Professional Documents
Culture Documents
In this chapter
Sources of finance Debt, Preference and Equity Capitals Operating and financial Leverage
Sources of Finance
Owned Capital:
Share Capital
Retained Earnings.
Debentures. Institutional Loans. Public Deposits.
Debt Capital:
Leverage
Leverage means the action of a lever and mathematical advantage gained by it. Firms ability to use fixed costs assets or sources of funds to magnify the returns to its owners. According to James Home, leverage is the employment of an asset or sources of funds for which the firm has to pay a fixed costs or fixed return.
Types of Leverage
Operating Leverage
The firms ability to use operating cost to magnify the effects of changes in sales on its EBIT. The degree of operating leverage may be defined as the change in the percentage of EBIT, for a given change in percentage of sales revenue.
Symbolically
Percentage change in EBIT Degree of Operating Leverage (DOL) = Percentage change in Sales Or
When the data is given only for one year, then we have to compute operating leverage, by the following formula.
Operating Leverage
It is helpful to know how operating profit would change with a given change in units produced. It will be helpful in measuring business risk.
Financial Leverage
Ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on firms EPS.
EBIT (Operating profit) Financial Leverage = EBT (Taxable income) Percentage change in EPS Degree of Financial Leverage (DFL) Or
It is helpful to know how EPS would change with a operating profit. It is helpful for measuring financial risk.
Combined Leverage
Or
EBIT Contribution
Contribution
EBIT
X
EBT
=
EBT
Effect of Leverage
Operating Leverage High Low High Financial Leverage High Low Low Combined Effect This combination is very dangerous policy, which should be avoided. This combination is very cautious policy and not assuming risk. This combination have adverse effects of operating leverage were taken care of by having low financial leverage. This combination is an ideal situation. The company can follow aggressive debt policy.
Low
High