UNIT -3:Financial Decision

Prepared &Presented
By
Dr Subramanian Shanmugam
Associate Professor,
Dept. of Commerce&BS,CUSB
UNIT CONTENTS
• ANALYSIS OF LEVERAGE-OPERATING ,fINANCIAL AND
COMBINED LEVERAGE
• EVALUATION OF CAPITAL STRUCTURE THROUGH EBIT-EPS
RELATIONSHIP
• RISK IN FINANCIAL LEVERAGE -CO-EFFICIENT OF
VARIATION.
Financing Decision
The Financing Decision is yet another crucial decision made by the financial
manager relating to the financing-mix of an organization. It is concerned with
the borrowing and allocation of funds required for the investment decisions.
The manager chose the source with minimum cost. The decisions related to
money are called ‘Financing Decisions.’The financing decision involves two
sources from where the funds can be raised, using a company’s own money,
such as share capital, retained earnings or borrowing funds from the outside in
the form debenture, loan, bond, etc.
• The objective of financial decision is to maintain an optimum capital
structure, i.e. a proper mix of debt and equity, to ensure the trade-off between
the risk and return to the shareholders. Optimum capital Structure refers to
simplicity, flexibility, lower cost of capital, less risk and maximum return.
• The Debt-Equity Ratio helps in determining the effectiveness of the financing
decision made by the company.
Debt -equity Mix
***
• While taking the financial decisions, the finance manager has to take the
following points into consideration:
• The Risk involved in raising the funds. The risk is higher in the case of debt as
compared to the equity. The Cost involved in raising the funds. The manager
chose the source with minimum cost. The Level of Control, the shareholders,
want in the organization also determines the composition of capital structure.
They usually prefer the borrowed funds since it does not dilute the ownership.
• The Cash Flow from the operations of the business also determines the source
from where the funds shall be raised. High cash flow enables to borrow debt
as interest can be easily paid. The Floatation Cost such as broker’s
commission, underwriters fee, involved in raising the securities also
determines the source of fund. Thus, securities with minimum cost must be
chosen.
***
• Financial decision is important to make wise decisions about when, where and
how should a business acquire fund. Because a firm tends to profit most when
the market estimation of an organization’s share expands and this is not only a
sign of development for the firm but also it boosts investor’s wealth.
Consequently, this relates to the composition of various securities in the capital
structure of the company.A decision to buy a new machine or plant implies
specific way of financing that project.
• Should a firm employ equity or debt or both?
• What are implication of the debt -equity mix?
• What is an appropriate mix of debt and equity?
• Thus, a company should make a judicious decision regarding from where,
when, how the funds shall be raised, since, more use of equity will result in the
dilution of ownership and whereas, higher debt results in higher risk, as fixed
cost in the form of interest is to be paid on the borrowed funds.
Capital structure i.e financing decisions
• In order to start and function a company smoothly, desired capital is
needed.The finance is needed from the date of propotion to the date of
incorporation and commencement. Capital structure of a company refers to
composition or make up of its capitalization. and it covers all long term capital
resources, loan, reserves, share and bonds etc., i.e Procurement of funds. A
firm should select such a financing-mix which maximises its value /the
shareholders' wealth (or minimises its overall cost of capital). Such capital
structure is referred to as the “optimum capital structure”.
• The assets of a company can be financed either by increasing the owner claims
or the creditor claims. The owner claims increase when the firm raises funds
by issuing ordinary share or by retaining the earnings, the creditors' claims
increase by borrowing. The various means of financing represent the financial
structure of an enterprise. The left -hand side of the balance sheet (liabilities
plus equity) represents the financial structure of a company.
***
i. Financial structure= Total liabilities
= Long term liablities +current liabilities
= equity+Pref.share+LT or ST debt+ Reserve
ii. Capital structure = Total Assets - Current Liabilities
= Long term debt+equity+pref.share+LT debts+Reserve and funds.
For example: Rs.
Equity share capital 2,00,000
Pref.share capital 2,00,000
Debenture 1,00,000
Retained Earning 3,00,000
Current liabilities 2,00,000
10,00,000
Calculate capitalisation, capital sructure and Financial structure.
***
A. Capitalization- Total amount of securities issued by a company
Rs
Equity share capital 2,00,000
Pref share capital 2,00,000
Debetnture 1,00,000
Capitalization 5,00,000
B. Capital Structure : It is the proportion amount that makes up
capitalization.
Rs. Mix(%)
Equity Share capital 2,00,000 40
Preference share capital 2,00,000 40
Debenture 1,00,000 20
5,00,000
***
C. Financial structure: It deals with all financial resources i.e ST&LT:
Rs Mix(%)
Equity share capital 2,00,000 20
Pref share capital 2,00,000 20
Debenture 1,00,000 10
Retained Earnings 3,00,000 30
Current liabilities 2,00,000 20
10,00,000 100%
Excercise 1
The following information ,you are required:
Calculate
i.Capitalization, ii. capital structure,iii.Financial structure.
Rs
• Equity share capital 18,00,000
• Preference capital 5,00,000
• Debenture 4,00,000
• Reatining earning 6,00,000
• Capital Surplus(fund) 50,000
• Current liabilitues 1,50,000
35,00,000
solution
A. Capitalisation: Rs.27,00,000
B. Capital structure : Rs Proportion/Mix(%)
Equity share capital 18,00,000 66.66
Pref. sharecapital 5,00,000 18.52
Debenture 4,00,000 14.82
27,00,000 100.00
C. Financial structure: Rs. Proportion/Mix(%)
Equity 18 ,00,000 54.54
Pref share 5,00,000 14.28
Debenture 4,00,000 11.42
R/E 6,00,000 17.14
Capital Surplus 50,000 1.42
Current liabilities 1,50,000 4.26
35,00,000 100.00
Note: Some school of thought include R/E, Capital surplus also for the purpose of capital structure.
Factors affecting Financing Decisions
The following important factors are :
