KWARA STATE UNIVERSITY MALETE

DEPARTMENT OF ACCOUNTING AND FINANCE

SCHOOL OF POST-GRADUATE STUDIES.

FINANCIAL STRUCTURE: FINANCIAL LEVERAGE AND SHAREHOLDERS’

RISK AND RETURN

GROUP ONE (1) ASSGNMENT 3

BEING THE ASSIGNMENT ON CORPORATE FINANCE ACC802/FIN801
SUBMITTED TO:

DR. I. B. ABDULLAHI

(Course Lecturer)

NAME MATRICULATION NO PROGRAMMME

SUBAIR MUHAMMED LAWAL 16/27/MAC027 M.Sc. Accounting

SAHEED DAUD OMOTOHO 16/27/MFI011 M.Sc.
Finance
IBRAHIM MAJEED AJIBOLA 16/27/MFI005 M.Sc. Finance
AYODABO O. DEBORAH 16/27/MAC013 M.Sc. Accounting
SIDIQUE MARUFU 16/27/MAC026 M.Sc. Accounting
MALIKI I. TOPE 16/27/MAC023 M.Sc. Accounting
AREMU OLAGOKE ISMAIL 16/27/MAC012 M.Sc. Accounting
BELLO MUSIBAU 16/27/MAC016 M.Sc. Accounting
SALIHU ABDULLATEEF A. 16/27/MFI012 M.Sc.
Finance

APRIL, 2017

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INTRODUCTION

Financial structure comprise of two concepts; financial and structure. Financial deals with the
flow of funds while structure depicts composition. This implies that financial structure is the
composition of the flow of funds. In corporate finance literature, financial structure which is used
interchangeably with capital structure refers to the way a firm’s assets are financed. Financial
structure is a mixture that directly affects the risk and value of the business which is divided into
the amount of a firm’s cash flow that goes to creditors and the amount that goes to shareholders
(Omolumo, 1993). It entails decision on the type of securities to be issued and the relative
proportion of each type of security namely shares, debentures, retained earnings etc. in the total
capitalization. A company raise its funds through equity and debt. The various means used to
raise the funds represent the financial structure of the company. The financial structure decision
is of tremendous significance for the management, since it influences the debt-equity mix of the
company, which ultimately affects the shareholders’ return and risk. When borrowed funds are
more as compared to the owners’ funds, it results in increase of the shareholders’ earnings
together with increase in their risk.

FINANCIAL STRUCTURE

Financial structure refers to the balance between all the company’s debts and its equities; it deals
with the entire liabilities + equities side of the statement of financial statement. It also involves
the mixture that directly affects the risk and value of the business. The main concern for the
financial manager of any company is deciding how much money should be borrowed and the
best mixture of debt and equity to obtain by looking for least expensive sources of funds for the
company to use. Financial structure is divided into the amount of the company's cash flow that
goes to creditors and the amount that goes to shareholders. Each business will have a different
mixture depending on its needs and expenses. Therefore, each company will have its own
particular debt-equity ratio. For example, a company could issue bonds and use the proceeds to

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buy stock or it could issue stock and use the proceeds to pay its debt. Thus, the risk of the
shareholders increase in case there is a high proportion of borrowed funds in the total capital
structure of the company. In a situation where the proportion of the shareholders’ funds is more
than the proportion of the borrowed funds, the return as well as the risk of the shareholders will
be much less. The concept of leverage helps in examining the effects of financing or debt-equity
mix on the shareholders’ earnings and risk.

CONCEPT OF LEVERAGE

The term leverage may be defined as a proportional changes in profit due to proportional
changes in sales. The primary objective of a financial manager in a firm is to increase profit of
that firm. Profit of firm can be increase but at a risk.

