LEVERAGE

Leverage means influence of power i.e. utilizing the existing resources to attain something else.
Leverage may be defined as meeting of fixed costs or paying a fixed return for employing
resources of funds.

There are 3 measures of leverage -

1. Operating leverage.
2. Financial leverage
3. Combined / Total leverage

❖ OPERATING LEVERGAGE
Operating leverage is the tendency of EBIT to vary disproportionately with sales. This happens
because every enterprise has fixed costs that have to be met regardless of the volume of sales.
Fixed cost remains fixed whether sales increase or decrease. Therefore, the percentage change in
operating profits on account of change in sales is greater than the percentage change in sales.

Degree of operating leverage (DOL) = % Change in EBIT OR Contribution

% Change in sales EBIT

❖ FINANCIAL LEVERAGE
Financial leverage can be defined as the tendency of the EBT to vary disproportionately with net
operating income (EBIT). In other words, a change in EBIT results in a larger change in EBT. This
happens because of fixed commitments on debentures, loans etc. hence, if there is a change in
EBIT, it will result in a larger change in the return of owner’s funds. Financial leverage will be
higher in the case of firms with higher debt equity ratio.

Degree of financial leverage (DFL) = % Change in EBT / EAT / E PS OR EBIT

% Change in EBIT EBT

❖ TOTAL or COMBINED LEVERAGE

Operating leverage indicates the possibility of loss in case of a fall in sales, and financial leverage
indicates the possibility of bankruptcy in case of a fall in EBIT. The total risk involved can be
seen by combining the operating leverage and financial leverage. This combination is known as
total leverage.
Composite leverage (DCL) = % Change in EBT / EPS / EAT OR Contribution
% Change in sales EBT

Note: A firm having high operating leverage and high financial leverage will be a very risky
proposition. Keeping both leverages low will mean that the management is too conservative in
using even the legitimate opportunity for maximising the wealth of shareholders.

Compiled by – Dr. Aanchal Singh for Financial Management Term III

1 Goa Institute of Management
 Interpretation of leverage
If DOL is 2, it means for every 1% increase in sales EBIT will be up by 2%
If DFL is 2, it means for every 1% increase in EBIT, EAT/EPS/EBT will go up by 2%. If
DCL is 4, it means for every 1% increase in sales, EBT/EAT /EPS will go up by 4%.

Q1. A firm sells products for Rs. 100 per unit. It has a variable cost of Rs. 50 per unit and fixed operating
costs of Rs. 50,000 per year. Show the various levels of EBIT that would result from the sales of:
i. 1,000 units
ii. 2,000 units
iii. 3,000 units

Calculate Operating leverage.

Q2. A company has Rs. 1,00,000 10% debentures and 5,000 equity shares outstanding. It is in the 35%
tax bracket. Assuming three levels of EBIT calculate the change in EPS:
i. Rs. 50,000 (base)
ii. Rs. 30,000
iii. Rs.70,000

Q3. Calculate DOL, DFL and DCL from the following - Sales
1,00,000 units @ Rs. 2
Interest Rs. 3668; Variable cost – 0.70 per unit
Fixed cost 1,00,000
[Ans. DOL – 4.33; DFL – 1.14; DCL – 4.94]

Q4: Calculate the degree of operating leverage, degree of financial leverage and the degree of
combined leverage for the following firm and interpret the results.
Firm A Firm B Firm C
(1) Output (in units) 60,000 15,000 1,00,000
(2) Fixed cost (Rs.) 7,000 14,000 1,500
(3) Variable cost per unit (Rs) 0.20 1.50 0.02
(4) Interest borrowed funds 4,000 8,000 --
(5) Selling price per unit (Rs) 0.60 5.00 0.10
[Ans. DOL-1.41, 1.36, 1.23; DFL-1.31, 1.26, 1.00; DCL- 1.85, 1.72, 1.23]

Q5. The sales revenue of levered (L) company @ Rs. 20 per unit of output is Rs. 20 lakhs and
contribution is Rs. 10 lakhs. At the present level of operation, the DOL of the company is 2.5. The
company does not have any preference shares. The number of ordinary shares is 1 lakh. Applicable
corporate income tax is 50% and the rate of interest on debt capital is 16% p.a. What are the EPS
(at sales revenue of Rs. 20 lakh) and amount of debt capital of the company if a 25% decline in
sales will wipe out EPS.
[Ans. 1.25 = EPS, Debt cap – 9,37,500]

Q6: The selected financial data for A, B, C companies for the year ended Dec. 1999 are as follows:

Compiled by – Dr. Aanchal Singh for Financial Management Term III

2 Goa Institute of Management
 A B C
Variable exp. as a % of sales 66.67 75 50
Interest 200 300 1000
Degree of operating leverage 5:1 6:1 2:1
Degree of financial leverage 3:1 4:1 2:1
Income tax Rate 50% 50% 50%
Prepare income statement of A, B, C.