1. Cost: Financing decisions are all about allocation of funds and cost-
cutting. The cost of raising funds from various sources differ a lot. The
most cost-efficient source should be selected.
2. Risk: The dangers of starting a venture with the funds from various
sources differ. Larger risk is linked with the funds which are borrowed,
than the equity funds. This risk assessment is one of the main aspects of
financing decisions.
3. Floation cost:The cost involved in issuing securities such as broker’s
commission, underwriter’s fees, expenses on prospectus etc. Higher the
flotation cost, less attractive is the source of finance.
***
4.Cash flow position: Cash flow is the regular day-to-day earnings of the
company. Good or bad cash flow position gives confidence or discourages
the investors to invest funds in the company.
5. Control: In the situation where existing investors need to hold control of
the business then finance can be raised through borrowing money,
However, when they are prepared for diluting control of the business,
equity can be utilized for raising funds. How much control to give up is
one of the main financing decisions.
6. Condition of the market: The condition of the market matter a lot for the
financing decisions. During boom period issue of equity is in majority but
during a depression, a firm will have to use debt. These decisions are an
important part of financing decisions.
Factors affecting capital structure
The following main factors are :
1. Trading on equity(TOE): It is also known as 'Financial Leverage'. Proportion of debt
capital to total capitalization. TOE is the ratio of net rate of return on shareholders' equity
and net rate of return on total capitalisation.
It is an arrangement under which a company makes use of borrowed funds including
pref capital i.e bearing a fixed rate of interest or dividend in such a way as to increase the
rate or return on equity share i.e Taking advantage of ordinary equity to borrow funds.
Fo eg: Suppose a company requires a total sum of Rs 5,00,000 which may fetch a return
of 10%. If the company raises its entire capital by the issues of equity share, it can not
declare a dividend at more than 10% (Rs 5,00,000X10/100=50,000). But suppose the
company raised Rs.5,00,000 (the entire investment) in the following manner.
i. Issuing 6% debenture Rs.2,00,000
ii Issuing 8% preference share Rs.1,00,00
iii.Issuing equity share Rs. 2,00,000
***
In this case, the company will have to pay out of the profits of Rs. 50,000
by
6% debenture =2,00,000X6/100 =12,000
8% preference share =1,00,000X8/100 =8, 000 20,000
Available profit for the equity holders 30,000
Rate of dividend for equity =30,000/2,00,000X100=15%
In this way, the rate of dividend on equity share capital can be
increased by issuing debenture or prference shares bearing a rate of
interest/dividend below the general rate of return.
Company will also have an advantage in the saving of income tax as
interest paid on debenture is a deductible expense. This double advantage
tempts the management to trading on equity.
***
2. Desire/Retaining control i.e issuing more debt for retaing control.
3. Period of finance: Short term -borrowed funds i.e debenture or redeemable
pref.share, Long term/permanent -equity is better.
4. Elasticity of capital structure -Flexiblity-i.e redeemable pref. share ,
debenture
5. Cost of capital - minimu cost of capital - debt is cheaper than equity, less
risk
6. Market conditions-boom -equity- depression- debt
7. Legal restriction: Banking regulation Act- issue equity only.
8. size of the company- small - own, large -both
9.Govt policy- SEBI, fiscal and monetary policy, lending policy etc.,
Capital Structure Theories
The capital structure theories explore the relationship between company's use of
debt and equity financing and the value of the firm. We will discuss these theories
one by one. The capital structure theories use the following assumptions for
simplicity: The firm uses only two sources of funds: debt and equity.
Whether a firm can affect its total valuation (debt plus equity) and its cost of capital
by changing its financing mix. Theories explain the relationship between capital
structure,cost of capital and value of the firm. These are as follows:
1. Net Income Approach(NI approach)
2. Net operating Income Approach(NOI approach)
3. Traditional approach
4. Modigliani-Miller Approach(hypothesis)
1. Net income approach(NI)
Suggested by the Durand, the value of the firm may be enhanced by lowering its
cost of capital. Thus value of the firm depends on its capital structure decision.
The theory propounds that a company can increase its value and reduce the
overall cost of capital by increasing the proportion of debt in its capital structure.
Value of the firm (V)= S+T OR S=EBT/Ke
Where S= MV of the equity , T= MV of the debt
Equity capitalization rate= Ke=EBT/S
Overall Capitalization Rate= EBIT/V
This approach based on the following assumptions:
i. the cost of debt is less than the cost of equity
ii. there are no corporate tax.
iii.the risk perception of investors is not changed by the use of debt
***
• Argument in favour of net income approach is that as the proportion of
debt financing in capital structure increases the proportion of an
expensive sources of funds decreases.
• This results in the decrease in the overall cost of capital leading to an
increase in the value of the firm. The reason for assuming cost of debt
to be less than the cost of equity are that interest rates are lower than
dividend rates due to element of riks and the benefit of tax as the
interest is deductible expense.
Excercise 1
• A company expect a net income of Rs 80,000. It has Rs 2,00,000 at
8% debetures. The equity capitalization rate of the company is 10%.
i. Calculate the value of the firm and overall capitalization rate
according to NI approach(ignoring income-tax)
ii. If the debeture debt is increased to 3,00,000.
What shall be the a. value of the firm and b. the overall capitalization
rate?
 Value of the firm&overall COC
Rs i. ii
• Net Inccme ie. EBIT 80,000 80,000
• Less Interest on debenture @ 8%(2L/3L) 16,000 24,000
Earning available to equity (EBT) 64,000 56,000
Equity capitalization rate (Ke) 10% 10%
Market value of equity:(S) EBT/Ke(64,000/10 X 100) Rs 6,40,000 5,60,000(56000/10x100)

