Financing Decisions

Bulbul Sharma
Roll No.- 12
PGDM
Presentation Scheme
 Introduction
 Leverage
 Types of Leverage
 Operating
 Financial
 Composite
Introduction

Financing decision involves the choice of an

appropriate mix of different sources of financing,
namely, owners' fund and outsider/Lenders’ funds.
Leverage

“the employment of an asset or sources of funds for

which the firm has to pay a fixed cost or a fixed
return”.
Types of Leverage
 Operating Leverage
 Financial Leverage
 Composite Leverage
Operating Leverage
Operating leverage can be defined as the firm’s
ability to use fixed operating expenses to magnify
the effects of changes in sales on its earnings before
interest and taxes.
The operating expenses of a firm fall into 3 basic
categories:
 Fixed Costs
 Variable Costs
 Semi-Variable Costs
Computation of OL

OL= Contribution/ EBIT

A company produces & sells 1000 units p.a. SP @

Re 200 and VC @ Re 70 per unit. FC (operating) Re
50,000. What is OL?
Contd…
 Sales (1000*200) 200000
 Less VC (1000*70) 70000
 Contribution (sales – VC)130000
 Less FC 50000
 EBIT 80000
 OL 130000/80000 = 1.625
Degree of Operating Leverage

DOL = % change in EBIT/ % change in sales

 E.g. increase in sales is 20% and profit @ 64%.

 Degree of OL = 64/20 = 3.2.
 If sales increase by Rs.1, profit will increase by Re 3.2. &
vice versa
Financial Leverage

 The use of fixed charges sources of funds, such as

debt and preference capital along with owners’
equity in the capital structure is described as
financial leverage or gearing or trading on equity.

 FL is favorable when earnings is more than FC and

vice versa
Computation of FL

FL = EBIT/EBT

For e.g. Sales – Rs 50000,

VC – 25000
FC – 15000,
Int. - 5000
Solution: FL = 10,000/5,000
FL = 2
Degree of FL
DOF= % change in EPS/ % change is EBIT

Degree of Financial Leverage of Alternative Financial Plans at

EBIT of 120,000
Debt level DFL
0 1
25% 1.185
50% 1.456
75% 1.882
Composite Leverage
 CL measures composite effect of all the fixed
cost (operating and financial)

 CL will disclose effect of changes in sales

over change in taxable profit (or EPS)
Computation of CL
CL = Contribution/EBT

 For e.g.
Sales – Re 1.00 lac
VC (40% of sales) 40 000
Fixed operating cost 30000
Fixed financial cost 10000
Calculate CL.
Calculate CL. If 5% increase in sales
Sales 100000 105000

VC 40000 42000
Contribution 60000 63000
FC – Operating 30000 30000
EBIT 30000 33000
FC- Financial 10000 10000
PBT 20000 23000

CL 60000/20000 =
3