LEVERAGE

• A firm can make use of different sources of financing whose costs are
different.
• These sources may be classified in those which carry a fixed rate of
return and those won which the returns vary.
• The fixed returns on some sources of finance have implications for those
who are entitled to a variable return.
• Since debt involves the payment of a stated rate of interest, the return
to the ordinary shareholders is affected by magnitude of debt in the
capital structure of a firm.
• The employment of an asset or source of funds for which the firm has to
pay a fixed cost or fixed return may be termed as leverage.
• LEVERAGE is the employment of an asset/source of finance for which
firm pays fixed cost/fixed return.
 LEVERAGE
• There are two types of leverage:
• Operating leverage and
• Financial leverage.
• The leverage associated with investment (asset acquisition) activities is
referred to as OPERATING LEVERAGE.
• While leverage associated with financing activities is called FINANCIAL
LEVERAGE.
• OPERATING leverage is determined by the relationship between the
firm’s sales revenues and its earnings before interest and taxes
(EBIT).The earnings before interest and taxes are also generally called as
operating profits.
• FINANCIAL leverage represents the relationship between the firm’s
earnings before interest and taxes (Operating Profits) and the earnings
available for ordinary shareholders.
• THE OPERATING PROFITS (EBIT) ARE, THUS, USED AS THE PIVOTAL
POINT IN DEFINING OPERATING AND FINANCIAL LEVERAGE.
 OPERATING LEVERAGE
• The operating leverage results from the existence of fixed operating
expenses in the firm’s income stream.
• The operating costs of a firm fall into three categories.
• Fixed costs which may be defined as those which do not vary with sales
volume.
• They must be paid regardless of the amount of revenues available.
• Variable cost which vary directly with the sales volume and
• Semi-variable or semi-fixed costs are those which are partly fixed and
partly variable.
• They are fixed over a certain range of sales volume and increase to
higher levels for higher sales volumes.
• Since this category of cost can be broken down into fixed and variable
components, the costs of a firm, in operation terms, can be divided into
• Fixed cost and Variable costs.
• The OPERATING LEVERAGE may be defined as the firm’s
ability to use fixed operating costs to magnify the effects
of changes in sales on its earnings before interest and
taxes.

• EXAMPLE
• A firm sells products for Rs 100 per unit, has variable
operating costs of Rs 50 per unit and fixed operating cost
of Rs 50,000 per year. Show the Various levels of EBIT that
would result from sale of (i) 1000 units (ii) 2000 units and
(iii) 3000 units.
• Let us use sales level of 2000 units as base for comparison
and try to understand the operating leverage.
ANALYSIS OF OPERATING LEVERAGE
CASE 2 BASE CASE 1

-50% +50%
SALES IN UNITS 1000 2000 3000

SALES REVENUE 1,00,000 2,00,000 3,00,000

LESS VARIABLE 50,000 1,00,000 1,50,000

OPERATING COST

CONTRIBUTION 50,000 1,00,000 1,50,000

LESS FIXED 50,000 50,000 50,000

OPERATING COST

EBIT ZERO 50,000 1,00,000

LEVERAGE EFFECT -100% +100%
 ANALYSIS OF OPERATING LEVERAGE
• ANALYSIS; A 50% increase in sales results in
100% increase in EBIT and a 50% decrease in
sales results in 100% decrease in EBIT.
• Alternative Definition of Operating Leverage
• OL can also be defined in another way. This is
more precise measurement in terms of
degree of operating leverage (DOL). The DOL
measures in quantitative terms the extent or
degree of operating leverage.
 OPERATING LEVERAGE
• When proportionate change in EBIT as a result of given change in
sales is more than the proportionate change in sales, operating
leverage exists.
• The greater the DOL, the higher is the operating leverage.
• DOL = Percentage change in EBIT / Percentage change in sales is >
1
• Alternatively, DOL = (∆ EBIT ÷ EBIT) / (∆ Q ÷ Q)
• EBIT = Q(S – V) – F
• ∆ EBIT = ∆ Q(S –V)
• Q = Sales quantity in units
• S = Selling price per unit
• V= Variable cost per unit
• F = Total fixed cost.
 OPERATING LEVERAGE
• DOL= ∆ Q (S –V) / Q(S-V) – F
• EXAMPLE
• Calculate the DOL for Poly Fibers Ltd given
the following additional information:
• Quantity produced = 5000
• Variable cost per unit = Rs 200
• Selling cost per unit = Rs 500
• Fixed cost = Rs 9, 00,000
 OPERATING LEVERAGE
• SOLUTION:
• DOL of Poly Fibre Ltd would be
• DOL = [Q(S-V)] / [Q (S-V)-F]
• = [5000 (500-200)] / 5000(500-200) -9,
00,000]
• =15,00,000 / 15,00,000-9,00,000
• = 15,00,000/6,00,000= 2.5
•  
 FINANCIAL LEVERAGE
• The sources, from which funds can be raised from the point of view of
cost/charges, can be categories into
• (i) Those which carry fixed financial charge, and
• (ii) Those which do not involve any fixed charge.
• The sources of funds which carry fixed financial charges are Debt,
Debenture and Preference capital.
• FINANCIAL LEVERAGE results from the presence of fixed financial
charges in the firm’s income stream.
• These fixed charges do not vary with the earnings before interest and
taxes (EBIT) OR operating profits.
• They are to be paid regardless of the amount of EBIT available to pay
them. After paying them, the operating profits belong to the ordinary
shareholders.
• Financial leverage concerned with the effects of changes in EBIT on the
earnings available to equity holders. It is defined as ;
• “The ability of a firm to use fixed financial charges to magnify the effects
of changes in EBIT on the earning per share”
• In other words, financial leverage involves the use of funds obtained at a
fixed cost in the hope of increasing the return to the shareholders.
• EXAMPLE
• The financial manger of Hypothetical ltd expects that its earnings before
interest and taxes (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 amounting to Rs 20,000. What would be the earnings per share
(EPS)? Assuming the EBIT being (i) Rs 6000 (ii) Rs 10,000 AND (III) Rs
14000, how would the EPS be affected? The firm can be assumed to be in
the 35% tax bracket. The number of ordinary shares is 1000.
 EPS FOR VARIOUS EBIT LEVELS
CASE 2 BASE CASE 1
-40% +40%
EBIT 6000 10,000 14,000
LESS INTEREST 2000 2000 2,000
ON BONDS
EBT 4000 8,000 12,000
LESS TAX 35% 1400 2,800 4,200
EAT 2600 5,200 7,800
LESS 2000 2000 2000
PREFERENCE
DIVIDEND
EARNING 600 3,200 5,800
AVAILABLE