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AFM- LEVERAGES

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C) Combined

Leverage

relative change in profits due to change in sales.

fluctuations in profits due to small changes in sales.

Operating B) Financial .

leverages.

operating & financial leverage.

Operating Leverage

in the overall assets of the firm.

operating leverage.

sensitive to the economic conditions.

changes in profitability vis--vis it sales.

tend to do well in good economic conditions and vice

versa.

are

more

as the percentage change in operating profits

resulting from a percentage changes in sales.

DoL = (% Change in Operating Profits )

(% Change in Sales)

(% Change in Sales)

Sales/Sales

then operating profits move (up or down) by 2% in

the same direction.

Let ,

Q= Number of units

sold

s= Selling price per

unit

v=Variable cost per

unit,

F= Total fixed cost

Then,

DOL= Q*(s-v)

Q*(s-v) F

However,

Contribution = EBIT +Fixed

Cost

So, DOL= 1+ (F/EBIT)

Consider 2 firms B & A with same product but B has a

higher fixed cost.

(All No's in Million unless

stated)

Recession

Normal

Expansion

A

B

A

B

A

B

Units Sold

5

5

6

6

7

7

Price Per Unit (Rs)

4

4

4

4

4

4

Sales(in Mn)

20 20

24

24

28

28

Variable Cost per

unit (Rs)

2

1

2

1

2

1

Total Variable Cost 10

5

12

6

14

7

Conribution

10 15

12

18

14

21

Fixed Cost (Rs. Mn) 10 16

10

16

10

16

EBIT

2

4

5

As (Rs.

one Mn)

can see 0

Firm-1with 2a higher

operating

leverage(i.e. higher fixed cost) tends to do well in

the expansion phase & losses out in the

recessionary environment.

Financial Leverage

source of funds, such as debt and preference capital

along with the owners equity in the capital structure

is known as Financial Leverage or gearing or trading

on equity.

will be used as the basis for raising debt. The supplier

of the debt has limited participation in the companys

profits and hence will insist on protection in earnings

and protection in values represented by owners

equity.

expected to earn more on fixed charges funds than

the cost of funds.

cost and generates 12% on it, the surplus 4% will go

to share holders of the firm. Where as if it earns only

6%, the shareholders returns will suffer by 2%

higher returns as well as creating higher risk for the

shareholders.

Measures of Financial Leverage

Debt to Equity Ratio (L2) = D/ E

Interest Coverage (L3) = EBIT/ Interest

L2 = L1/ (1-L1). These are called gearing measures

and are static in nature as they give the current

position of the firm at a point of time.

service the fixed-charges.

Limitations

charges, it is the cash flow that is more relevant than

the reported earnings.

does not reflect on the future.

leverage.

The primary purpose of using financial leverage

is to magnify the shareholders returns. For this

to happen, the cost of funds on the leverage

should be less than the returns earned on the

funds.

Thus, when the difference between the fixed

charges funds & and returns generated on the

funds is distributed to shareholders the EPS &

RoE increases.

However, EPS or ROE will fall if the company

obtains the funds at higher rate than it generates

the return on the capital.

So, it must be very clear that, EPS, ROE and ROI

are very important figures when we discuss

financial leverage.

Effects of Leverage

Favorable

Unfavorable

Neutral

Where,

- r is pre-tax return on investment or

assets

Conclusions:

The equation in previous slide clearly shows that

RoE is more by

(r-i)*D/E *(1-t) factor when the firm uses debt.

It is also seen that if return on assets exceeds the

interest rate (r>i), RoE will increase linearly with

increase in the financial leverage i.e. D/E. The effect

of leverage depends on both D/E and spread between

r & i.

If, r=i , no benefits of the financial leverage will be

seen.

The leverage effect will be unfavorable if r<i.

With a given financial leverage, tax rate & interest

As we have seen, Financial leverage affects the

earning per share of the Company.

The degree of financial leverage (DFL) is defined as

the percentage changes in EPS due to given

percentage change in EBIT.

DFL =

% Change in EPS

% Change in EBIT

EBIT/EBIT

So, if the DFL is 2, then for every 1% change in EBIT,

then profits move (up or down) by 2% in the same

direction.

Let ,

Q= Number of units

sold

s= Selling price per

unit

v=Variable cost per

unit,

F= Total fixed cost

However,

Then,

EBIT= Q *(s-v)-F

DFL= EBIT

(EBIT-INT)

i.e. DFL= EBIT

PBT

Q*(s-v)-F-INT

Equity

Debt

Total Investment

Equity

Debt

No of Shares@

Rs.10

100%

0%

50%

50%

25%

75%

1000000 500000 250000

0 500000 750000

100000

50000

25000

Debt@ 15%

I rate

15%

EBIT Margin

Case 1

EBIT

Interest

PBT

Tax @ 50%

PAT

EPS

ROE

24%

240000 240000 240000

0

75000 112500

240000 165000 127500

120000

82500

63750

120000

82500

63750

1.2

1.65

2.55

12.0%

16.5%

25.5%

Case 1 : EBIT

Margin (i.e.

ROI) > Rate of

Interest

Equity

Debt

100%

0%

50%

50%

25%

75%

Total Investment

0

0

0

100000

Equity

0 500000 250000

Debt

0 500000 750000

No of Shares@ Rs.10 100000 50000 25000

Debt@ 15%

I rate

15%

EBIT Margin

Case 2

EBIT

Interest

PBT

Tax @ 50%

15%

150000 150000 150000

0 75000 112500

150000 75000 37500

75000 37500 18750

Case 2 : EBIT

Margin (i.e.

ROI) = Rate of

Interest

Equity

Debt

Total Investment

Equity

Debt

No of Shares@

Rs.10

100%

0%

50%

50%

25%

75%

0

0

0

100000

0 500000 250000

0 500000 750000

100000

50000

25000

Debt@ 15%

I rate

15%

EBIT Margin

Case 3

EBIT

Interest

PBT

12%

120000 120000 120000

0 75000 112500

120000 45000

7500

Case 3 : EBIT

Margin (i.e.

ROI) < Rate of

Interest

Combined Leverage

Combined leverage in the impact of change of sales

on the EPS.

Higher the combined leverage higher will be the

sensitivity of EPS with respect to sales.

Combined leverage is nothing but the combined

impact of operating & financial leverages.

The degree of combined leverage (DCL) is defined as

the percentage changes in EPS due to given

percentage change in Sales.

DCL =

% Change in EPS

% Change in Sales

change in EBIT we get,

DCL =

DoL * DFL

As we know, DFL =

% Change in EPS

% Change in EBIT

(% Change in Sales)

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