We can generally refer to the concept of the term leverage (gearing) as an increased means of
achieving a purpose. In a business, the financial manager is interested in increasing profits of the
business. Profits can be increased but at a risk. Risk can be accessed through leverage. Leverage
can be used to assess business and financial risks. Business risk is the volatility of the profits due
to the nature of business operation. Financial risk is the risk associated with the introduction of
debt capital structure of a company.
Akinsulire (2011) states that leverage can however be looked at in three ways:
(i.) Operating Leverage
(ii.) Financial Leverage
(iii.) Combined Leverage

FINANCIAL LEVERAGE

Financial leverage is the use of fixed-charges sources of funds, such as debt, debenture and
preference shares/capital along with floating-charges or owners’ equity (ordinary shares) in the
capital structure of an organization. It measures ability of a firm in using debt capital for the
benefits of its owners. Financial leverage is also termed “trading on equity”.It is a factor that
influences financial risk.

The financial leverage employed by a company is intended to earn more return on the fixed-
charge funds than their costs. The surplus (or deficit) will increase (decrease) the Return on the

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Owners’ Equity (ROE). Thus financial leverage is a double-edged sword with the potentials of
increasing shareholders earnings (positive financial leverage) as well as creating the risk of loss
(negative financial leverage) to them. In other words, a positive financial leverage means that the
assets acquired with the funds provided by the creditors or fixed-charges sources of fund
generate a rate of return that is higher than the rate of interest or dividend payable to the
providers of the funds. On the other hand, a negative financial leverage occurs when the assets
acquired with the fixed-charges sources of funds generate a return that is less than the rate of
interest or dividend payable to the providers of such funds. One of the financial ratios that is
being use in determining the amount of financial leverage in a business is the debt/equity ratio.
The debt/equity ratio shows the proportion of debt in a business firm to equity.

DEGREE OF FINANCIAL LEVERAGE:

The degree of financial leverage at particular EBIT level is measured by the percentage change
in earnings before interest and tax (EBIT). The degree of financial leverage can be measured
using the following formula:

Degree of financial leverage = EBIT

EBT
However since EBIT = Q(SP - VC) – FC
Q (SP – VC) – FC
Q (SP - VC) – FC – R
For a firm that has percentage shares in its capital structure, then the formula will be adjusted
as shown below.
= Q (SP – VC) – FC
Q (SP - VC) – FC – R - Dp
1–t

Where:
Q = Sales volumes in unit
S = Selling price per unit
V = Variables cost per unit

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 FC = Total fixed cost
R = Annual fixed interest charged on debenture
DP = Annual fixed dividend paid on preference shares
t = Corporate tax rate
ILLUSTRATION 1

AXY Nig. Plc has a fixed cost of N600,000 producing 480,000 unit of empty creates for the
manufacturer of Toys Top Plastic in Lagos. It sells a plastic for N60 but in a variable cost of N40
on a plastic. The company’s capital structure is made up of N4 million equity share and N2.4
million 10% debenture. Calculate the company’s

Degree of financial leverage

SOLUTION

Q = Total units of output sold

S = Selling price per unit

V = Variable cost per unit

FC = Total fixed cost

R = Annual fixed interest on debt

Degree of financial leverage (DDFL)

Q (S – V) – FC
Q (S – V) – FC – R
480,000 (60 - 40)
480,000 (60 – 40) – 600,000 – 240,000
= 1.096times

FINANCIAL LEVERAGE AND THE SHAREHOLDERS’ RETURN

The primary motive of a company in using financial leverage is to magnify the shareholders’
return under favourable economic conditions. The role of financial leverage in magnifying the
return of the shareholders is based on the assumption that the fixed change funds (such as the
loan from financial institutions and bank or debentures) can be obtained at a cost lower than the
firm’s rate of return on net assets (ROA or ROI). Thus, when the difference between the earnings
generated by the assets financed by the fixed-charges funds and costs of these funds is

