ILLUSTRATION.

1:
Calculation of EPS and Financial Leverage
Particulars Financial Financial Financial Financial
Plan - I Plan - II Plan - III Plan - IV
Equity Shares Issued Capital 7,000,000 5,500,000 5,000,000 5,500,000
4,000,000+3,000,000
4,000,000+1,500,000
4,000,000+1,000,000
4,000,000+1,500,000

Equity Shares (Number/$100) 70,000 55,000 50,000 55,000

8% Debentures --- 1,500,000 --- ---

9% Long Term Borrowings --- --- 2,000,000 ---

(3,000,000 -
1,000,000)
5% Preferential Shares --- --- --- 1,500,000
(3,000,000 -
1,500,000)

EBIT 1,500,000 1,500,000 1,500,000 1,500,000

(Earnings Before Interest and Tax)
Less:
a. Interest on debentures ---- (120,000) --- ---
b. Interest on long term borrowing ---- ---- (180,000) ---
EBT (Earnings Before Tax) 1,500,000 1,380,000 1,320,000 1,500,000
Less: Tax @50% 750,000 690,000 660,000 750,000
EAT Earnings After Tax 750,000 690,000 660,000 750,000
Less: Preferential Dividend ---- ------ ---- (75,000)
(5% on 1,500,000)
Earning for EQ Shareholders 750,000 690,000 660,000 675,000
Number of Equity Shares 70,000 55,000 50,000 55,000
EPS (Earning Per Share) $10.71 $12.55 $13.20 $12.27
Ex: 750,000/70,000 = $10.71
DFL 1.00 1.087 1.136 1.00
Degree of Financial Leverage
(EBIT/EBT )

Since the EPS as well as degree of financial leverage (DFL) is highest in Financial Plan III, It
should be accepted. The company should raise $1,000,000 in equity shares and the balance of
$2,000,000 through long term borrowing at 9% interest per annum.
ILLUSTRATION. 2:

Operating Leverage
Description Previous Year Current Year Percentage
$ $ $
(I)
Sales 200,000 250,000 25%
Less: Variable Cost (70% on Sales) 140,000 175,000 25%
Profit from Operations 60,000 75,000 25%
(II)
Sales 200,000 250,000 25%
Less: Variable Cost (70% on Sales) 140,000 175,000 25%
Contribution 60,000 75,000 25%
Less: Fixed Cost 50,000 50,000
Profit from Operations 10,000 25,000 150%

1. In situation (i) where there are no fixed costs (or absence of leverage) the percentage
change in sales and percentage change in operating profit is the same i.e 25%)

2. In situation (ii) where there are fixed costs, the leverage being occurring, the percentage
change in profits (150%) is much more than the percentage in sales (25%).

3. The fixed cost element has helped in magnifying the percentage increase in operating
profits.

Percentage Calculation:

200,000 - 50,000

100 - ?

100 x 50,000
------------------ = 25%
200,000
ILLUSTRATION. 3:

Composite Leverage Model:

Contribution
1. Operating Leverage = -----------------------
EBIT
Contribution = Sales - Variable Cost
= 1,050,000 - 767,000
= $ 283,000

EBIT = $208,000 (given in the problem)

$283,000
Operating Leverage = ------------
$208,000

= $1.36

Interpretation:
Operating leverage of 1.36 indicates that 1% change in sales is likely to result in 1.36%
change in earnings before interest and tax.

Earnings Before interest and Tax (EBIT)

2. Financial Leverage = -----------------------------------------------------
Earnings Before Tax (EBT)

EBIT = $208,000
EBT = EBIT – Interest = 208,000 – 110,000 = $98,000

$208,000 (EBIT)
Financial Leverage = ---------------
$98,000 (EBT)

= $2.12
Interpretation:

The financial leverage of 2.12 indicates that 1% change in EBIT is likely to cause a change
of 2.12% in the next income of the company.
 3. Combined Leverage = Operating Leverage x Financial Leverage

= 1.36 x 2.12

= 2.88
Interpretation:
Combined leverage of 2.88 indicates that 1% change in sales is likely to result in 2.88%
change in net income of the company.