Market value of debenture(T) =Rs 2,00,000 3,00,000 (+1Lakh)

Total Value of the firm (V) 8,40,000 8,60,000
Overall capitalization rate = EBIT/V
i. 80,000/8,40,000 X 100 = 9.5% 9.30%
ii. 80000/8,60,000 X100
*It is relevant that incresing debt content in the Capital structure would increses the value
of the Firm and decrease the overall COC.
Exercise 2

i) X Ltd is expecting an annual EBIT of Rs 2 Lakhs. The company

has 8% debentures of Rs 5 Lakhs. The cost of equity or capitalization
rate is 10% .
ii) If the company determines to raise Rs 2 lakhs (7L) by issue of 8%
debenture.
iii) If the company determines to redeem debenture of Rs 2 lakhs, ie.
3 Lakhs.
Compute the total value of the firm and over all cost of capital.
Value & Overall COC
i) Rs. 21 Lakhs- 9.52%
ii) Rs. 21,40,000 - 9.35%
(2,00,000-56,000=1,44,000
= capitalization rate 10% of MV =1,44,000/10X100=14,40,000
Total value V =(14,40.000 +7,00,000=21,400,000 )
=2,00,000/21,40,000x100
=9.35% Increase debt contents from 5L to 7L , decrease overall cost of
capital and increase the value of the company.
iii) Rs. 20,60,000-9.72% ( reduce the debt content may increase the
overall cost of capital and reduce value of the firm.
2. Net operating Income approach(NOI)
David Durand identified the extreme two NI & NOI approach in capital structure
theories. The value of a firm depends on its net operating income and business risk
and not in debt -equity mix. NOI approach, there is no relationship between market
value of the firm and Change in debt- equity ratio /mix. This approach is opposite
to NI approach based on the following assumptions:
Assumptions:
a. The overall cost of capital (K) remains constant for all degrees of leverages(i.e
debt and equity mix)
b. the NOI is capitalized at an overall capitalization rate to find out the total market
value of the firm. The split in debt and equity is irrelavant.
c. There are no corporate taxes.
d. The use of low cost debt enhances the risk of equity shareholders, this in turn,
enhances the equity capitalization rate. Thus the benefit of debt is nullified by the
increase in the equity capitaization rate.
***
• V= EBIT/Kw
where, V-Value of the firm, Kw -Overall cost of capital
Value of equity S=V-T
Where , V- value of the firm, T -value of the Debt
Market value of Equity = EBIT-I / Ke Or EBT/Ke
Equtiy Capitalization Rate- Ke-EBT/Sx100
The division between debt and equity is not relevant. An increase in the
use of debt funds which are apparently cheaper' is offset by an increase in
the equity capitalization rate. This occurs because the equity investors seek
more compensation as they are exposed to higher risk arising from increase
in the degree of leverage.
Excercise 3 value of the company
• XYZ Ltd has an EBIT of Rs 2 lakhs.The company has 8% debenture of
Rs. 5 Lakhs. Presuming the overall capitalization rate as 10% ,
• Compute the total value of the company and the equity capitalization rate.
EBIT Rs 2,00,000
Overall capitalization rate (Kw) 10%
• Market value of the company (V):
2,00,000/10X100= 20,00,000
Total value of debt 5,00,000
S (V-T) 15,00,000
Equity capitalization rate (Ke):
Ke= EBT=1,60,000/15,00,000X100 = 10.67%
Excercise 4
• ABC co Ltd has an EBIT 1,00,000, the company has 10% debt of Rs. 5
lakhs and the overall capitalizatio rate 12.5%.
• Compute total value of the firm and equity capitalization rate.
EBIT 1,00,000
Overall capitaliztion rate =10%
• Market value of the firm(V):
EBIT/Ke= 100,000/12.5X100= 8,00,000
value of debt = 5,00,000
S(V-T) 3,00,000
Equity capitalization rate Ke
= EBT/SX100= 1,00,000- 50,000/3,00,000x100 =16.67%
3.Traditional approach
• This approach intermediate approach, compromise between the two approach . But
support the view for the use of debt capital reduces the overall cost of capital and increase
the value of the firm. The capital structure that gives highest value to the firm and lowest
cost of capital is the optimum one.
• The cost of capital is dependent on the capital structure and there is an optimal capital
structure which minimizes the cost of capital. The optimum capital structure is the point at
which the overall cost of capital is the minimum or value of the firm maximum.
• It is partly contains the charateristics of both approaches are:
i. it accept that Capital Structure is dependent on cost of capital & its value but does not
subcribe to the NI approach that value of the firm will necessarily enhance with all levels of
leverage
ii it subcribes to NOI that after attaining a certain level of leverage, the Overall cost of
capital enhances resulting in decline in the total value of the firm. But it varies from NOI
approach in the sense that the Overall cost will not remain constant for all level of leverage.
4. Modigliani-Miller(M-M hypothesis) approach