5
distributed to the shareholders, the earnings per share (EPS) or return on equity (ROE) increases.
However, EPS or ROE will fall if the company obtains the fixed-charges funds at a cost higher
than the rate of return on the firm’s assets. It should, therefore be clear that EPS, ROEand ROI
are the important figures for analyzing the impact of financial leverage.
EPS and ROE calculations
EPS is calculated by dividing profit after taxes, PAT also called net income, NI, by the number
of shares outstanding. PAT is found out in two steps. First, the interest on debt, INT, is deducted
from the earning before interests and taxes, EBIT, to obtain the profit before taxes, PBT. Then
taxes are computed on and subtracted from PBT to arrive at the figure of PAT. The formula for
calculating EPS is as follows:

Profit after tax

Earnings per share =
Number of shares

PAT
EPS = = ¿¿
N
Where T is the corporate tax rate and N is the number of ordinary share outstanding. If the firm
does not employ any debt, then the formula is:
EBIT (1−T )
EPS =
N
ROE is obtained PAT by equity (E). Thus, the formula for calculating ROE is as follows:
Profit after tax
ROE =
Valueof equity
ROE = ¿ ¿
For calculating ROE either the book value or the market value equity may be used.
How does the financial leverage affect EPS and ROE? We shall describe two situations to
illustrate the impact of financial leverage on EPS and ROE. First, we shall analyse the impact of
alternative financial plans on EPS and ROE assuming that EBIT is constant. Second, we shall
assume the EBIT varies and shows the effect of the alternative financial plans on EPS and ROE
under the conditions of varying EBIT.
ILLUSTRATION 2:
Suppose a new firm Mosorire Ltd. is being formed. The management of the firm is expecting a
before tax rate of 24%, 20% and 16% with state of economy of 30% (Boom), 40%(Normal) and
30%(Recession) respectively on the estimated total of investment of N500,000. The firm is
considering three (3) alternative financial plans. (i) either to raise the entire funds by issuing

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50,000 ordinary shares @ N10 per share, or (ii) to raise N250,000 by issuing 25,000 ordinary
shares @ N10 per shares and borrow N250,000 at 12% rate of interest, and (iii) to raise
N125,000 by issuing 12,500 ordinary shares @ N10 per shares and borrow N375,000 at 12% rate
of interest. The tax rate is 50%. What are the effects of the alternative plans for the shareholders’
earnings?
(Plan 1)

Debt/Equity Debt/Equity
Particulars Only Equity (50:50) (75:25)
Equity Shares of N10 Each 500,000 250,000 125,000
Debt @ 12 % 250,000 375,000

EBIT 120,000 120,000 120,000

Interest 30,000 45,000
PBT 120,000 90,000 75,000
Tax @50% 60,000 45,000 37,500
PAT 60,000 45,000 37,500
No. of Shares 50,000 25,000 12,500
EPS 1.2 1.8 3.0
ROE 12% 18% 30%

Given that interest rate = 12%.

Solution

Profit after tax

1. Earnings per share =
Number of shares

o Equity-financed
60,000
EPS = = 1.2
50000
o Debt-Equity Financed (50:50)
45,000
EPS = = 1.8
25,000
o Debt-Equity Financed (75:25)

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 37,500
EPS = = 3.0
12,500

Profit after tax

2. Return on Equity =
Valueof equity
o Equity-financed
60,000
ROE = = 0.12 = 12%
500,000
o Debt-Equity Financed (50:50)
45,000
ROE = = 0.18 = 18%
250,000
o Debt-Equity Financed (75:25)
37,500
ROE = =0.3=30 %
125,000

(Plan 2)

Debt/Equity Debt/Equity
Particulars Only Equity (50:50) (75:25)
Equity Shares of N10 Each 500,000 250,000 125,000
Debt @ 12 % 250,000 375,000

EBIT 100,000 100,000 100,000

Interest 30,000 45,000
PBT 100,000 70,000 55,000
Tax @50% 50,000 35,000 27,500
PAT 50,000 35,000 27,500
No. of Shares 50,000 25,000 12,500
EPS 1.0 1.4 2.2
ROE 10% 14% 22%

Given that interest rate = 12%.

