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MODULE 6

MBA II SEMESTER
Objectives
The fundamental concept and rationale of leverage in
finance
The different types of leverages and their importancein
business
The operating leverage, degree of operating leverage
calculations and its contribution to business risk.
The concept and determination of financial leverageand
its contribution to financial risk
Background..
In corporate finance,
leverage applies to the
use of certain fixed
costs (that act as
levers) that results in
a manifold increase
(or leverage) in a
firms profitability.
Background..
Operating leverage is the sensitivity of the
relationship between the sales and the earning
before interest and tax (EBIT), or the operating
profit of a firm, due to its fixed operating cost.

Financial leverage is the sensitivity of the relationship


between the EBIT and the earning per share (EPS) of
the firm due to its fixed financing cost.
Interrelationship- OL,FL & TL
Operating leverage
Use of certain fixed operating costs, the profitability of
the business can be increasedmanifold.
A small change in sales produces a large change in the
operating profits
Effect on volatility of profits-
A higher proportion of fixed cost per unit, OR
A lower proportion of variable cost per unit
Degree of Operating Leverage
DOL is the percentage change in operating income (or
EBIT) that results from a given percentage change in
sales.

DOL is an index number which measures the effect of


a change in sales [number of units] on operating
income, or EBIT.
Degree of Operating Leverage (Contd)

Where, SP is the sales price, VC is variable costs, Q is quantity produced, Q* is


break-even quantity, and EBIT is earnings before interest and taxes.
Business Risk and DOL
Firms with high DOL generate a good bottom line
(during growth phase)
During adversities even a small amount of sales
decline leads to more than proportionate decline in
profits.
DOL is a double-edged sword, so firms must aim to
keep it low.
Generally, a high degree of operating leverage is not
preferred.
Business Risk and DOL

Firms having high DOL are prone to large fluctuations in


their operating profits anytime sales levels fluctuate.
The greater the DOL of a given firm, the higher is its
business risk.
DOL, however, is only one component of the total business
risk that a firmfaces.
Financial Leverage
Magnifies the result of the firm by using fixed cost
financing.
Debt carries a fixed interest rate and preferred capital
also carries a fixed preferred dividendpayout.
Financial leverage occurs when firms use debt in their
capital structure.
Firms that have some degree of debt financing are
called levered firms.
Degree of Financial Leverage (DFL)
DFL is the change in EPS caused by a change in operating
profit.

For example, if we estimate DFL to be 2.0, then a 10 per


cent decrease in EBIT will lead to a 20 per cent decrease in
PAT or EPS.
Degree of Financial Leverage (Contd.)
Similarly,

% Change in PAT or EPS = (% Change in EBIT ) (DFL)

Thus, financial leverage magnifies the change in EPS


due to changes in EBIT as small change in EBIT causes
a large proportion change in EPS of the firm.
Degree of Financial Leverage (Contd.)

Here,
EBIT = earning before interest andtax
EBT = earnings before tax
PD = preference dividend
I = interest ondebt
t = corporate taxrate
DFL and Financial Risk
May lead bankruptcy or insolvency.
The more is the level of fixed cost financing of a
firm, i.e., use of debt, the more is its financialrisk.
While business risk Vs financial risk
The higher the amount of debt that the firm uses,
the higher the financial risk
EBIT-EPS Analysis
Financial leverage helps companies to increase their
earnings by using debt and preferred capital, i.e., fixed
cost financing.

An effective means to measure the optimum amount


of fixed cost of financing, i.e., debt and preferred
capital or both is EBIT-EPSanalysis.
EBIT-EPS Analysis (Contd)

When fixed cost of financing will change, the equity


financing will also getaffected.
EBITEPS analysis helps us to understand the affect on
Earning Per Share (EPS) due to the changes in Earning
Before Interest and Taxes (EBIT) under different
financing alternatives.

PRACTICE..
Analyzing Alternative Financial Plans: constant EBIT

11

Effect of Financial Plan on EPS and ROE:


The firm is considering two Constant EBIT
alternative financialplans:
(i) either to raise the entire
funds by issuing 50,000
ordinary shares at Rs 10per
share, or
(ii) to raise Rs 250,000 by
issuing 25,000 ordinary
shares at Rs 10 per shareand
borrow Rs 250,000 at 15 per
cent rate of interest.
The tax rate is 50 per cent.

PRACTICE..