Introduction to leverages

Leverage: Employment of as asset/ source of finance for which firm pays fixed cost/fixed
return

Types of Leverages

Operating Leverage Financial Leverage

Combined Leverage

Sales Computation of EPS from Sales

Less: Variable cost Revenue:

Contribution EBIT= Contribution – FC

Less : Fixed Operating cost Contribution = EBIT +FC

EBIT (earnings before interest and tax)

Less : Interest (on Debt)- fixed financial cost
EBT (earnings before tax) EBT= EBIT-Interest

Less : Tax Interest = EBIT-EBT

EAT/ PAT (earnings/ profits after tax)

Less: Preference Dividend Operating Leverage: is caused due to
fixed operating expenses. It may be
Earnings Available to Equity defined as the firm’s ability to use
Shareholders fixed operating costs to magnify the
Earnings Per Share (EPS) effects of changes in sales on its
earnings before interest and taxes
=
Earnings Available ¿ Equity Shareholders ¿ Ex:
Number of Equity Shares
A firm sells products for Rs 100 per unit, has variable operating costs of Rs 50 per unit
and fixed operating costs of Rs 50000 per year. Show the various levels of EBIT and the
degree of operating leverage that would result from sale of i) 1000 units ii) 2000 units and
iii) 3000 units
If Sales level of 2000 units is used a base for comparison, the operating leverage is shown
as follows:
Particulars Base Case 1 +50% Case 2 -50%
Sales in Units 2000 3000 1000
Sales revenue Rs 200000 Rs 300000 Rs 100000
(SP=Rs100 pu)

Less: Variable Rs 100000 Rs 150000 Rs 50000

operating cost
(VC=Rs50 pu)
Contribution Rs100000 Rs 150000 Rs 50000
Less: Fixed Operating Rs 50000 Rs 50000 Rs 50000
cost
EBIT Rs 50000 Rs 100000 zero
+100% -100%

Operating Leverage
Alternatively, Degree of Operating Leverage (DOL)
Percentage Change∈ EBIT
= Percentage change∈Sales

△ EBIT
EBIT
= △Q
Q

OR
Contribution
DOL= EBIT
 Sales-500 units Sales- 600 units
Revenues Rs 5,00,000 Rs 6,00,000
Variable Operating costs Rs2,50,000 Rs3,00,000
Fixed operating costs Rs200000 Rs200000
Profits before interest and 50,000 1,00,000
taxes (PBIT or EBIT)

Find the DOL at sales of 500 units and 600 units

Sales-500 units Sales- 600 units
Revenues Rs 5,00,000 Rs 6,00,000
Less: Variable Operating costs Rs2,50,000 Rs3,00,000
CONTRIBUTION Rs 250000 Rs 300000
Fixed operating costs Rs200000 Rs200000
PBIT or EBIT Rs 50000 RS 100000

Contribution
DOL= EBIT
250000
DOL (Q=500 units) = 50000 = 5.0

300000
DOL (Q=600 units) = 100000 = 3.0

Financial Leverage: is caused due to fixed financial costs- (interest paid on debt or
loans)
 The financial Manager of Hypothetical Ltd expects that its EBIT in the current year would
amount to Rs 10,000. The firm has 5 % bonds aggregating to Rs 40,000. While the 10%
preference shares amount to rs20000. What would be the earnings per share (EPS)?
Assuming the EBIT being 1) Rs 6000 and 2) Rs 14000, how would the EPS be affected?
The firm can be assumed to be in the 35% tax bracket. The number of outstanding
ordinary shares is 1000.
Base Case 1(-40%) Case 2(+40%)
EBIT Rs 10,000 Rs 6000 Rs 14000
Less: interest on bonds (40000*5%) Rs 2000 Rs 2000 Rs 2000
Profit/ earnings before tax (PBT or EBT) Rs 8000 Rs 4000 Rs 12000
Less: Tax @ 35% Rs 2800 Rs 1400 Rs 4200
PAT / EAT Rs 5200 Rs 2600 Rs 7800
Less: Preference Dividend (20000*10%) Rs2000 Rs2000 Rs 2000
Earnings available to Equity Rs3200 Rs 600 Rs 5800
Shareholders
No. of Equity Shares 1000 1000 1000
EPS Rs 3.2 0.6 5.8
-81.25% +81.25%