Solution

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 Profit after tax
3. Earnings per share =
Number of shares

o Equity-financed
50,000
EPS = = 1.0
50,000
o Debt-Equity Financed (50:50)
35,000
EPS = = 1.4
25,000
o Debt-Equity Financed (75:25)
27,500
EPS = = 2.2
12,500

Profit after tax

4. Return on Equity =
Valueof equity
o Equity-financed
50,000
ROE = = 0.10 = 10%
500,000
o Debt-Equity Financed (50:50)
35,000
ROE = = 0.14 = 14%
250,000
o Debt-Equity Financed (75:25)
27,500
ROE = =0.22=22 %
125,000
(Plan 3)

Debt/Equity Debt/Equity
Particulars Only Equity (50:50) (75:25)
Equity Shares of N10 Each 500,000 250,000 125,000
Debt @ 12 % 250,000 375,000

EBIT 80,000 80,000 80,000

Interest 30,000 45,000

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 PBT 80,000 50,000 35,000
Tax @50% 40,000 25,000 17,500
PAT 40,000 25,000 17,500
No. of Shares 50,000 25,000 12,500
EPS 0.8 1.0 1.4
ROE 8% 10% 14%

Given that interest rate = 12%.

Solution

Profit after tax

5. Earnings per share =
Number of shares

o Equity-financed
40,000
EPS = = 0.8
50,000
o Debt-Equity Financed (50:50)
25,000
EPS = = 1.0
25,000
o Debt-Equity Financed (75:25)
17,500
EPS = = 1.4
12,500

Profit after tax

6. Return on Equity =
Valueof equity
o Equity-financed
40,000
ROE = = 0.08 = 8%
500,000
o Debt-Equity Financed (50:50)
25,000
ROE = = 0.10 = 10%
250,000
o Debt-Equity Financed (75:25)
17,500
ROE = =0.14=14 %
125,000

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From the tables above, we can see that the impact of the financial leverage is quite significant
when 50% debt and 75% debt are used respectively to finance the investment. The firm’s EPS
stands at 1.8, 1.4 and 1.0(debt/equity 50:50) and 3.0, 2.2 and 1.4(debt/equity 75:25) which are
more than 1.2, 1.0 and 0.08 EPS with no leverage. In like fashion, when the firm increases its
debt under constant EBIT, the EPS and ROE also increased, thus creating much more value for
the shareholders
FINANCIAL LEVERAGE AND THE SHAREHOLDERS’ RISK
We have seen that financial leverage magnifies the shareholders earnings. We also find that the
variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure.
That is with more debt, EPS rises and fall faster than the rise and fall in EBIT.
The variability of EBIT and EPS distinguish between two types of risk– operating risk
and financial risk. The distinction between operating and financial risk was long ago recognized
by Marshall in the following words.
… Let us suppose that two men are carrying on similar business, the one working with
his own, the other chiefly with borrowed, capital. There is one set of risks common to both,
which may be described as the trade risk of the particular business in which they are engaged…
But there is another set of risks, the burden of which has to be borne by the man working with
borrowed capital and not by another.
We can use two measures of risk to measure the riskiness of EBIT and EPS standard deviation
and coefficient of variation.

Operating Risk
Operating risk can be defined as the variability of EBIT (or return on assets). The environment –
internal and external – in which a firm operates determines the variability of EBIT. So long as
the environment is given to the firm. Operating risk is an unavoidable risk. A firm is better
placed to face such risk if it can predict with a fair degree of accuracy.
The variability of EBIT has two components.
- Variability of sale
- Variability of expenses.
Variability of sales: the variability of sales revenue is in fact a major determinant of operating
risk. Sales of a company may fluctuate because of three reasons. First, the change in general
economic conditions may affect the level of business activity. Business cycle is an economic
phenomenon, which affects sales of all companies. Second, certain events affects sales of
companies belonging to a particular industry. For example, the general economic conditions may
be good but a particular industry may be hit by recession. Other factors may include the

