of EBIT on EPS of the company. A company’s sources of funds fall under two categories – those which carry a fixed financial charge – debentures, bonds and preference shares and those which do not carry any fixed charge – equity shares. Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firm’s revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.
Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the company’s income stream. Such expenses have nothing to do with the firm’s performance and earnings and should be paid off regardless of the amount of EBIT. It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as “Trading on Equity”. Example:
The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest @ 5% on debentures worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken as 40% and number of outstanding shares as 1000. Solution: EBIT Interest on deb. EBT Tax 40% EAT Preference div. Earnings available to equity holders 10000 1250 8750 3500 5250 1200 4050 5000 1250 3750 1500 2250 1200 1050 15000 1250 13750 5500 8250 1200 7050Sikkim Manipal University
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EPS Interpretation: 4.05 1.05 7.05 · A 50 % increase in EBIT from Rs. 10000 to Rs. 15000 results in 74% increase in EPS. · A 50 % decrease in EBIT from Rs. 10000 to Rs. 5000 results in 74% decrease in EPS.
This example shows that the presence of fixed interest source funds leads to a more than proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial leverage DFL is a more precise measurement. It examines the effect of the fixed sources of funds on EPS. DFL=%change in EPS %change in EBIT DFL={ΔEPS/EPS} {ΔEBIT/EBIT} Or DFL =
EBIT {EBIT—I—{Dp/(1T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate. Example:
Kusuma Cements Ltd. has an EBIT of Rs. 500000 at 5000 units production and sales. The capital structure is as follows: Capital structure Paid up capital 500000 equity shares of Rs. 10 each 12% Debentures Total Corporate tax rate may be taken at 40% Solution: EBIT EBT
500000 452000
Less Interest on debentures 48000
Amount Rs. 5000000 400000 5800000 10% Preference shares of Rs. 100 each 400000 Sikkim Manipal University
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DFL= EBIT {EBIT—I—{Dp/(1T)}} 500000 (500000—48000—{40000/(1—0.40)} DFL=1.30
6.3.1 Use of Financial Leverage
Studying DFL at various levels makes financial decisionmaking on the use of fixed sources of funds for funding activities easy. One can assess the impact of change in EBIT on EPS.
Like operating leverage, the risks are high at high degrees of financial leverage. High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments. A firm not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On the one hand trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firm’s mix of sources of funds. One main goal of financial planning is devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up. Impact of financial leverage:
Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used. This can be explained with the help of the following example: Following are the balance sheets of 2 firms A and B
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Balance sheet of A Equity 10000 capita 0 l Assets 10000 0 Balance sheet of B Equity 40000 capital Debt @15% 60000 Assets 10000 0 Total 10000 0 Total 10000 0 Total 10000 0 Total 10000 0 Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and interpret the results thereof. DFL=
EBIT
{ EBIT - I - { Dp /( 1 - T )}}
4000
= 1
40000 - 0 - 0
4000
= 1 . 29
40000 - 9000 - 0
Company A = Company B =
The company not using debt to finance its assets has a higher DFL. Financial leverage does not exist when there is no fixed charge financing. 6.4Total or Combined Leverage
The combination of operating and financial leverage is called combined leverage. Operating leverage affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide fluctuation in EPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more pronounced. The combined effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the product of DOL and DFL. DTL =
Q( S - V )
Q ( S - V ) - F - I - { Dp /( 1 - T )}
Example:
Calculate the DTL of M/s Pooja Enterprises Ltd. given the following information. Quantity sold
10000 units
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Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt
Preference shares Tax rate
Rs. 100 per unit Rs. 500 per unit Rs. 1000000 100000
Rs. 1000000 @ 20% interest
10000 shares of Rs. 100 each @ 10% dividend 50%
DTL =
Q( S - V )
Q ( S - V ) - F - I - { Dp /( 1 - T )}
10000 ( 500 - 100 )
10000 ( 500 - 100 ) - 1000000 - 200000 - { 100000 / 0 . 5 }
DTL=1.54 Cross verification: DOL= =
{ Q ( S - V )}
{ Q ( S - V ) - F }
10000( 500 - 100 ) 10000 ( 500 - 100 ) - 1000000
DOL=1.33 DFL=
EBIT
EBIT - I - { Dp /( 1 - T )}}
3000000 3000000 - 200000 - { 100000 / 0 . 5 }
DFL=1.15 DTL=DOL*DFL 1.33*1.15=1.54 6.4.1 Uses of DTL
DTL measures the total risk of the company as it is a combined measure of both operating and financial risk. It measures the variability of EPS.