Case 1: 40% decrease in EBIT will result in 81.25% decrease in EPS

Case 2: 40 % increase in EBIT will result in 81.25% increase in EPS
Degree of financial leverage (DFL)
Percentage Change∈ EPS
= Percentage change ∈EBIT
 △ EPS
EPS
= △ EBIT
EBIT

EBIT
DFL= EBT

Fintex Ltd has the fixed interest expense of Rs 30000, falls into tax bracket of
50% and outstanding shares are 10,000

Case A Case B
EBIT 50000 60000
Interest expense 30000 30000
EBT 20000 30000
Tax 10000 15000
PAT 10000 15000
EPS 1 1.50

EBIT
DFL= EBT

DFL (Case A) = 50000/ 20000= 2.5

DFL (Case B) = 60000/ 30000 = 2.0

Combined Leverage: Is the product of operating and financial leverage. It is known as

total risk; the risk associated with combined leverage
 Percentage Change∈ EPS
Degree of Combined Leverage (DCL) = Percentage change ∈Sales

△ EPS
EPS
= △ sales
sales

COntribution
DCL = EBT

DCL= DOL × DFL

A firm has sales of Rs 75,00,000, VC= Rs 4200000 and fixed cost of Rs 600000. It
borrowed Rs 4500000 at 9% interest. What are the DOL, DFL and DCL?
Sales Rs 75 00 000
Less: VC Rs 42 00 000
Contribution Rs 33 00 000
Less: FC Rs 6 00 000
EBIT Rs 27 00 000
Less: Interest on Rs 4 05 000
Rs 4500000@ 9%
EBT Rs 22 95 000

Contribution
DOL = EBIT
= 3300000/ 2700000 = 1.22
EBIT
DFL = EBT = 2700000/ 2295000= 1.18
 COntribution
DCL = EBT = 3300000/ 2295000 = 1.44

DCL= DOL × DFL = 1.22 * 1.18 = 1.44

Calculate the operating and financial leverages under situation A, B and C and
financial plans 1, 2 and 3.
Installed capacity (Units)-1200
Actual Production and sales-800 units
SP per Unit-Rs 15, VC pu = Rs 10
Fixed Cost: Situation A-Rs 1000, B- Rs 2000, C-Rs 3000
Capital Structure
Financial plan 1 Financial plan 2 Financial plan 3
Equity Rs 5000 Rs 7500 Rs 2500
Debt Rs 5000 Rs 2500 Rs 7500
Cost of Debt for all plans -12%

Determination of Operating Leverage:

Particulars Situation A B C
Sales (800 units* Rs15) Rs 12000 Rs 12000 Rs 12000
Less: VC (800*Rs 10) Rs 8000 Rs 8000 Rs 8000
Contribution Rs 4000 Rs 4000 Rs 4000
Less: FC Rs 1000 Rs 2000 Rs 3000
EBIT Rs 3000 Rs 2000 Rs 1000
Contribution 4000/ 3000 = 4000/ 2000= 4000/ 1000 =
DOL = EBIT 1.33 2.0 4
Determination of Financial Leverage:
Financial plan 1 Financial plan 2 Financial plan 3
Situation A
EBIT Rs 3000 Rs 3000 Rs 3000
Less: Interest on Rs5000*0.12 Rs 2500*0.12 Rs 7500* 0.12
Debt @12%
= 600 = 300 = 900
EBT 2400 2700 2100
EBIT 3000/2400 = 1.25 3000/ 2700 = 1.11 3000/2100 = 1.43
DFL = EBT

Situation B
EBIT Rs 2000 Rs 2000 Rs 2000
Less: Interest on Rs5000*0.12 Rs 2500*0.12 Rs 7500* 0.12
Debt @12%
= 600 = 300 = 900
EBT Rs 1400 Rs 1700 Rs1100
DFL 2000/1400= 1.43 2000/ 1700= 1.18 2000/ 1100 = 1.82

Situation C
EBIT Rs 1000 Rs 1000 Rs 1000
Less : Interest on Rs5000*0.12 Rs 2500*0.12 Rs 7500* 0.12
Debt @12%
= 600 = 300 = 900
EBT 400 700 100
EBIT 1000/ 400 = 2.5 1000/700 = 1.43 1000/ 100 = 10
DFL = EBT

