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Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed returns. As a result, the earnings available to the shareholders/owners are affected as also their risk. There are three types of leverage, namely,
Leverage associated with asset acquisition or investment activities is referred to as the operating leverage. It refers to the firm’s ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits (EBIT) and results in more than a proportionate change (±) in EBIT with change in the sales revenue.
Degree of operating leverage (DOL) is computed in two ways:
1) Percentage change in EBIT/Percentage change in sales and
The operating leverage is favourable when increase in sales volume has a positive magnifying effect on EBIT. It is unfavourable when a decrease in sales volume has a negative magnifying effect on EBIT. Therefore, high DOL is good when sales revenues are rising and bad when they are falling.
The DOL is a measure of the business/operating risk of the firm. Operating risk is the risk of the firm not being able to cover its fixed operating costs. The larger is the magnitude of such costs, the larger is the volume of sales required to recover them. Thus, the DOL depends on fixed operating costs.
A firm sells products for Rs 100 per unit, has variable operating costs of Rs 50 per unit and fixed operating costs of Rs 50,000 per year. Show the various levels of EBIT that would result from sale of (i) 1,000 units (ii) 2,000 units and (iii) 3,000 units.
Solution
If sales level of 2,000 units are used as a base for comparison, the operating leverage is illustrated in Table 1
A firm sells its products for Rs 50 per unit, has variable operating costs of Rs 30 per unit and fixed operating costs of Rs 5,000 per year. Its current level of sales is 300 units. Determine the degree of operationg leverage. What will happen to EBIT if sales change: (a) rise to 350 units, and (b) decrease to 250 units?
Solution: The EBIT for various sales levels is computed in Table 2.
Alternative definition of Operating LeverageWhen proportionate change in EBIT as a result of a 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. Symbolically,
Since the DOL exceeds 1 in both the illustrations, operating leverage exists. However, the degree of operating leverage is higher (3 times) in the case of the firm in Example 2 as compared to the firm in Example 1, the respective quotients being 6 and 2. The quotients mean that for every 1 per cent change in sales, there will be 6 per cent (Examples 2) and 2 per cent (Example 1) change in EBIT in the direction the sales change.
Operating leverage exists only when there are fixed operating costs. If there are no fixed operating costs, there will be no operating leverage. Consider Example 3.
Example 3
Particulars Base Level New Level
1. Units sold 1,000 1,100
2. Sales price per unit Rs 10 Rs 10
3. Variable cost per unit 6 6
4. Fixed operating cost Nil Nil
Solution The relevant computations are given in Table 3.
TABLE 3 EBIT for Various Sales Volume
Particulars Base Level New Level
1. Sales revenues Rs 10,000 Rs 11,000
2. Less: Variable costs 6,000 6,600
3. Less: Fixed costs — —
4. EBIT 4,000 4,400
Applying Equation 1, DOL = 1. Since the quotient is 1, there is no operating leverage.
Financial leverage is related to the financing activities of a firm. It results from the presence of fixed financial charges (such as interest on debt and dividend on preference shares). Since such financial expenses do not vary with the operating profits, financial leverage is concerned with the effect 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 effect of changes in EBIT on the earnings per share (EPS).
The financial manager of the 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 per cent bonds aggregating Rs 40,000, while the 10 per cent preference shares amount to Rs 20,000. What would be the earnings per share (EPS)? Assuming the EBIT being (i) Rs 6,000, and (ii) Rs 14,000, how would the EPS be affected? The firm can be assumed to be in the 35 per cent tax bracket. The number of outstanding ordinary shares is 1,000.
Solution
TABLE 4 EPS for Various EBIT Levels
Case 2 Base Case 1
–40% +40%
EBIT Less: Interest on bondsEarnings before taxes (EBT) Less: Taxes (35%)Earning after taxes (EAT) Less: Preference dividendEarnings available for ordinary shareholdersEarnings per share (EPS)
A company has Rs 1,00,000, 10% debentures and 5,000 equity shares outstanding. It is in the 35 per cent tax-bracket. Assuming three levels of EBIT (i) Rs 50,000, (ii) Rs 30,000, and (iii) Rs 70,000, calculate the change in EPS (base level of EBIT = Rs 50,000).
Solution
TABLE 5 EPS at Various EBIT Levels
Case 2 Base Case 1
–40% +40%
EBIT Less: interestEarnings before taxes Less: TaxesEarning after taxesEarnings per share (EPS)
Rs 30,00010,00020,000
7,00013,000
2.6
Rs 50,00010,00040,00014,00026,000
5.2
Rs 70,00010,00060,00021,00039,000
7.8
– 50% +50%
Thus, a 40 per cent increase in EBIT in case 2 from the base level of EBIT has led to 50 per cent increase in EPS. And a decrease of 40 per cent in EBIT has decreased the EPS by 50 per cent.
The procedure outlined above is merely indicative of the presence or absence of financial leverage. Financial leverage can be more precisely expressed in terms of the degree of financial leverage (DFL). The DFL can be calculated by Eq. (3)
As a rule, when a percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. In other words, financial leverage occurs when the quotient in Equation 3 is more than one.
In both the examples, the relevant quotient is larger than one. Therefore, financial leverage exists. But the degree of financial leverage is higher in Example 4 (2.03) than in Example 5 (1.25). The higher the quotient of percentage change in EPS due to percentage change in EBIT, the greater is the degree of financial leverage. The quotient of 2.03 implies that 1 per cent change in EBIT will cause 2.03 per cent change in EPS in the same direction (± increase/decrease) in which the EBIT changes. With 1.25 quotient the proportionate change in EPS as a result of 1 per cent change in EBIT will be comparatively less, that is, 1.25 per cent in either direction.