11
availability of raw materials, technological changes, actions of competitors, industrial relations,
shifts in consumer preferences and so on. Third, sales may also be affected by the factors, which
are internal to the company. The change in management, the product – market decisions of the
company and its investment policy, or strike in the company have a great influence on the
company’s sales.
Variability of expenses: given the variability of sales, the variability of EBIT is further affected
by the composition of fixed and variable expenses. Higher the proportion of fixed expenses
relatives to variable expenses, the higher the degree of operating leverage. We have seen in the
previous section that operating leverage affects EBIT. High operating leverage leads to faster
increase in EBIT when sales are rising. In bad times when sales are falling, high operating
leverage becomes a nuisance; EBIT decline at a greater rate than fall in sales. Operating leverage
causes wide fluctuation in EBIT with varying sales. Operating expenses may also vary on
account of changes in input prices, and may also contribute to the variability of EBIT.

Financial risk
For a given degree of variability of EBIT, the variability of EPS (and ROE) increases with more
financial leverage. The variability of EPS caused by the use of financial leverage is called
financial risk. Firms exposed to same degree of operating risk can differ with respect to financial
risk when they finance their assets differently. A totally equity financed firm will have no
financial risk. But when debt is used, the firm adds financial risk. Financial risk is thus an
avoidable risk if the firm decides not to use any debt in its capital structure.

ILLUSTRATION 3
Calculation of Shareholders’ risk using illustration 2
1.All Equity
State of Economy Prob ROE P(ROE) ROE – E(ROE) P.[ROE – E(ROE)]2
Boom 0.3 12 3.6 2 1.2
Normal 0.4 10 4.0 0 0
Recession 0.3 8 2.4 -2 1.2
10 2.4
Variance = 2.4
Standard Deviation= √Variance
Standard Deviation= √2.4
SD = 1.55

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2.Debt/Equity (50:50)
State of Economy Prob ROE P(ROE) ROE – E(ROE) P.[ROE – E(ROE)]2
Boom 0.3 18 5.4 4 4.8
Normal 0.4 14 5.6 0 0
Recession 0.3 10 3.0 -4 4.8
14 9.6
Variance = 9.6
Standard Deviation= √Variance
Standard Deviation= √9.6
SD = 3.10

3. Debt/Equity (75:25)
State of Economy Prob ROE P(ROE) ROE – E(ROE) P.[ROE – E(ROE)]2
Boom 0.3 30 9.0 6 10.8
Normal 0.4 22 8.8 0 0
Recession 0.3 14 4.2 -6 10.8
22 21.6
Variance = 21.6
Standard Deviation= √Variance
Standard Deviation= √21.6
SD = 4.65
From the results above, it is clearly indicated that debt increases both risk and return. An increase
in debt (from 50% to 75%) increases both the expected value of EPS and its standard deviation.
The debt/equity financing (75:25) results in the highest standard deviation of EPS. This result
supports the notion that financial leverage increases the returns to owners, but also increases the
risk associated with the returns to owners.
OPERATING LEVERAGE

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Operating leverage is concerned with the investment activities of the firm. It shows the
relationship between the firm’s sales revenue and its earnings before interest and tax
(EBIT).Operating leverage is the impact of a change in revenue on profit or cash flow. It arises
whenever a firm can increase its revenue without a proportionate increase in operating expenses.
Operating leverage measures the effect of fixed cost on the firm.The higher the fixed costs as a
percentage of total costs, the higher the company's operating leverage. Operating leverage is a
factor that influences business risk and is classified into three types: Fixed cost, variable cost and
semi-variable or semi-fixed cost. Fixed cost is a contractual cost and it’s a function of time and it
does not change with the sales volume. Variable costs vary directly with the sales revenue. If no
sales are made variable cost will be nil. Semi-fixed costs or semi-variable costs vary partly with
sales and remain partly fixed and is broken down onto fixed and variable portions and is merged
accordingly with variable or fixed cost. Hence, the firm’s ability to use fixed operating costs to
magnify the effects of changes in sales on its EBIT is termed as operating leverage.

