CHAPTER 14 FINANCIAL AND OPERATING LEVERAGE

Capital Structure Defined

2

 The term capital structure is used to represent the

proportionate relationship between debt and equity.

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 The various means of financing represent the financial
structure of an enterprise.

 Capital structure is defined as debt plus equity.

 Some authors exclude short-term borrowings from the

definition of capital structure. Thus, capital structure
may imply long-term debt plus equity.

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 The capital structure
decision process
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Financial Management, 12e I M Pandey
 While making the Financing Decision...
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 How should the investment project be financed?

 Does the way in which the investment projects are

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financed matter?
 How does financing affect the shareholders’ risk, return
and value?
 Does there exist an optimum financing mix in terms of the
maximum value to the firm’s shareholders?
 Can the optimum financing mix be determined in practice
for a company?
 What factors in practice should a company consider in
designing its financing policy?

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 Meaning of Financial Leverage
5

 The use of the fixed-charges sources of funds, such as debt (and

preference capital) along with the owners’ equity in the capital

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structure, is described as financial leverage or gearing or trading
on equity.
 The financial leverage employed by a company is intended to earn
more return on the fixed-charge funds than their costs. The surplus
(or deficit) will increase (or decrease) the return on the owners’
equity. The rate of return on the owners’ equity is levered above or
below the rate of return on total assets.

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 Measures of Financial Leverage
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 Debt ratio: Debt/(Debt + Equity)

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 Debt–equity ratio: Debt/Equity
 Interest coverage: EBIT/Interest or EBITDA/Interest
 The first two measures of financial leverage can be
expressed either in terms of book values or market values.
These two measures are also known as measures of
capital gearing.
 The third measure of financial leverage, commonly known
as coverage ratio. The reciprocal of interest coverage is a
measure of the firm’s income gearing: Interest/EBIT or
Interest/EBITDA.

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 Financial Leverage and the
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Shareholders’ Return
 The primary motive of a company in using financial leverage is
to magnify the shareholders’ return under favourable

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economic conditions.

 Assumption debt can be obtained at a cost lower than the firm’s

rate of return on net assets (RONA or ROI).

 EPS, ROE and ROI are the important figures for analysing the
impact of financial leverage.

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 EPS and ROE Calculations
8

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 For calculating ROE either the book value or the market value
equity may be used.

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 Analyzing Alternative Financial Plans:
Constant EBIT
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Effect of Financial Plan on EPS

 The firm is considering and ROE: Constant EBIT
two alternative financial

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plans:
 (i) either to raise the entire
funds by issuing 50,000
ordinary shares at Rs 10 per
share, or
 (ii) to raise Rs 250,000 by
issuing 25,000 ordinary
shares at Rs 10 per share and
borrow Rs 250,000 at 15 per
cent rate of interest.
 The tax rate is 50 per cent.

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 Interest Tax Shield
10

 The interest charges are tax deductible and,

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therefore, provide tax shield, which increases the
earnings of the shareholders.

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 Effect of Leverage on ROE and EPS
11

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Favourable ROI > i
Unfavourable ROI < i
Neutral ROI = i

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 Effect of Financial Plan on EPS and
ROE: Varing EBIT
12

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Financial Management, 12e I M Pandey
 Effect of Financial Plan on EPS and
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ROE: Varing EBIT

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Financial Management, 12e I M Pandey
 EBIT–EPS chart-Example
14

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 Calculation of indifference point
15

 The EPS formula under all-equity plan is

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 The EPS formula under debt–equity plan is:

 Setting the two formulae equal, we have:

𝑁1
𝐸𝐵𝐼𝑇 = × 𝐼𝑁𝑇
𝑁1 − 𝑁2
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 Example
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 A firm wants to raise ₹50,00,000 funds. It is considering two alternative financial

plans (i) an all-equity plan (50,000 shares at ₹100 per share) and (ii) a 50 % debt

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and 50% equity plan. Interest rate is 12% and tax rate is 35%. The firm wants to
know the level of EBIT at which EPS would be the same under both the plans.
 The company will issue 50,000 shares under all-equity plan and 25,000 shares
under debt-equity plan. It will raise debt of ₹25,00,000 and incur interest charges
of ₹300,000. Break-even EBIT can be calculated as follows:

0.65EBIT=
0.65EBIT=390,000
EBIT==₹600,000

 Alternate formula:

=₹600,000

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 Calculation of indifference point
17

 Sometimes a firm may like to make a choice between two

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levels of debt. Then, the indifference point formula will be:

 The firm may compare between an all-equity plan and an

equity-and-preference share plan. Then the indifference point
formula will be:

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 Operating Leverage
18

 Operating leverage
affects a firm’s operating

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profit (EBIT). % Change in EBIT
DOL 
 The degree of operating % Change in Sales
leverage (DOL) is defined  EBIT/EBIT
DOL 
as the percentage change in  Sales/Sales
the earnings before interest
and taxes relative to a
given percentage change in
sales.

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 Degree of Financial Leverage
19

 The degree of financial leverage (DFL) is defined

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as the percentage change in EPS due to a given
percentage change in EBIT:

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 Combining Financial and Operating
Leverages
20

 Operating leverage affects a firm’s operating

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profit (EBIT), while financial leverage affects
profit after tax or the earnings per share.

 The degrees of operating and financial

leverages is combined to see the effect of total
leverage on EPS associated with a given change
in sales.

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 Combining Financial and Operating
Leverages
21

 The degree of combined leverage (DCL) is given by the

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following equation:
% Change in EBIT % Change in EPS % Change in EPS
  
% Change in Sales % Change in EBIT % Change in Sales

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 Financial Leverage and the
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Shareholders’ Risk
 The variability of EBIT and EPS distinguishes between
two types of risk—operating risk and financial risk.

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 Operating risk can be defined as the variability of EBIT
(or return on total assets). The environment—internal and
external—in which a firm operates determines the
variability of EBIT
 The variability of EBIT has two components:
 variability of sales
 variability of expenses
 The variability of EPS caused by the use of financial
leverage is called financial risk. Financial risk is an
avoidable risk if the firm decides not to use any debt in its
capital structure.
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 Risk-Return Trade-off
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 If the firm wants higher return (EPS or ROE) for the

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shareholders for a given level of EBIT, it will have to employ
more debt and will also be exposed to greater risk (as
measured by standard deviation or coefficient of variation).

 In fact, the firm faces a trade-off between risk and return.

 Financial leverage increases the chance or probability of

insolvency.

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