• This approach which is similar/support the NOI approach. The total market value the
firm and cost of capital are independent of its capital structure.He states that this
situation can not remain for long period by virtue of the operation of Arbitrage process
ie. buy at lower price & sell at higher price upto value of two firms are identical.
Assumption:
• a. existence of perfect capital market-information is freely avilable, no restriction, free
to buy or sell.
• b. Homogeneous expectations of investors
• c. all firms can be classified into uniform risk classes.
• d.The dividend pay out ratio is 100%
e corporate tax- removed now
M-M has has developed two preposition:
i. The market value of the firm and its cost of capital are independent.
ii.The firm's use of debt increases , its cost of equity also rises.
Interpretation of M-M hypothesis
• The proposition i) and ii) are combined, the inclusion of more debt in
the capital structure of a firm will not increase its value because the
benefits of cheaper debt capital are exactly offset by the increase in the
cost of equity.Thus, a firm can not change its total value (V) or its
WACC by leverage.
• The financing decision does not matter from the objective of
maximising the market price per share. In other words, the value of the
firm is completely unaffected by its capital strcture.
• Criticism of M-M hypotheis was not always correct and appropriate.
Proof of M-M-Argument -The Arbitration process
• M-M , The proof is based on the arbitrage/switching mechanism. They argue
that if two firms differ only i) in the way they are financed , and ii) in their
total market values, investors will sell shares of the overvalued(High price)
firm and buy the shares of the undervalued firm.
• This process will cotinue till the two firms have the same market values. M-
M argue that this situation (value of levered firm exceeds that of the
unlevered)can not continue as arbitrage will drive the total values of the two
forms together.
• Arbitrage is an act of buying an asset of security in one market having lower
price and selling it in another market at a higher price. The result of such an
action is that the market price of the securities of the two firms cannot remain
different for long period in different markets(firms are similar in all aspects
except capital structure). Thus the equilibrium in value of securities can be
restored with the help of arbitration process.
ANALYSIS OF LEVERAGE