Q7: A firm has sales of Rs. 10,00,000; variable cost Rs. 7,00,000 and fixed cost Rs. 2,00,000. A
debt of 5,00,000 at the rate of 10% interest. If the firm wants to double up its EBIT, how much
of a rise in sales would be needed on a percentage basis.
[Ans. 33.33%]

Q8. Calculate operating leverage and financial leverage under situation A, B and C
financial plans I, II, and III from the following –
Production and Sales 800 units
Selling price per unit Rs. 15
Variable cost per unit Rs. 10
Fixed cost: A situation Rs. 1000
B situation Rs. 2000
C situation Rs. 3000
Capital Structure
Financial plans
I II III
Equity 5,000 7,500 2,500
Debt 5,000 2,500 7,500
Cost of debt 12% 12% 12%
Find out the combination of operating and financial leverage, which gives the highest value and
the least value.
I II III I II III
Ans. A DOL 1.33 1.33 1.33 B. DOL 2 2 2
DFL 1.25 1.11 1.43 DFL 1.43 1.18 1.82
DCL 1.66 1.48 1.90 DCL 2.86 2.36 3.64
C DOL 4 4 4
DFL 2.5 1.43 10
DCL 10 5.72 40

Q9: Operating leverage 2.5; Financial leverage 3; EPS – 30; Market price per share 225; Capital
20,000 shares. It is proposed to raise a loan of Rs. 50,00,000 @ 18%, sales will increase by 25%
and Fixed cost by Rs. 3,00,000. Estimate MPS after expansion assuming Tax @ 50%. [Ans.
421.88]

Compiled by – Dr. Aanchal Singh for Financial Management Term III

3 Goa Institute of Management
 EBIT – EPS ANALYSIS

Q1: Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to Rs.
10,00,000. The firm now wishes to raise additional Rs. 10,00,000 for expansion. The firm has four
options:
It can raise the entire amount in the form of equity capital
It can raise 50% as equity capital and 50% as 5% debentures.
It can raise the entire amount as 6% debentures.
It can raise 50% as equity capital and 50% as 5% preference capital.

Further, assume that the existing EBIT is Rs. 1,20,000 and the tax rate is 35%. The outstanding ordinary
shares are 10,000 and the market price is Rs. 100 per share. Which alternative should the firm choose?

INDIFFERENCE POINT

This concept is relevant when we have to choose out of two proposed capital structures. One capital
structure may have no financial leverage i.e. no debt and others may have financial leverage i.e.
others may have debt or a higher degree of financial leverage. Our decision criteria are EPS.
Indifference point is that level of EBIT at which EPS is the same under both capital structures. If a
company is likely to have EBIT higher than the indifference point, it should go for the capital
structure with a higher degree of financial leverage. If its EBIT is likely to be less than the
indifference point, it should opt for a capital structure with a lower degree of financial leverage. If
its EBIT is likely to be equal to the indifference point, it may go for either of the two capital
structures as both will result same EPS.

Indifference point = (EBIT – Intt) (1 – tax) = (EBIT – Intt) (I – tax)

No of equity shares in plan I No. of equity shares in plan II

It can also be identified graphically by plotting the EBIT – EPS lying for various plans. Take EBIT
on x – axis and EPS on Y – axis. The intersection point of plans is the indifference point of both
plans is indifference point.
Plan I

