Leverages

 It refers to “an increased means of

accomplishing some purpose.”
 In Physics, a multiplication of a
force into even larger forces.
 In finance, a multiplication of %
change in sales into even larger
change in profitability measures.
A hypothetical income statement
for a firm is as follows:

Sales 4000
Less: Variable costs 1600
--------
Contribution 2400
Less: Fixed costs 1000
--------
Profit 1400
--------
 If sales and VC are increased
by 25% ...
Sales 5000 (increase of 25%)
Less:Variable costs 2000 (increase of 25%)
--------
Contribution 3000 (increase of 25%)
Less: Fixed costs 1000 (No change)
--------
Profit 2000 (6/14*100 = 43%)
--------
Leverage
 A 25% increase in sales from 4,000 to 5,000, profits
have increased from 1400 to 2000, an increase of
43%.

 This is the effect of leverage.

 If there are not fixed costs and all its costs were
variable, there would have been no leverage and the
percentage change in sales would have been the same
as the percentage change in profits.

 It is fixed costs that introduce leverage into the

firm and higher the fixed cost, higher is the
leverage.
Types of Leverages

 Operating Leverage

 Financial Leverage

 Combined Leverage
Types of Leverages
Sales xxx
Less:Variable Cost xx Operating
Leverage
Contribution xxx
Less: fixed Operating expenses xx
EBIT xxx
Less: Interest xx
EBT xxx
Less:Tax xx Financial
Leverage
PAT xxx
Less: Preference Dividend xx
Earnings available to Equity Share holders xxx
Operating Leverage
 The firm’s ability to use fixed
operating costs and magnify the
effects of changes in sales on its
earnings before interest and taxes.
 The relationship between sales and
earnings before interest and tax.
Operating Leverage
Degree of % change in EBIT
Operating = --------------------------
Leverage % change in Sales

Degree of Contribution
Operating
Leverage = --------------------------
(at base level) EBIT
Example – 1
A firm sells products for 100 per unit,
has variable operating costs of 50 per
unit and fixed operating cost of
50,000 per year. Show the various
levels of EBIT that would result from
sale of
(i) 1,000 units
(ii) 2,000 units
(iii) 3,000 units
Degree of Operating Leverage of 2

indicates that a 1% change in sales

leads to 2% change in EBIT.

Example – 2
A firm sells products for 50 per unit,
has variable operating costs of 30 per
unit and fixed operating cost of 5,000
per year. Its current level of sales are
300 units. Determine the degree of
operating leverage. What will happen
to EBIT if sales change
(a) rise to 350 unit
(b) decrease to 250 units
Financial Leverage
 It studies the impact of change in
EBIT on EPS.
 The degree of financial leverage
measures the financial risk
associated with the firm.
 It is also known as trading on
equity.
Financial Leverage

Degree of % change in EPS

Financial = --------------------------
Leverage % change in EBIT
Financial Leverage

Degree of EBIT
Financial
Leverage = --------------------------
Dp
(at base level) EBIT – I – -------
(1-T)

I Interest
Dp Preference Dividend
T Tax Rate
Example – 3
The EBIT of a firm is 60,000. The firm’s
capital structure is as follows:

10% Debt of 1,00,000; 8% Preference

shares of face value 100 amounting to
2,00,000 and Equity shares of face value
100 amounting to 4,00,000. The company
fall in 35% tax bracket. Compute Degree of
Financial Leverage.
Degree of Financial Leverage of

___ indicates that a 1% change in

EBIT leads to ____% change in

EPS.
Combined Leverage
 It studies the impact of change in
sales on Earnings Per Share (EPS).
 It quantifies the relationship
between sales and EPS.
 It measures the total risk
associated with the firm.
Combined Leverage

Degree of % change in EPS

Combined = --------------------------
Leverage % change in sales
Or
Degree of operating Leverage
= x
Degree of Financial Leverage
Combined Leverage
Degree of Contribution
Combined
Leverage = --------------------------
Dp
(at base level) EBIT – I – -------
(1-T)

I Interest
Dp Preference Dividend
T Tax Rate
Example – 4
A firm sells 10,000 units at 50 per
unit. The variable costs is 30 per unit
and fixed operating cost of 50,000 per
year. The firm’s capital structure is as :
7% Debt of 2,00,000; 8% preference
shares of face value 100 amounting to
1,00,000 and Equity shares of face value
100 amounting to 5,00,000. Tax rate
is 35%. Compute the degree of
combined leverage.
Degree of Combined Leverage of

___ indicates that a 1% change in

sales leads to ____% change in

EPS.
EBIT – EPS Analysis
 It examines the effect of the financial
leverage.
 It involves calculation of EPS of the
firm at each financing alternative at a
given level of EBIT.
 The financing alternative which
maximises the EPS of the firm should
be selected.
Example – 5
A company currently finances its projects with equity of face
value Rs.100 amounting to Rs.20,00,000. The company is
considering to raise additional capital of Rs.10,00,000 to
finance its future expansion projects. The following financing
alternatives are under consideration :
 Plan 1 : Raise the entire amount by issue of equity shares
 Plan 2 : Raise Rs.6,00,000 by issue of 11% debt and the
balance by equity
 Plan 3 : Raise Rs.5,00,000 by issue of 11%preference
shares and the balance by equity
 Plan 4 : Raise Rs.3,00,000 by issue of 10% debt,
Rs.3,00,000 by issue of 11% preference shares
and balance by equity

If the company’s EBIT is Rs.5,00,000 and company falls in 35%

tax bracket, Advise the firm which of the financing alternative
should be selected.
Decision

Which financial alternative have

the highest EPS, the company

should adopt that alternative for

financing its future expansion

projects.
Financial Break Even Point
The level of EBIT which is equal to
fixed financial costs.
Dp
FBEP = I + --------
1-T

I : Interest
Dp : Preference Dividend
T : Tax Rate
Example – 6
The capital structure of Zenith Ltd. is
as follows.
Amount (Rs.)
8% Debt 10,00,000
10% Preference Shares 15,00,000
Equity Share Capital 20,00,000
Total 45,00,000

If the corporate tax rate is 30%,

compute the firm’s financial break
even point.