Leverage denotes the ability of a firm to use fixed cost assets or funds to
magnify the return to the shareholders. The policy of using debt capital in the
capital structure is called leverage. There are two aspects of it.
• It arises out of operating fixed cost and is referred to as operating leverage
• It arises out of financing by fixed cost- bearing instruments i.e debt capital
and preference share capital and is referred to as financial leverage.
The use of leverage implies that, other things constant, a relatively small
change in sales results in a large change in income (EBIT). It may be
mentioned that leverage may occur in varying degees. The higher the degree of
leverage, the greater is the risk. But at the same time, it also increases the
possibility of higher rate of return to the shareholders. Hence, the term “Risk'
implies the degree of uncertainty that the firm has to face in meeting fixed -
payment obligation i.e operating fixed cost ,cost of debt,and preference share
capital.
 ***
Operating Leverage indicates the degree of operating risk( i.e variability
in EBIT due to the risks inherent in the operations of the firm) while
financial leverege signifies the degree of financial risk of the firm.
The combine effect of operating and financial leverage(i.e Combined
leverage) provides a risk profile ot the total risk of the firm.
The capital structure refers to the proportion of different kinds of
securities raised by a company as long term finance.
Capital Gearing
Capital gearing is the relationship between the owned capital and
borrowed capital i.e ratio between various kinds of securities to the total
capitalization
High gear- ownership capital is less than the creditorship capital i.e
more amount of debt capital in the capital structure
Low gear- Ownership capital is greater than creditorship capital. Loe
gear is prefer low gear during initial period like operating in automobile.
Discuss example: C/S 40 L = 30 L equity & 10L Debt=3:1 low gear and
vice-versa high gear.
Types of leverages
There are three types of leverages. They are:
1. Operating Leverage(OL): It refers to the use of fixed costs in the operation of a firm. If
the fixed cost to total cost is NIL, it should not have operation levearage. The OL is
defined as the tendency of the operating profit to vary disproportinately with sales.Thus
operating leverage appears from the existence of fixed operating expenses.
OL is the firm's ability to use Fixed operating costs to magnify the effect of change in
sales on its EBIT.
OL is the function of three factors:
a. the amount of fixed costs, b. the contribution margin, c. the volume of sales. It can be
calculated:
=Contribution /Operation profit I.e EBIT
This may be either favourable or adverse. If favourable is contribution is more than the
Fixed cost and in opposite case, is termed as adverse.
Degree of Operating Leverage
It is defined as the percentage change in the profit resulting from a percentage change
in the sales. The degree of OL:
DOL= % change in Profits/ % change in Sales or C/OP
A firm should have high degree of OL:
= It employes a large amount of Fixed cost and small amount of variable cost.
A firm is said to have a low degree of OL:
= It occures a large amount of variable cost and small amount of Fixed cost.
A firm's small change in sales should have a large impact on its operating income
if it has a high degree of OL. In other words, the operating profits of such a firm will
go up at a faster rate than the increase in sales.
Similarly, the Operating profits of such a firm will suffer a heavy loss in comparision
with the reduction in its sales i.e a small reduction in sale leads to an excessive
damage to the firm's efforts to attain proitability.
Excercise 1
The installed capacity of a manufacturing concern is 1200 units. The actual capacity used is 800
units .Selling price per unit is Rs 10. Variable cost is Rs 7.
Compute the operating leverage in the following situations:
i. When Fixed cost is Rs 300, ii.When Fixed cost is Rs 800, iii. When Fixed Cost is Rs 1200.
Statement showing OL
S1 S2 S3
Sales 8,000 8,000 8,000
VC 5,600 5,600 5,600
Contribution(S-VC) 2,400 2,400 2,400
FC 300 800 1,200
Operating Profit(C-FC) 2,100 1,600 1,200
OL C/OP 2,400 2,400 2,400
2,100 1,600 1,200
=1.14 =1.50 =2.00
Interpretations
• DOL increases with every increase in the share of fixed cost in the total cost structure of
the firm. it shows that situation S3 the amount of sales changes by one, the profit will
change by 2 times. This can be examined by S3 when sales increase Rs 8000 to Rs
16,000, the prfoit will be as under:
• sales 16,000
VC 11,200
Contribution 4,800
• FC 1,200
Profit 3,600
If sales enhanced from Rs. 8000 to 16,000 i.e +100%. The operating profit has enhanced
Rs 1,200 to 3,600 i.e 200.
DOL= % change in Income/ %change in sales=200/100=2
In fact , the OL exists only when the quotient in the above equation is more than one .
 Excercise 2
• The installed capacity of a factory is 600 units. actual capacity is 400 units. Selling price
per unit Rs 10. Variable cost Rs 6 p.u. Calculate OL in each of the following situations:
• i. When FC Rs. 400, ii.when Fc is Rs 1,000, iii. WhenFC is Rs 1,2000.
Ans: i.OL= C/ EBIT=1600/1200=1.33, ii. 1600/600=2.67, iii.1600/400=4.00 .
If sales enhanced from Rs. 4000 to 8,000 i.e 100% .The operating profit has enhanced Rs
400 to 1,600 i.e 400%
Sales Rs 8000
VC 4800 3200
FC 1200
Operating profit 2000
DOL= %change in Income/%change in sales= 400/100=4 times,
There is a100% increase in sales for 400% increase in Profits. It indicate that every
increase of one rupees is sales ,the profit will increase four times i.e 400%. In fact , the
OL exists only when the quotient in the above equation is more than one.
2. Financial Leverage(FL):
• Financial leverage is the use of fixed financiang cost i.e interest/dividend
bearing secutities such as debt, preference share along with owner's equity in
the total capital structure. It signify the existence of fixed cost securities in the
total capital structure of the company.
• The leverage is said to be high when the fixed financing cost such as interest/
divided bearing securities are more than the equity in the capital structure of
the company and vice-versa.More int/divided payment could decrese the
earning per share.
• Finalcial leverage is also known as Trading on equity(TOE). but the trading on
equity is used for only when the FL is favourable i.e earning exceeds the fixed
cost and vice -versa. If unfavourable or negative leverage does not earn as
much as Fiancial costs.
• In other words, FL is the ratio relationship of debt to total capital in the capital
structure. ie. percentage of debt capital in the capital structure.
Degree of financial leverage(DFL):

