CH 014

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J axplain the concept of financial leverage.
J Discuss the alternative measures of financial
leverage.
J Understand the risk and return implications of
financial leverage.
J Analyse the combined effect of financial and
operating leverage.
J Highlight the difference between operating
risk and financial risk.
By Akash saxena
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J ^he term capital structure is used to represent
the proportionate relationship between debt
and equity.
J ^he various means of financing represent the
financial structure of an enterprise. ^he left-
hand side of the balance sheet (liabilities plus
equity) represents the financial structure of a
company. ^raditionally, short-term borrowings
are excluded from the list of methods of
financing the firm¶s capital expenditure.
By Akash saxena
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J How should the investment project be financed?
J Does the way in which the investment projects are
financed matter?
J How does financing affect the shareholders¶ risk,
return and value?
J Does there exist an optimum financing mix in terms
of the maximum value to the firm¶s shareholders?
J Can the optimum financing mix be determined in
practice for a company?
J What factors in practice should a company consider
in designing its financing policy?
By Akash saxena

J ^he use of the fixed-charges sources of funds, such
as debt and preference capital along with the owners¶
equity in the capital structure, is described as

or
or

J ^he financial leverage employed by a company is
intended to earn more return on the fixed-charge
funds than their costs. ^he surplus (or deficit) will
increase (or decrease) the return on the owners¶
equity. ^he rate of return on the owners¶ equity is
levered above or below the rate of return on total
assets.
By Akash saxena

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J ^he first two measures of financial leverage can be
expressed either in terms of book values or market
values. ^hese two measures are also known as
measures of

J ^he third measure of financial leverage, commonly
known as

^he reciprocal of interest
coverage is a measure of the firm¶s
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By Akash saxena

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By Akash saxena

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J ^he primary motive of a company in using financial
leverage is to magnify the shareholders¶ return under
favourable economic conditions. ^he role of financial
leverage in magnifying the return of the shareholders¶
is based on the assumptions that the fixed-charges
funds (such as the loan from financial institutions and
banks or debentures) can be obtained at a cost lower
than the firm¶s rate of return on net assets (RONA or
ROI).
J a , ROa and ROI are the important figures for
analysing the impact of financial leverage.
By Akash saxena
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J Ôor calculating ROa either the book value or

the market value equity may be used.
By Akash saxena
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J ^he firm is considering Ô
two alternative financial

plans:

J ) either to raise the entire
.a*" #$"$$$ #$"$$$
funds by issuing 50,000 a
ordinary shares at Rs 10 #¦ " / $ 01"2$$
per share, or
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J ( ) to raise Rs 250,000 by /
issuing 25,000 ordinary ¦ *" a / 5$"$$$ "#2$
shares at Rs 10 per share 2. *" a 3 5$"$$$ "#2$
/ 3
and borrow Rs 250,000 at
5." 6 5$"$$$ 14"12$
15 per cent rate of /
interest. 1./!, " 2$"$$$ #2"$$$
J ^he tax rate is 50 per 4¦ a a 3 / 3 .#$ .52

cent. 7¦ &
a a 3 / 3
#.$8 5.28
By Akash saxena
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By Akash saxena
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By Akash saxena

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affects a firm¶s operating
profit (aBI^).
J ^he
'(

(DOL) is defined as the
percentage change in '( '(
the earnings before
interest and taxes
relative to a given
percentage change in
sales.
By Akash saxena
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affects a firm¶s operating
profit (aBI^), while
affects
profit after tax or the earnings per share.
J ^

By Akash saxena
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J ^he

(DCL) is
given by the following equation:
'( ' '

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J another way of expressing the degree of
combined leverage is as follows:
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By Akash saxena

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J ^he variability of aBI^ and a distinguish between
two types of risk²

and
.
J

can be defined as the variability of
aBI^ (or return on total assets). ^he environment²
internal and external²in which a firm operates
determines the variability of aBI^
J ^he variability of aBI^ has two components:
J variability of sales
J variability of expenses
J ^he variability of a caused by the use of financial
leverage is called
.
By Akash saxena

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J We can use two measures of risk:
J tandard deviation and
J Coefficient of variation.
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By Akash saxena

CH 014

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*

*

J Ôor calculating ROa either the book value or

two alternative financial

J ^he tax rate is 50 per 4¦ a a 3 / 3 .#$ .52

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CH 014

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J Ôor calculating ROa either the book value or

two alternative financial

J ^he tax rate is 50 per 4¦ a  a 3 / 3   .#$ .52

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J ^he tax rate is 50 per 4¦ a a 3 / 3 .#$ .52