DCL=
EBIT-EPS Analysis
Involves comparison of alternative methods of financing at various levels of EBIT
Study the effect of leverages
Suppose a firm has capital structure exclusively comprising of ordinary shares amounting
to Rs 10, 00,000. The firm now wishes to raise additional Rs 1000000 for expansion. The
firm has four alternative financial plans.
a. It can raise entire amount as equity capital
b. In can raise 50% as equity capital and 50% as 5% debentures
c. It can raise entire amount as 6% debentures
d. It can raise 50% as equity and 50% as 5% preference

Further assume that the existing EBIT are Rs 120000, the tax rate is 35%,
outstanding ordinary shares-10000 and market price per share Rs 100 under all the
four alternatives. Which financing plan should it select?

Particulars a b c d
EBIT 1 20 000 1 20 000 1 20 000 1 20 000
Less: Interest on - 500000*0.05= 1000000*0.06= -
debt 25000 60000
EBT 120000 95000 60000 120000
Less: Tax@35% 42000 33250 21000 42000
EAT 78000 61750 39000 78000
Less: Preference - - - 500000*0.05=
dividend 25000
Earnings 78000 61750 39000 53000
available to
equity
shareholders
Number of 20000 15000 10000 15000
equity shares
EPS 3.9 4.1 3.9 3.5

Option b is the best as it results in highest EPS at Rs 4.1

Option b = Rs 25000
Option c= Rs 60000
Option D= 25000/(1-0.35) = Rs38462
38462*0.35 = 13462= 38462-13462 = 25000
Financial BEP (Financial break even point_
IT Is the level of EBIT which is equal to firms’ fixed financial Cost.
It is the minimum EBIT which the firm has to earn
Dp
Financial BEP = = I +
1−t

Option b= 25000
Indifference point
Is the EBIT level beyond which benefits of financial leverage accrue with respect to EPS.
Equity shares versus debentures
X (1−t) ( X −I )(1−t)
N1
= N2

X= EBIT, I= interest on debentures

Equity Shares versus Preference capital
X (1−t) X ( 1−t )−D p
N1
=
N2

A financial manager has formulates various financial plans to finance Rs 30,00,000. Tax
rate @ 35% and FV of equity is Rs100
1. Either equity capital of rs 30,00,000 or Rs15,00,000 10% debentures and Rs
15,00,000 of equity

X (1−t) (X −I )(1−t)
N1
= N2

Only equity of Rs 30L= no. of equity shares= 3000000/100 = 30000 shares

When Rs15,00,000 10% debentures and Rs 15,00,000 of equity, Interest (I) will be
Rs 150000, No. of equity shares = 15,00,000/ 100 = 15000 shares
X (1−0.35) ( X −150000)(1−0.35)
=
30000 15000
0.65 X ( 0.65 X−97500 )
30000
= =X= Rs300000
15000

Particulars Equity Financing (Rs) Equity + Debt Financing (Rs)

EBIT 300000 300000
Less: Interest - 150000
EBT 300000 150000
Less: Tax@35% 105000 52500
EAT 195000 97500
No. of Equity Shares 30000 15000
EPS 6.5 6.5

Consider the following information

EBIT- RS 12L
EBT- Rs 300000
Operating fixed cost-rs 2400000
Preference dividend = Rs 60000
Tax rate- 40%
Calculate DOL, DFL, DCL. By what % the operating profits would increase if sales
increase by 10%

Statement showing computation of DOL, DFL and DCL

Contribution (Contribution = EBIT +FC) 3600000
(1200000+2400000)
Less: FC 2400000
EBIT 1200000
Less: Interest (EBIT-EBT) 900000
1200000-300000
EBT 300000
Less: Tax @40% 120000
EAT 180000
Less: Preference dividend 60000
Earnings available to Equity 120000

DOL = C/EBIT= 3600000/1200000 = 3.0

EBIT
DFL= EBT = 1200000/ 300000 = 4.0

DCL = 12
If Sales increase by 10%,

DOL= % change in EBIT/ %change in sales

3= % change in EBIT/10%
% change in EBIT= 30%