Potential of increasing return to the equity shareholders' and it indicates

change in taxable income as a result of changes in Operating profit. The
earning per share( EPS) will increase due to using debt fund.
Degree Financial leverage =Operating profit/ PBT or EBIT/PBT
Excercise 3:A firm has a choice of the following three financial plans.
Compute the Financial leverage in each situations and interpret it.
Interest@10% on debt in all situations:
A(Rs) B(Rs) C(Rs)

Equity share capital 4.000 2,000 6,000

Debt 4,000 6,000 2,000

Operating profit/EBIT 800 800 800

Computation of Financial Leverage
A(Rs) B(Rs) C(Rs)

Operating profit 800 800 800

LESS Interest@10% 400 600 200

PBT 400 200 600

FL =OP/PBT 800/400=2 800/200=4 800/600=1.33

***

• FL indicates the change that will take place in the taxable income on account of change
in the operating income. For example, considering situation 'A' as the basis, in case the
OP reduces from Rs 800 to Rs 400 (-50%), its effect on taxable income is as follows:
operating profit/EBIT Rs 400
Less Interest 400
Profit Before tax NIL
FL in situation 'A' is 2 . It indicates that every 1% change in operating profit results
in 2% change in the taxable profit.
In the above situations operatig profit has reduced from Rs 800 to Rs 400(i.e 50%). As a
result of taxable profits has reduced from Rs. 400 to Zero( i.e 100%).
The degree of FL = % change in Taxable income/ % change in the OP
= 100/50=2 i.e DFL is 2.
Note: The financial manager must plan to increase EBIT otherwise the company goes to
liquidation. A higher degree of financial leverage means that the company has more
volatile EPS.
***
• The degree of financial leverage is calculated by dividing the
percentage change in a company's EPS by its percentage change in
EBIT.
• The ratio indicates how a company's EPS is affected by percentage
changes in its EBIT. A higher degree of financial leverage means that
the company has more volatile EPS.
Excercise 4
A comapny has a choice of the following three Financial plan Required
to calculate the Financial leverage in each case & interpret it.
Interest on debt @10%.
X(Rs) Y(Rs) Z(Rs)

Equity capital 2,000 1000 3,000

Debt 2,000 3,000 1,000

Operating profit 400 400 400

***
X(Rs) Y(Rs) Z(Rs)
EBIT/OP 400 400 400

INTEREST 200 300 100

PBT 200 100 300

FL 400/200=2 400/100=4 400/300=1.33

the change that will take place in the taxable income as a result of change in the
operating profit. if plan X OP Decrease from Rs 400 to Rs 200(-50%) the impact of taxable
income will be decresed to 100%. i.e Op 200
- Interest 200
PBT NIL.
DFL= 100/500=2
ii.When capital structure comprises preference and equity share

