LEVERAGES

Financial Management Session 4 and 5

Leverage
• leverage is measured between two financial variables it explains how
the dependent variable responds to a particular change in the
independent variable.
Three measures of leverage.
• Operating Leverage
• Financial Leverage
• Combined/ Total Leverage.
• Three measures of leverage depend to a large extent on the various
income statement items
Operating Leverage

•  Percentage change in net operating income EBIT associated with a

given percentage change in quantity of sale.
• Operating leverage examines the effect of the change in the quantity
on the EBIT

• DOL =
•  DOL = = (Q is quantity sold)

• EBIT = Q(S – V) – F

• DOL = =
•Ex:
  Calculate the DOL for XYZ Company Ltd. given the following
additional information:
Quantity produced = 5,000
Variable cost per unit = Rs.200
Selling price per unit = Rs.500
Fixed asset = Rs.9,00,000
DOL of XYZ Company Ltd=
= [5,000(500 – 200)]/[5,000*(500 – 200) – 9,00,000] = 2.50

1% change in the sales , there will be a 2.5 % change in EBIT.

 Following are the different DOL for the various levels of Q for XYZ
Company Ltd.:

Quantity produced 1000 2000 3000 4000 5000 6000 7000

Variable cost per unit 200 200 200 200 200 200 200
selling price per unit 500 500 500 500 500 500 500
fixed cost 900000 900000 900000 900000 900000 900000 900000
DOL -0.5 -2 #DIV/0! 4 2.5 2 1.75

When the value of Q is 3000 the EBIT of the company is zero and this is the operating
break-even point.
At operating break-even point, where the EBIT is zero, the quantity produced
can be calculated as follows:
Q = F/(S – V)

For XYZ Company Ltd

Q = 9,00,000/(500 – 200) = 3,000

 Quantity
Each level of output has a distinct DOL. produced DOL
1000 -0.5
DOL is undefined at the operating break-even 2000 -2
3000 #DIV/0!
point. 4000 4
5000 2.5
If Q is less than the operating break-even point, 6000 2
7000 1.75
then DOL will be negative

If Q is greater than the operating break-even point, then the DOL will be
positive.

The DOL will start to decline as the level of output increases and will reach a
limit of 1.
 Measurement of Business Risk:

DOL helps in understand the change in operating income for a given change in
Quantity sold

If the DOL of a firm is 2, then a 10% increase in the level of output will
increase operating income by 20%.

A large DOL indicates that small fluctuations in the level of output will
produce large a fluctuations in the level of operating income.

DOL measures the firm’s business risk.

The uncertainty or variability of the firm’s EBIT is called as Business Risk

Every thing else being equal, a higher DOL means higher business risk and
vice-versa.
 Financial Leverage
The financial leverage measures the effect of the Change in EBIT on the
EPS of the company
Financial leverage also refers to the mix of debt and equity in the capital
structure of the company

Degree of Financial Leverage (DFL)

DFL = (percentage change in EPS)/ (percentage change in EBIT)

DFL = (ΔEPS/EPS)/(ΔEBIT/EBIT)
Example of XYZ Company Ltd., which has an EBIT of Rs.6,00,000 at
5,000 level of production, the capital structure of the company is as follows:

calculate the DFL of XYZ Company Ltd.

Earnings Before Interest and Tax (EBIT) = Rs.6,00,000

Interest on Long-term Debt (I) = Rs.75,000 Corporate Tax (T) = 50%

Preference Dividend (Dp) = Rs.50,000

 DFL

Consider the case of XYZ Company Ltd. and measure DFL for varying
levels of EBIT.
EBIT DFL
The DFL at EBIT level of 175000 is undefined 50000 -0.4
100000 -1.33333
This point is the Financial Break-even Point. It can be 175000 #DIV/0!
defined as: 600000 1.411765
700000 1.333333
EBIT = I + Dp/(1 – T)
750000 1.304348
 EBIT DFL
Observations from studying the behavior of DFL 50000 -0.4
100000 -1.33333
Each level of EBIT has a distinct DFL
175000 #DIV/0!
DFL is undefined at the financial Break-even Point 600000 1.411765
700000 1.333333
DFL will be negative when the EBIT level goes below the
Financial Break-even Point 750000 1.304348

DFL will be positive for all values of EBIT that are above the Financial Break-
even Point. This will however start to decline as EBIT increases and will reach a
limit of 1.
It also helps in assessing the financial risk of the firm.
Impact of Financial Leverage on Investor’s Rate of
Return

