Leverage

Anupama
 Capital Structure
• Various means of financing represent financial
structure of the firm.
• It includes liabilities + equity
• Traditionally short term borrowings are
excluded from the list of methods of financing
capital exp. and hence all long term claims are
a part of capital structure.
 Types of Leverage
• Three types
- Operating Leverage.
- Financial Leverage.
- Combined Leverage
 Operating Leverage
• Effect of change in sales on EBIT of the company
• DOL indicates – small change in level of sales will
produce large change in Operating income
• It’s a measure of firms business risk- variability in
EBIT
• DOL=( % change in EBIT)/ (% change in sales or
output)
• or {Q(S-V)}/ {Q(S-V)-F)
 Operating Leverage Contd..
• DOL at Operating break even point, where
EBIT is zero is undefined.
• Units at Break even point can be cal. Using
formula Q= Total Fixed cost/(S-V)p.u
• Different levels of output has different DOLs
• It’s a measure of Firms business risk
 Financial Leverage
• Measures effect of change in EBIT on EPS
• Also refers to mix of debt and equity in capital
structure of the firm.
• Double edged sword.
• DFL = (% change in EPS)/(% change in EBIT)
– Or DFL= EBIT/ {EBIT-I- [Pref Div/(1-t)]}
 Financial Leverage Contd…
• DFL is undefined at Financial Break Even point.
• EBIT= I+{Pref Div./(1-t)} gives us the point of
Fin Break Even point.
• EPS is zero at Fin Break Even point
• Each level of EBIT has different DFL
• It indicates the financial risk of the firm.
 Total Leverage
• Combination of DOL & DFL.
• It’s a measure of impact in change in
output/sales on the EPS of the company
• DTL=% change in EPS/ % change in output.
• Or DTL= Q(s-v)/(Q(s-v)-F-I-{Pref Div/(i-t)})
• Measure of Total Risk