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Self Assessment Questions 1
1. ________________arises due to the presence of fixed operating expenses in the firm’s income
flows.
2. EBIT is calculated as _____________.
3. Higher operating risks can be taken when _____________of companies are rising. 4. Dividend on __________is a fixed charge.
5. Financial leverage is also referred to as ____________. 6.5 Summary
Leverage is the use of influence to attain something else. The advantage a company has with its current status is used to gain some other benefit. There are three measures of leverage – operating leverage, financial leverage and total or combined leverage. Operating leverage examines the effect of change in quantity produced upon EBIT and is useful to measure business risk and production planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It also refers to the debtequity mix of a firm. Total leverage is the combination of operating and financial leverages. Solved Problems
1. The following information has been collected from the annual report of Garden Silks. What is the
degree of financial leverage? Total sales Rs. 1400000 Contribution ratio 25% Fixed expenses Rs. 150000
Outstanding bank loan Rs. 400000 @ 12.5% Applicable tax rate 40%
Solution: DFL = EBIT / (EBITI) = 200000/20000050000 = 1.33 EBIT = Sales*25% less fixed expenses 1400000*25% = 350000150000 = 200000
2. X and Y have provided the following information. Which firm do you consider risky?
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X Ltd. Sales in units Price per unit Variable cost p.u Fixed financing cost Fixed financing cost 40000 60 20 Rs. 100000 Rs. 300000 Y Ltd. 40000 60 25 Rs. 50000 Rs. 200000 Solution: DOL = Q(SV) / Q(SV)F
Company X: 40000(6020) / 40000(6020)400000 1600000/1200000 = 1.33
Company Y: 40000(6025) / 40000(6025)250000 1400000/1100000= 1.22
3. Calculate EPS with the following information.
EBIT Rs. 1180000 Interest Rs. 220000
No. of shares outstanding 40000 Tax rate applicable 40%
Solution: EBIT
Less Int EBT Tax 40% EAT
1180000 220000 960000 384000 576000
EPS = EAT/no of shares outstanding 576000/40000 = Rs. 14.4
4. The leverages of three firms are given below. Which one of the combinations should be chosen
for the combined leverage to be maximum and what are the inferences?
A Operating leverage Financial leverage 1.14 1.27 B 1.23 1.3 C 1.33 1.33Sikkim Manipal University
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Solution: We should calculate the combined leverage to draw inferences. Combined leverage of A is 1.14*1.27 = 1.45,
Combined leverage of B is 1.23*1.3 = 1.60, Combined leverage of C is 1.33*1.33 = 1.77
We find that the combined leverage is highest for firm C and this suggests that this firm is working under very high risky situation.
Terminal Questions
1. Mishra Ltd. provides the following information. What is the degree of operating leverage?
Output Fixed costs
Variable cost per unit Interest on borrowed funds Selling price per unit Output Fixed costs Variable cost
Interest on borrowed funds Selling price
performance through leverage
A Ltd. (Rs. In lakhs) Sales Variable cost Fixed cost EBIT Interest 1000 300 250 450 50 B Ltd. (Rs. In lakhs) 1500 600 400 500 100100000 Units Rs. 15000 Rs. 0.50 Rs. 10000 Rs. 1.50 25000 units Rs. 25000 Rs. 2.50 per unit Rs. 15000 Rs. 8 per unit
2. X Ltd. provides the following information. What is the degree of financial leverage?
3. The following information is available in respect of 2 firms. Comment on their relative
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4. ABC Ltd. provides the following information. Calculate the DFL.
Output Fixed costs Variable cost
Interest on borrowed funds Selling price per unit
200000 units Rs.3500 Rs. 0.05 per unit Nil 0.20
Answers to Self Assessment Questions Self Assessment Questions 1 1. Operating leverage 2. Q(S—V)—F 3. Income levels 4. Preference shares 5. Trading on Equity
Answers to Terminal Questions: 1. Hint DOL = 2. Hint DFL =
{ Q ( S - V )} { Q ( S - V ) - F }
EBIT { EBIT - I - { Dp /( 1 - T )}}
3. Hint calculate DFL
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