DEGREE OF OPERATING LEVERAGE (DOL) is the percentage change in operating

income, also known as EBIT, divided by the percentage change in sales. It is the measure of the
sensitivity of EBIT to changes in sales as a result of changes in operating expenses. Degree of
operating leverage is also commonly estimated using production output. A key shortcut to
remember is that, if fixed cost is equal to 0, the DOL is actually 1. It can be mathematically
expressed as:

Contribution Salesrevenue−Variable cost

(i) DOL = ∨
EBIT ( Sales revenue−Variable cost )−¿ costs

Breakeven analysis shows us that there are essentially two types of costs in a company's cost
structure , fixed costs and variable costs. Operating leverage refers to the percentage of fixed
costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to
variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then the
firm is said to have high operating leverage.

ILLUSTRATION 4

Using illustration 1 calculate the degree of operating leverage (DOL)

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Solution

Q (S - V)

Q (S – V) – FC

480, 000 (60 – 40)

480,000 (60 – 40) – 600,000

= 1.067 times

COMBINED/TOTAL LEVERAGE

The combination of operating leverage and financial leverage is called combined or total
leverage. A firm incurs total fixed charges in the form of fixed operating cost and fixed financial
charges. If a firm has a high amount of operating leverage and financial leverage, a small change
in sales will lead to a large variability in EPS. Combined leverage is mainly related with the risk
of not being able to cover total fixed charges. It is the firm’s ability to cover the aggregate of
fixed operating and financial charges. DCL expresses combined leverage in quantitative terms
and the higher the proportion of fixed operating cost and financial charges, the higher is the
degree of combined leverage. The value of combined leverage must be greater than 1. The
degree of total leverage (DCL) measures the total risk of the business. It can be calculated as:
EBIT Contribution
DCL=DFL × DOL∨ ×
EBT EBIT
Contribution
¿
EBT
If preference share exists in the capital structure the above formula will be revised as:
contribution
DCL= PDiv
EBT −
1−t
Similarly, leverage can be use to magnify the returns from a business. Operating leverage
magnifies the returns from our plant and equipment or fixed assets. Financial leverage magnifies
the returns from debt financing. Combined leverage is the total of these two types of leverage or
the total magnification of returns. This is looking at leverage from a balance sheet perspective.It
is also helpful and important to look at leverage from an income statement perspective.

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Operating leverage influences the top half of the income statement and operating income,
determining return from operations. Financial leverage influences the bottom half of the income
statement and the earnings per share to the stockholders. The concept of leverage, in general, is
used in breakeven analysis and in the development of the capital structure of a business firm.

ILLUSTRATION 5

The comparative income statement for two companies, Mosese Nig. Ltd and Otisumi Plc as at
31st December, 2003 are given below.

MOSESE OTISUMI

N’000 (N’000) N’000 (N’000)

Sales 4,000 7,000

Less: Variable cost 650 1,00

Fixed cost 500 1150 700 1700

Net income before tax and interest 2850 5300

Less interest on debt 500 -

Net income before tax 2350 5300

Less income tax (40%) 940 2120

Net income after tax 1410 3180

Calculate for each company

i. Degree of operating leverage

ii. Degree of financial leverage
iii. Degree of combined leverage
iv. Comment on the relative risks of the 2 firms ( Culled from Unilag M.Sc.)