EBIT XXX
- Pref. dividend XXX
PBT XXXX
iii.When capital structure comprises equity, Pref.share, Debt capital:
EBIT XXX
-Pref Dividend XX
- Interest XX XXX
PBT XXXX
Note: After clculating PBT, remaining should continue the same as in
the previous excercise.
 3. Combined/composite Leverage or Total Leverage
• The total risk involved in afirm can be determined by combined the operating and
financial leverages. It may be recalled that operating leverage is determined by the
cost structure and , therefore, by the nature of the operating of a firm. Financial
leverage, on the otherhand, is determined by the mix of debt-equity funds to
finance the firm's assets. therefore, the combined effect of operating and financial
leverage provides arise profile of the firm.
• Combine leverage= OLXFL
Degree of Combined Leverage = DOLXDFL
i.e % change in EBIT/%change in saleX % Change in EPS/ % change in EBIT
= % change in EPS/% change in Sales
alternatively, at any given level = Contribution /PBT
(when Debt & pref. share capital used)
***
• The Utility of combined leverage lies in fact that it signifies the effect that
the change in sales will have on the EPS or the EBIT, as the case may be.
Since the changes may be positive (increase in sales) or negative (decrease
in sales), the combine leverage may be favourable or unfavourable. As a
general rule, a firm having a high OL should have a low FL and vice-versa.
• If both the leverage of the firm are at a high level, it will be a very risky
proportion becauses the combined effect of the two is a multiple of these
two leverages .Therefore, if a firm, has a high OL, the FL should be kept
low. A firm has low OL, it can opt for a high FL by changing its debt-
equity mix.
• While planning combined leverage of a firm, attention should first be
given to OL. FL is the superstructure which should be built-up on the
foundation that is provided by a low OL. Only a proper balancing between
the two can provide an ideal combined leverage.
 Excercise 5
A firm's sales is Rs.2 lakhs.The variable cost is 30% of the sales.The
fixed operating cost Rs.50,000.the amount of interest on long term debt
is Rs. 15,000. Compute the composite leverage and also effect in case
sales increase by 10%
Statement of composite leverage (Rs)
sales 2,00,000
less Variable cost (30% on sales) 60,000
Contribution(C) 1,40,000
Less Fixed Operating cost 50,000
EBIT/OP 90,000
Less Interest 15,000
PBT 75,000
Combined leverage C/PBT= 1,40,000/75,000=1.87 this implies that with every change
1% sales ,the taxable incomes changes by 1.87.
 If sales increase by 10%
Rs.
Sales (10% increase) 2,20,000
Less VC (30% sales ) 66,000
Contribution 1,54,000
Less FC 50,000
EBIT 1,04,000
Interest 15,000
Taxable income(PBT) 89,000
Increase in Percentage of profit-=89000-75000=Rs. 14000
Increase in profit/ Base profit
= 14,000/75,000X100= 18.67%
Excercise 6
ABC Ltd. has sales of Rs 10,00,000 Variable cost Rs 7,00,000 and Fixed costs of Rs
2,00,000 and a debt of Rs.5,00,000 at 10% rate of interest. i. Compute the OL, FL
and combined leverage.b. if the company likes to double its EBIT, how much of a
sales would be needed on percentage bais?
Operating Leverage=C/OP=300,000/1,00,000=3
Financial leverage=OP/PBT=1,00,000/50,000=2
Combined leverage= PLXFL=3X2=6
Profit at present:
Sales Rs 10,00,000
Vc 7,00,000
Contribution 3,00,000
FC 2,00,000
EBIT 1,00,000
Interest (10% on %Lakhs) 50,000
PBT 50,000
Financial decision
Operating leverage is 3 times. This implies that in case sales increase by
100%, operating profit (EBIT) will increase by 300%(ie. 3 times increase in
sale).
Thus if the company wants to double it EBIT(i.e 100% rise),then a 33.33%
(100/300X100) rise in sales will be required. This is confired by the
following calculations:
Sale (+33.33% ) 13,33,333
-VC 9,33,333
Contribution 4,00,000
-Fixed cost 2,00,000
Operating profit 2,00,000
Degree of Leverages
Formula for calculating degree of leverages are:
1. DOL= % change in OP / % change in sales volume>1
alternatively, DOL can be measured at any level of output(Q) as:
Contribution/Operating profit or EBIT
If high degree of OP, greater is the operating risk associated with the firm and
vice-versa. High opearting leverage is welcomed when sales are raising and it is
undesirable when sales are falling. This is because a higher degree of OL implies
a relatively high operating fixed costs, for recovering which a large volume of
sales is required. positive impact on that arise out of an increase in sales
represents a favourable leverage. Similarly, decrease in sales has a negative
impact on the operating profit and implies an unfavourable leverage. In profit
planning, the objective is to maximise profit or minimize loss. Therefore,
unfavourable or negative leverage impact on profit (due to in decrease sales) is
not desirable.
***
2. DFL
= % change in EPS/ % chnage in EBIT>1,
Alternatively , the DFL can be mesured at any level of the OP
(EBIT)as : = OP/PBT
Financial decision of the firm, how much to be financed by fixed cost
bearing capital(debtand pref.share) and how much by equity.
3.DCL
• the combined effect of operating and financial leverage provides arise
profile of the firm.
• Combine leverage= OLXFL
Degree of Combined Leverage = DOLXDFL
i.e % change in EBIT/%change in saleX % Change in EPS/ %
change in EBIT
= % change in EPS/% change in Sales
alternatively, at any given level = Contribution /PBT
(when Debt & pref. share capital used)
Excercise 7

• Calculate DOL,DFL,DCL for the following firms and interpret the

results:
P(Rs) Q(Rs) R(Rs)
Ouput(units) 3,00,000 75,000 5,00,000
Fixed cost(Rs) 3,50,000 7,00,000 75,000
VC p.u 1.00 7.50 0.10
Interest expenses (Rs) 25,000 40,000 NIL
selling price p.u (Rs) 3.00 25.00 0.50
Degree of leverage(DOL,DFL and DCL)
P(Rs) Q(Rs) R(Rs)