EPS Plan II

BEP

Compiled by – Dr. Aanchal Singh for Financial Management Term III

4 Goa Institute of Management
 Ques. 1: A Co. has the choice for raising an additional sum of Rs. 50 lakhs either by sale or 10%
debentures or by issue of additional equity shares by Rs. 50 per share. The current Capitalization
structure of the company consists of 10 lakh equity shares of Rs. 50 each and no debt. Determine
the indifference point. Also determine the level of EBIT at which uncommitted earnings per share
would be same, either by issuing shares or by issuing debentures, if sinking fund obligation of Rs.
5,00,000 per year. Tax @ 50%.
[Ans. (i) 55,00,000 (ii) 1,65,00,000]

Ques. 2: ABC Corporation plans to expand assets by 50% to finance the expansion, it is choosing
between 12% debt issue and equity shares. Its Balance sheet and Profit and loss A/c are as follows.
Balance Sheet As on 31-12- 01
11% Deb. 40,00,000 Assets 2,00,00,000
10,00,000 equity Shares 1,00,00,000
Retained Earnings. 60,00,000
2,00,00,000 2,00,00,000

Profit & Loss A/C for the year ended 31-12-01

Sales 6,00,00,000
Total cost (excluding Int) 5,40,00,000
EBIT 60,00,000
Interest 4,40,000
EBT 55,60,000
Tax @ 50% 27,80,000
EAT 27,80,000
Price Earning Ratio 7.5

If the expansion is financed by debt, Price Earning Ratio will be 5. If the company decides to
issue equity shares, the issue would be at 20% premium
(i) Assuming EBIT is 10% of sales, calculate earning per share (EPS) at a sales level of 8
crores and 10 crores, when financing with (i) debt and (ii) equity
(ii) Market price per share (MPS) for each sales level for both equity and debt
financing.
(iii) Indifference point.
(iv) Indifference point (on the basis of uncommitted earnings) if sinking fund
obligations of Rs. 5,00,000 per year.

Ques. 3: A Ltd. is considering 3 financial plans. The Key information is as follows – Assume
50% Tax.
I Plan II Plan III Plan
Common stock Rs.2,00,000 8% Bonds Rs. 1,00,000 Pref. stock 8% Rs.1,00,000
Common stock Rs. 1,00,000 common stock Rs.1,00,000
Common stock will be sold @ Rs. 20. Expected EBIT Rs. 80,000 determine
(a) EPS for each plan
Compiled by – Dr. Aanchal Singh for Financial Management Term III
5 Goa Institute of Management
 (b) Financial BEP for each plan.
[Ans. (a) I – 4, II – 7.20, III – 6.40; (b) I – 0, II – 8000, III – 16000]

Ques. 4: X Ltd. is planning an expansion programme which will require Rs. 30 crores and can
be funded through one of three following options -
(i) Issue further equity shares of Rs. 100 each at par.
(ii) Raise a 15% loan
(iii) Issue 12% preference shares.
The present paid up capital is 60 crores and the annual EBIT is Rs. 12 crores. The tax may be taken
at 50%. After the expansion plan is adopted, the EBIT is expected to be 15 crores.
Calculate the EPS under all three financing options indicating the alternative giving the highest
return to the equity shareholders. Also, determine the indifference point between the equity share
capital and the debt financing.
[Ans. EPS - 8.33, 8.75, 6.50]

Ques. 5: ABC Ltd. has 6% debt of Rs. 10,00,000 and 4,00,000 equity shares of Rs. 10 each. market
price of share Rs 10. Ignore tax. Find out:
(i) Financial BEP
(ii) What is the minimum EBIT to be able to pay a dividend of Rs. 1.00 per share.

Ques. 6: A company is considering 2 financial plans to finance an expansion plan of Rs.

1.00 crore. I plan equity shares @ Rs. 12.50 II plan 14% debentures. Tax rate is 40%. Its present
capital structure consists of 20,00,000 equity shares & 8% debentures of Rs. 50,00,000. The
expected price earning ratio in the case of I Plan is 14 and in the case of II Plan it is 12. Calculate
the indifference point at which market price of the share will be same.

Ques. 7: A new company has to raise Rs. 60,00,000 from the market. It can issue equity shares
@ Rs. 25, 15% debentures at par and 12% preference shares at par. Tax 50%. The four possible
financial plans.
Plan Debenture Pref. Sharers equity
1 NIL NIL 100%
2 20% NIL 80%
3 40% NIL 60%
4 45% 15% 40%
Determine indifference point.

Compiled by – Dr. Aanchal Singh for Financial Management Term III

6 Goa Institute of Management