SOLUTION

i. Degree of operating leverage (DOL)

(ii) = Q (S – V)
(iii) Q (S –V) – FC
(iv) MOSESE = 4,000, 000 650,000
(v) 4,000,000 (650,000) – 500,000

= 3,350,000
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 2,850,000 = 1.18
OTISUMI = 7,000,000 – 1,000,000
7,000,000 – 1,000,000 – 7000,000
= 6,000,000
5,3000,000 = 1.13

ii. Degree of financial leverage (DOFL)

(vi) Q (S – V)
(vii) Q (S –V) – FC – R
(viii)
(ix) MOSESE = 4,000, 000 - 650,000 – 500,000
(x) 4,000,000 650,000 – 500,000 – 500,000

= 2,850,000
2,350,000 = 1.21

OTISUMI = 7,000,000 – 1,000,000 – 700,000

7,000,000 – 1,000,000 – 7000,000 – 0
= 6,000,000
5,3000,000 = 1.00
iii. Degree of combined leverage
(xi) = DOL X DOFL

MOSOSE = 1.18 x 1.13

= 1.33

OTISUMI = 1.21 x 1.00

= 1.21

(xii)
iv. Mosese Nig. Ltd has a relative higher financial leverage, which makes it relatively
riskier than Otisumi Nig. Ltd. Mosese Nig. Ltd. Has higher combined leverage than
Otisumi nig. Ltd, this confirm that Mosese Nig. Ltd is more riskier than Otisumi Nig.
Ltd

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ILLUSTRATION 6

Firm A has a contribution margin of N15.00 per unit, fixed operating costs of N625,000 and
sales of 500,000 units, interest is N175,000 per annum. Preference dividend is N60,000.

Firm B has a contribution margin of N3.00 per unit, fixed operating cost of N60,000 and sales of
500,000 units interest is N100,000 per annum. Preference dividend is N40,000

Assuming that both firms are in the 40% tax bracket

Required

i. Calculate the degree of operating, financial and combined leverage for firm A.
ii. Calculate the degree of operating, financial and combined leverage for firm B.
iii. Comment on the relative risks of the two firms.

SOLUTION

Q = Total units of output sold

Sp = Selling price per units

Vc = Variable cost per unit

R = Annual fixed interest on debt

Fc = Total Fixed cost

Dp = Preference share dividend

T = Corporate tax

i. FIRM A
Degree of operating leverage = Q (SP - VC)
Q (SP - VC) – FC
(xiii)

= 500,000 x N15
500,000 x N15 – 625,000
(xiv)
(xv)
(xvi)

= 7,500,000
6,875,000
(xvii)

= 1.09

Degree of financial leverage = Q (SP – VC) – FC

Q (SP - VC) – FC – R - Dp

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 1–t
= 500,000 x N15 – 625, 000
500,000 x N15 – 625,000 – 175,000 – 60,000
1 – 0.4
= 6,875,000
6,600,000
DFL = 1.04

Degree of combine leverage = DOL x DFL

= 1.09 x 1.04

= 1.13

FIRM B

Degree of operating leverage = Q (SP - VC)

ii. Q (SP - VC) – FC
= 500,000 x N3.00
500,000 x N3.00 – 60,000
= 1,500,000
1,440,000
DOL = 1.04

Degree of financial leverage = Q (SP – VC) – FC

Q (SP - VC) – FC – R - Dp
1–t

= 500,000 x N3.00 – 60, 000

500,000 x N3.00 – 60,000 – 100,000 – 60,000
1 – 0.4

= 1,500,000 x 60,000
1,500,000 x N60,000 – 100,000 – 66667
= 1,440,000
1,213,333

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 DFL = 1.19
Degree of combine leverage = DOL x DFL
= 1.04 x 1.19
= 1.24
Firm B has a relative higher financial leverage, which makes it relatively riskier than firm
“A”, firm “B” has higher combined leverage than firm A, this confirm than firm B is
more riskier than firm A.