A company needs a capital of Rs.10,000 to operate

1. By equity source
2. By debt source

Option 1: company brought the money from equity source

Sales 10000
expenses 7000
the return on equity is = 1500/10000= 15%.
EBIT 3000
Tax 50% 1500
Net profit 1500
Option2: capital of 10000 brought from debt and equity sources at a ratio
of 2:1
Debt capital = 10000*(2/3) = Rs.6,667 at an interest rate of say, 15%,.
Equity Capital= 10000*(1/3)= ₹ 3,333
use of debt in the company’s capital structure has caused
the net profit to decline from Rs.1,500 to Rs.1,000.
Sales 10000
expenses 7000 Return on Equity ??? Is it declined?
EBIT 3000
Return on equity = 1000/3333= 30%
interest 1000
EBT 2000 What were the factors which contributed to this
Tax 50% 1000 additional return?
NI 1000
By using debt capital, company has to pay an interest rate of 15%. But
company’s operations have been able to generate more than the 15% ,that
excess returns are transferred to the equity shareholders.

Interest is a tax deductible expense, on this interest amount company could

save tax amount i.e ₹ 500

Company may increase the return on equity (ROE) by using debt capital i.e.,
the use of financial leverage
 Financial Leverage and Risk

If increased financial leverage leads to increased return on equity

why do companies not resort to ever increase debt capital ?

Why special focus on Debt-Equity Ratio?
Because increased use of debt financing will lead to increased financial risk

Increased fluctuations in the return on equity.

Increase in the interest rate on debts.

 Increased Fluctuations in Returns All equity capital

10000 sales revenue 9000 ass sales revenue

Unleavered firm Unleavered firm
Sales 10000 Sales 9000
expenses 7000 ROE at Sales of Rs.10,000 15%
expenses 7000 ROE at Sales of Rs.9,000 10%
EBIT 3000 EBIT 2000
interest 0 interest 0
Change is 33.3% decline
EBT 3000 EBT 2000
Tax 50% 1500 Tax 50% 1000
NI 1500 NI 1000
   
   
ROE 10.0%
ROE 0.15
 Increased Fluctuations in Returns
Debt equity ratio 2:1
10000 sales revenue 9000 ass sales revenue
Levered firm 2:1 Levered firm 2:1
Sales 10000 Sales 9000
expenses 7000 expenses 7000 ROE at Sales of Rs.10,000 30%
EBIT 3000 EBIT 2000
ROE at Sales of Rs.9,000 15%
interest 1000 interest 1000
EBT 2000 EBT 1000
Tax 50% 500 ROE declined to 50%
Tax 50% 1000
NI 1000 NI 500
   
   
ROE 15%
ROE 30%

Hence, the greater the use of financial leverage, the greater the potential
fluctuation in return on equity.
 INCREASE IN INTEREST RATES
In the first situation, the company was unleveraged, in the second situation the debt-equity ratio
was 2:1.
 The Degree of Financial Leverage (DFL) in each case is calculated as:

DEL of Unleveraged = 3000/3000 = 1

if EBIT is changed by 1%, EPS will also change by 1%

DFL of Leveraged = 3000/(3000-1000)= 1.5

if EBIT is changed by 1%, EPS changes by 1.5%

Hence, greater the leverage, the wider are fluctuations in the return on equity and the greater
is the financial risk
EBIT-EPS analysis,
Total Leverage
 A combination of the operating and financial leverages is the total or
combined leverage
 DTL = x = x

 𝐷𝑇𝐿=[ Q ( S   –  V )]
𝐷𝑃
[ Q ( S   –  V )  –  F  −  I − ] 
(1 − 𝑇 )
Calculating the DOL,DFL and DTL for XYZ Co. Ltd. given the following
information:
Equity Earnings = Rs.1,62,500
Quantity Produced (Q) = 5000 Units
Variable Cost per unit (V) = Rs.200
Selling Price per unit (S) = Rs.500
Number of Equity Shareholders (N) 5,00,000
Fixed Expenses (F) = Rs.9,00,000
Interest (I) = Rs.75,000
Preference Dividend (D ) = Rs.50,000
p

Corporate Tax (T) = 50%

  DOL = = = 2.5%

 DFL= =

 = = 3.53

One percent change in Q will results in 3.5% change in EPS.

 Overall break-even point
The overall break-even point is that level of output at which the DTL will be
undefined and EPS is equal to zero. This level of output can be calculated as follows:
 
Q=
Example:
 
F = Rs.8,00,000 Q =
I = Rs.80,000
D = Rs.60,000
p
Q= 2500 units
S = Rs.1,000
V = Rs.600
Tax= 50% The overall break-even point is at 2500 units.
 Observations from Degree of total leverage

There is a unique DTL for every level of output.

At the overall break-even point of output the DTL is undefined

If the level of output is less than the overall break-even point, then the DTL will
be negative.
If the level of output is greater than the overall break-even point, then the DTL will
be positive.

DTL decreases as Q increases and reaches a limit of 1.

Measures changes in EPS Measures Total Risk