KAILAS SREE CHANDRAN

M100447ME

2

» The employment of an asset or source of funds
for which the firm has to pay a fixed cost or
fixed return may be termed as Leverage.
» If the earnings before interest and taxes
exceeds the fixed return requirement, the
leverage is called favorable.
» Leverage:
 Operating Leverage
 Financial Leverage

3

» Financial Leverage results from the presence of
fixed financial charges in the firm’s income
stream.
» Kinds of Sources of funds:
1. Those which carry a fixed financial charge
2. Those which do not involve any fixed charge.

» Financial Leverage involves the use of funds
obtained at a fixed cost in the hope of
increasing the return to the share holders.

4

»
»
»
»
»
»
»

EBIT= `10,000
Bonds @ 5%= `40,000
Preference Share @10% = `20,000
Tax= 35%
Ordinary shares = 1,000
Case1, EBIT= `6000 (-40%)
Case2, EBIT= `14000 (+40%)

5

Case 1

Base

Case 2

`6,000

`10,000

`14,000

2,000

2,000

2,000

Earnings before taxes(EBT)

4,000

8,000

12,000

Less: Taxes(35%)

1,400

2,800

4,200

2,600

5,200

7,800

2,000

2,000

2,000

600

3200

5800

EBIT
Less: Interest on bonds

Earning after taxes(EAT)
Less: Preference Dividend
Earnings available for share holders
Earnings Per Share

0.6
-81.25%

3.2

5.8
+81.25%

6

Case 1

Base

Case 2

`6,000

`10,000

`14,000

2,000

2,000

2,000

Earnings before taxes(EBT)

4,000

8,000

12,000

Less: Taxes(35%)

1,400

2,800

4,200

EBIT

Less: Interest on bonds

Earning after taxes(EAT);
Earnings available for share holders
Earnings Per Share
-50%

2,600

5,200

7,800

2.6

5.2

7.8

-50%

7

DFL = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

DFL =

>1 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇

− 𝐼−𝐷𝑝/(1−𝑡)

Example Case 1 & 2:

81.25
40

= 2.03

1% change in EBIT will cause 2.03% change in EPS.
Example Case 1 &

50
2(w/o Preference dividend):
40

= 1.25

8

» Method to study the effect of leverage.
» It involves the comparison of alternative
methods of financing.
» Choices to raise funds:
1.
2.
3.
4.

Equity Capital
Debentures
Preference Capital
Combination of above

9

A firm has a capital structure of ordinary shares
amounting to `10 lakhs. Now the firm wishes to
raise additional `10 lakhs. The firm has four
alternative financial plans:
a)
b)
c)
d)

Entire Equity Capital
50% Equity capital- 50% debentures @ 5%.
Entire Debentures @ 6%.
50% Equity capital- 50% Preference capital @ 5%.

Existing EBIT: `1.2 lakhs. Tax rate: 35%. Ordinary
shares: 10,000. Market Price/share: `100.

10

Particulars

Financing Plans
A

B

C

D

`120,000

`120,000

`120,000

`120,000

-

25,000

60,000

-

120,000

95,000

60,000

120,000

Taxes

42,000

33,250

21,000

42,000

Earnings after taxes

78,000

61,750

39,000

78,000

-

-

-

25,000

78,000

61,750

39,000

53,000

EBIT
Less: Interest

Earnings before taxes

Less: Preference dividend
Earnings available to
ordinary share holders
Number of shares
Earnings per share

20,000
3.9

15,000
4.1

10,000
3.9

15,000
3.5

11

»
»
»
»
»

`80,000 (4% return on total assets)
`100,000 (5% return on total assets)
`130,000 (6.5% return on total assets)
`160,000 (8% return on total assets)
` 200,000 (10% return on total assets)

12

Particulars

Financing Plans
A

EBIT

Less: Taxes
EAT

Number of shares
EPS

D

80,000

80,000

80,000

-

25,000

60,000

-

80,000

55,000

20,000

80,000

28,000

19,250

7,000

28,000

52,000

35,750

13,000

52,000

-

-

-

25,000

52,000

35,750

13,000

27,000

Less: Preference Dividend
EAT for equity-holders

C

80,000
Less: Interest

EBT

B

20,000
2.6

15,000
2.38

10,000
1.3

15,000
1.8

13

Earnings Per Share

Financing Plans

EBIT

A

B

C

D

`80,000

2.6

2.38

1.3

1.8

`100,000

3.25

3.25

2.6

2.67

`130,000

4.22

4.55

4.55

3.97

`160,000

5.2

5.8

6.5

5.3

`200,000

6.5

7.6

9.1

7

14

15

Sign up to vote on this title
UsefulNot useful