ILLUSTRATION. 4:

WHEN EARNINGS BEFORE INTEREST AND TAX (EBIT) ARE $50,000

Description Plan – I Plan - II
Earnings Before Interest and Tax (EBIT) 50,000 50,000
Less: Interest on Debt 40,000 10,000
(10% on 400,000)
(10% on 100,000)
Earnings Before Tax (EBT) 10,000 40,000
Less: 5,000 20,000
Tax @50% on 10,000 & 40,000
Earnings After Interest and Tax (EAIT) 5,000 20,000
Number of Equity Shares 10,000 40,000

EAIT
Earnings Per Share = ----------
No. of Equity Shares

5,000 20,000
Earnings Per Share = ---------- = ---------
10,000 40,000

= 0.50 = 0.50
 WHEN EARNINGS BEFORE INTEREST AND TAX (EBIT) ARE $75,000
Description Plan – I Plan - II
Earnings Before Interest and Tax (EBIT) 75,000 75,000
Less: Interest on Debt 40,000 10,000
(10% on 400,000)
(10% on 100,000)
Earnings Before Tax (EBT) 35,000 65,000
Less: 17,500 32,500
Tax @50% on 35,000 & 65,000
Earnings After Interest and Tax (EAIT) 17,500 32,500
Number of Equity Shares 10,000 40,000

EAIT
Earnings Per Share = ----------
No. of Equity Shares

17,500 32,500
Earnings Per Share = ---------- = ---------
10,000 40,000

= 1.75 = 0.81

WHEN EARNINGS BEFORE INTEREST AND TAX (EBIT) ARE $125,000

Description Plan – I Plan - II
Earnings Before Interest and Tax (EBIT) 125,000 125,000
Less: Interest on Debt 40,000 10,000
(10% on 400,000)
(10% on 100,000)
Earnings Before Tax (EBT) 85,000 115,000
Less: 42,500 57,500
Tax @50% on 85,000 & 115,000
Earnings After Interest and Tax (EAIT) 42,500 57,500
Number of Equity Shares 10,000 40,000

EAIT
Earnings Per Share = ----------
No. of Equity Shares
42,500 57,500
Earnings Per Share = ---------- = ---------
10,000 40,000

= 4.25 = 1.44
Comments:

1. Plan I is a leveraged financial plan because it has 80% debt financing and has only 20% equity
financing. Plan II is a conservative financial plan where fixed cost funds are only 20% of total
funds and the rest is financed through equity capital.

2. The EPS is increasing in Plan – I with the increase in profits (EBIT) in situation (I) the
earnings per share is same in both the plans i.e 0.50. As the EBIT has increased from $50,000 to
$75,000 (Situation 2). The EPS in Plan is $1.75 while it is 0.81 in Plan II. EPS is $4.25 in Plan I
is $1.75 while it is 0.81 in Plan II. EPS is $4.25 in Plan I and $1.44 in Plan II when EBIT
increases to $125,000.

3. It is a clear from the analysis that EPS is increasing with the increase in profits in Plan I as
compared to that of Plan II. This is possible with the use of more fixed cost funds in Plan – I as
compared to Plan II.

4.The increase in EPS in Plan I is due to the financial leverage because earnings before interest
and tax are same in all the situation.
ILLUSTRATION.5:

Description Plan – I Plan – II Plan - III Plan-

IV
EBIT $150,000 $150,000 $150,000 $150,000
Less: Interest ----- 20,000 30,000 ----
(10%on200,000 (10%on300,000)
)
150,000 130,000 120,000 150,000
Less: Tax @50% 75,000 65,000 60,000 75,000
EAIT 75,000 65,000 60,000 75,000
Less: Preference Dividend ---- ------ ------ 16,000
@8% (8% on
200,000)
Earnings Available for 75,000 65,000 60,000 59,000
Common Stock Holders
Number of Common Shares 8,000 6,000 5,000 6,000
500,000 +300,000 =
800,000/100
500,000 + 100,000 =
600,000/100
500,000 + nil =
500,000/100
500,000 + 100,000 =
600,000/100
EPS $9.375 $10.83 $12 $9.83

Working of EPS:
75,000/8,000 = 9.375 : 65,000/6,000 = 10.83 : 60,000/5,000 = 12 : 59,000/6000 = 9.83

Comments:
In four plans of fresh financing, plan III is the most leveraged of all. In this case additional
financing in done by raising loans @10% interest. Plan II has fresh capital stock of $100,000
while $200,000 are raised from loans Plan IV does not have fresh loans but preference capital
has been raised for $200,000.

The EPS is highest in Plan III i.e $12. This plan depends upon fixed cost funds and thus
benefited the common stockholders by increasing their share in profits. Plan II is next best
scheme where EPS is $10.83. In this case too. $200,000 are raised through fixed cost funds.
Even in Plan IV, where preference capital of $200,000 is issued, it is better than Plan I where
common stock of $300,000 is raised.
The analysis of this information shows that financial leverage has helped in improving earnings
per share for Equity share holders. It helps to conclude that higher the ratio of debt to equity the
greater the return for equity stock holders.