FACTORS THAT DETERMINE THE LEVERAGE OF A BUSINESS

Businesses can utilize different types of financial in or structure to expand or sustain their
current operations. Depending on the type of company, some businesses may take on more debt,
while others may look for asset-based capital with lower amounts of debt. In any case, all
companies need to find a balance between debt and asset capital for an optimal structure. Here
are some factors that may influence financial structure decisions:

1. Size
A company’s size will greatly impact its financial structure. A small start-up company
may not want to take on substantial debt capital in its initial stages. An owner may also
reject asset capital from investors to retain control over his or her company. Furthermore,
a small business owner may be closely linked to the credit rating of the company. Larger
corporations will likely have more access to credit and capital opportunities, and will opt
to implement those into their financial structure.
2. Growth
Firms that are growing quickly are more likely to take on debt capital and will borrow
money faster. More established and mature companies will typically seek out less debt
capital than newer and smaller businesses.
3. Marketconditions
Fluctuating market conditions affect financial structure. Tight credit conditions
following the recession created a challenging environment for businesses to borrow
money and grow. Fortunately, lenders have become more lenient. Opportunities have
opened up for companies to borrow money and increase their debt capital, leading to a
shift in capital structures.
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 4. Management
Business owners and company management are ultimately responsible for decisions
regarding financial structure. More aggressive managers will borrow more money to
grow the business, while conservative owners will rein in spending for higher profits.
While most businesses want to find a balance, management styles can sway financial
structure to either end of the spectrum.

5. Industry
In highly competitive industries, it may be harder for companies to find financing, as new
companies may carry a higher risk. These companies will then be less reliant upon debt
capital

6. Business Risk
If a company does not have a record of stable earnings, its risk of failure increases. If a
company has an unstable capital structure with high amounts of debt, it is also more
likely to end up in bankruptcy. These are both examples of high risk companies. Business
risk and optimal debt capital have an inverse relationship, as companies will still be
responsible for repaying their debt obligations when profits are down.

CONCLUSION

It is seen that the financing decision is a significant managerial decision for a company. It
influences the shareholders’ return and risk. Consequently the market value of the share may be
affected by capital structure decisions. A demand for raising the funds leads a firm to restructure
the existing structure since decisions of capital structure has to be revised considering the amount
and forms of financing. The new financing decisions of the company may affect its debt -equity
mix. The debt-equity mix has implications for the shareholders’ earnings and risk. Thus the
leverage provides the potential of increasing shareholders earnings as well as creating the risks of
loss to them. It is a double edged sword. The following statement provided by I M Pandey very
well summarizes the concept of financial leverage:

“The lower the interest, the greater will be the profit, and the less the chance of loss; the less the
amount borrowed, the lower will be profit or loss; also, the greater the borrowing, the greater the
risk of unprofitable leverage and the greater the chances of gain”.

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The role of leverage in magnifying the return of shareholders is based on the assumptions that
the fixed charges fund can be obtained at a cost lower than the firm’s rate of return on net assets.
Thus when the difference between the earnings, generated by assets financed by fixed charges
funds, and cost of these funds is distributed to the shareholders, then EPS increases. It should be
clear that EPS is the important figure for analyzing the impact of leverage

References

Van Hones J. C. (1989). Financial Management and Policy. U.S.A. Prentice Hall Inc.

University of Lagos (2011). M.Sc. Corporate Finance Past Question

Pandey, I.M. (2005). Financial Management. New Delhi: Vikas Publishing House

Owuala S. I. (2000). Principle of Financial Management. Lagos, G-Mag investments Ltd

Omolumo, I. G. (1993).Financial Management and Company Policy. Lagos: Omolum Consult.

Maheshwari, S.N., Sharad K. M. &Suneel K. M. (2011) A Textbook of Accounting for

Management. New Delhi: Vikas Publishing House Ltd

ICAN Study Pack (2009).Strategic Financial Management. Lagos: VI Publishers Ltd

Brealey, R.A., Mayers S.C., & Marcus A.J. (2001).Fundamentals of corporate finance. (3rd
edition). New Jersey: The McGraw-Hill Companies.

Akinsuliere, O. (2003). Financial Management. Lagos: Control Nigeria Limited

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