Sales 9,00,000 18,75,000 2,50,000

less VC 3,00,000 5,62,500 50,000
Contribution 6,00,000 13,12,500 2,00,000
LessFC 3,50,000 7,00,000 75,000
EBIT 2,50,000 6,12,000 1,25,000
Less Interest 25,000 40,000 -
PBT 2,25,000 5,72,000 1,25,000
1.DOL=C/OP 6,00,000/2,50,000=2.4 13,12,500/6,12,500=2.14 2,00,000/1,25,000=1.60
2DFL=OP/PBT 2,50,000/2,25,00=1.11 6,12,500/5,72,500=1.07 1,25,000/1,25,000=1.00
3.DCL=C/PBT 6,00,000/2,25,000=2.67 13,12,500/5,72,500=2.29 2,00,000/1,25,000=1.60
Financial decisions &comments
• In the above statement, DOL reveals that in case there is change in sales by 1%,
there is corresponding change in OP by 2.4%,2.14% and 1.6% in case of the firms
P,Q,R respectively. On the contrary, the DFL shows that in case OP changes by 1%
there will be a corresponding change in EPS by 1.11%, 1.07% and 1% in the case of
the firms P,Q R. Similarly, DCL,shows that in case sales changes by 1% the
corresponding change in EBT by 2.67,2.29,1.60 in the case of the firms P,Q &R
respectively.
• It is also seen from the above statement that firm P' has all the above three highest
leverage followed by Q and R. However, the DFL is less than DOL in all the cases.
As a general rule, a firm having a low FL should have a high OL. Combined
leverage is the results of these two leverages and measures the total risk of the firm.
Hence, if the two leverages are high,no doubt, it is a very risky one. In case a firm
enjoys low financial leverage and high operating leverage, it can partly adjust/dilute
the effect of the high operating leverage.This condition is fulfilled in all the three
firms.
***
• A low OL implies high controllable costs(VC) and low uncontrollable
costs(FC) and,therefore, a less risky situtions. A high FL suugests that
a firm has adequaltely taken help of fixed interest-bearing securities,
while planning its capital structure, in order to increase the return to
the shareholders.
• Thus, it is desirable that a firm has low OL and a high FL. Viewed this
angle, none of the three firms can claim to have adopted an ideal
combination of leverages.
Uses or significance of leverages
• Leverage refers to the use of fixed costs in an attempt to increase the profitability.
Leverage affects the level and variability of the firm's after tax earnings and hence, the
firm's overall risk and return. The study of leverage is significant due to the following
reasons.
• Measurement Of Operating Risk: High operating leverage is good when sales are rising
but bad when they are falling.
• Measurement Of Financial Risk: High financial leverage is good when operating profit is
rising and bad when it is falling.
• Managing Risk:obtain a desirable degree of total leverage and level of total firm risk.
• Designing Appropriate Capital Structure Mix: One widely used means of examining the
effect of leverage to analyze the relationship between EBIT and earning per share:
• Increase Profitability:Leverage is an effort or attempt by which a firm tries to show high
result or more benefit by using fixed costs assets and fixed return sources of capital
EBIT-EPS analysis
• This analysis is very useful for examining the effect of Financial leverage on the
behaviour of the EPS:
• i. Under alternative Financial plans, and ii. with varying level of EBIT.
when EPIT-EPS analysis is ued to determine the optimum capital mix of various
sources (equity,Pref.share, debt) at a point of time.
Simply put, EBIT-EPS analysis examines the effect of financial leverage on the EPS
with varying levels of EBIT or under alternative financial plans. EBIT-EPS analysis
is used for making the choice of the combination and of the various sources. It helps
select the alternative that yields the highest EPS(maximum return to the equity).
EBIT-EPS analysis is a technique used to determine the optimal capital structure
in which the value of earnings per share (EPS) has the highest amount for a given
amount of earnings before interest and taxes (EBIT).
CALCULATION OF EPS
ABC Co. Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given
as under:
EBIT-EPS ANALYSIS
Risk in Financial Leverage
• The higher the DFL, the greater is the financial risks associated and
vice-versa.
• Financial risk rfer to the ability of the firm to cover it fixed financial
charges due to a variation in the EBIT. the greater the amount of fixed
financial charges,the larger is the EBIT required to cover them.Thus,
in the event of greater variability of the EBIT, a firm with a high level
of fixed financial charges is exposed to more nad more financial risk.
***
• The DFL can be favourable or unfavourable. If the effect on the EPS is
positive(i.e arising out of increase in EBIT) ,the leverage is favourable. On te
otherhand, a negative impact on the EPS(arising out of decrease in the EBIT)
implies unfavourable. Unfavourable is not desirable.Under favourable market
condition, a firm having ahigh DFL will be in better position to increase the
ROE or EPS. Thus, a high DFL is welcomed under favourable operating and
market condition, alow DFL will enable a firm to absorb fiancial risk more
when sales are falling.
The selection of Financial risk by:
• i. The risk(DFL) remain constant,select alternative that gives higher rate of
return(EPS)
• ii. The return remain constant, select the alternative that shows a lower
Degree of risk.
Co efficient of variation(Excrcise-Refer material)
Finacial Plan:

EPS I(Rs) II*Rs III(Rs) IV(Rs)

EBIT:Rs.3.5Lakhs 2.5 2.1 1.7 1.8

EBIT:Rs 7 L 5.0 5.3 5.2 5.0

EBIT: 10.50L 7.5 8.5

α 8.7 8.2

EBIT: Rs15 L 10.7 12.6 13.2 12.3

Mean(Rs)=∑ x/n=25.7/4 6.4 7.1 7.2 6.8

Standard deviation(Rs) 3.04 3.9 4.3 3.9

= √ (X-X)2/n=
Coefficient of variation 3.04/6.4x100 =54.9% =59.7% =57.4%
= SD/MeanX100 =47.5%
Standard deviation= √∑ D2/n
X X- 6.4 = D D2

2.5 3.9 15.21

5 1.4 1.96

7.5 1.1 1.21

10.7 4.3 18.49 =

∑d2=36.87/4
Mean= 25.7/4=6.4 PLAN I = √9.2175=3.04
Like that S.D of Plan II,III,IV, 3.9, 4.3,3.9
respectively.
END OF UNIT 3

THANK YOU TO ALL