1.2510,000 Rs50,000 Rs
50,000 Rs
1.25 40%
50% 2 Case 1.25,
40%
50% 1 Case :5 e(ii)Exampl
2.030.3512,000/ RsRs2,00010,000 Rs
10,000Rs
2.03 40%-
81.25 2 Case 2.03,
40%
81.25% 1 Case :4 Example (i)For
5, and 4 Examples in 2 Case and 1 Case to 3 Equations Applying
Degree of financial leverage (DFL): Applying Eq. (3)
(i) Case 1 = (+40% / + 40%) = 1
(ii) Case 2 = (-40% / -40%) = 1
Thus, the quotient is 1. Its implication is that 1 per cent change in EBIT will result in 1 per cent change in EPS, that is, proportionate. There is, therefore, no magnification in the EPS.
There will be, however, no financial leverage, if there is no fixed-charged financing. (Table 6).
To devise an appropriate capital structure, the amount of EBIT under various financing plans should be related to EPS. The EBIT-EPS analysis is a widely-used method of examining the effect of financial leverage/use of debt. A financial alternative that ensures the largest EPS is preferred, given the level of EBIT.
Example 6
Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to Rs 10,00,000. The firm now wishes to raise additional Rs 10,00,000 for expansion. The firm has four alternative financial plans:
(A) It can raise the entire amount in the form of equity capital.
(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.
(C) It can raise the entire amount as 6% debentures.
(D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital.
Further assume that the existing EBIT are Rs 1,20,000, the tax rate is 35 per cent, outstanding ordinary shares 10,000 and the market price per share is Rs 100 under all the four alternatives.
EBIT Less: InterestEarnings before taxesTaxesEarnings after taxes Less: Preference dividendEarnings available to ordinary shareholdersNumber of sharesEarnings per share (EPS)
Rs 1,20,000—
1,20,00042,00078,000
—
78,00020,000
3.9
Rs 1,20,00025,00095,00033,25061,750
—
61,75015,000
4.1
Rs 1,20,00060,00060,00021,00039,000
—
39,00010,000
3.9
Rs 1,20,000—
1,20,00042,00078,00025,000
53,00015,000
3.5
The calculations in Table 7 reveal that given a level of EBIT of Rs 1,20,000, the financing alternative B, which involves 50 per cent ordinary shares and 50 per cent debt, is the most favourable with respect to EPS. Another disclosure of the table is that although the proportion of ordinary shares in the total capitalisation under the financing plan D is also 50 per cent, that is, equal to plan B, EPS is considerably different (lowest). The difference in the plans B and D is due to the fact that interest on debt is tax-deductible while the dividend on preference shares is not. With 35 per cent income tax, the explicit cost of preference shares would be higher than the cost of debt.
Financial break-even point (BEP) represents a point at which before-tax earnings are equal to the firm’s fixed financial obligations. Symbolically, it is computed as follows:
[I + Dp + Dt)/(1 – t)] (5)
In other words, at financial BEP, EPS is zero.
Equation 5 gives before-tax earnings necessary to cover the firm’s fixed financial obligations.
As fixed financial charges are added, the break-even point for zero EPS is increased by the amount of the additional fixed cost. Beyond the financial break-even point, increase in EPS is more than the proportionate increase in EBIT. This is illustrated in Table 8, which presents the EBIT-EPS relationship for the data in Example 6 under the various EBIT assumptions given in the box:
1) Rs 80,000 (4 per cent return on total assets)2) 1,00,000 (5 per cent return on total assets)3) 1,30,000 (6.5 per cent return on total assets)4) 1,60,000 (8 per cent return on total assets)5) 2,00,000 (10 per cent return on total assets)
EAT for equity-holders 1,30,000 1,13,750 91,000 1,05,000
EPS 6.5 7.6 9.1 7
It can be seen from Table 8 that when the EBIT level exceeds the financial break-even level (Rs 25,000, Rs 60,000 and Rs 38,462 for financing alternatives, B, C and D respectively) EPS increases. The percentage increase in EPS is the greatest when EBIT is nearest the break-even point. Thus, in Plan C, an increase of 25 per cent in EBIT (from Rs 80,000 to Rs 1,00,000) results in a 100 per cent increase in EPS (from Re 1.3 to Rs 2.6), whereas the percentage increase in EPS is only 40 per cent (from Rs 6.5 to Rs 9.1) as a result of the change in EBIT at higher levels from Rs 1,60,000 to Rs 2,00,000 (i.e. 25 per cent increase).
The indifference point can be determined by using the following equations:
(8)
N
Dt1IX
N
t1X:Debentures and shares Preference versus sharesy (iii)Equit
(7A)N
Dt1Dt1X
N
t1X
:dividend Preference ontax withshares Preference versus sharesEquity (ii)(b)
(7)N
Dt1X
N
t1X:shares Preference versus sharesEquity (ii)(a)
(6)N
t1IX
N
t1X:Debentures versus shares(i)Equity
4
p
1
3
p
1
3
p
1
21
For an Existing Company
If the debentures are already outstanding, let us assume I1 = interest paid on existing debt, and I2 = interest payable on additional debt, then the indifference point would be determined by Equation 9.
The indifference point can also be determined graphically. In order to graph the financial plan, two sets of EBIT-EPS coordinates are required for each financial plan. The point at which the two lines intersect is the IP.
In order to graph the financial plan, two sets of EBIT-EPS coordinates are required. The EPS values associated with EBIT values of Rs 2,00,000 and Rs 6,00,000 are calculated and plotted on the graph paper under each financial plan in case of Figure 1. It may noted that 100 per cent equity financing plan starts from origin (O) because EPS would be zero if EBIT is zero.
However, EBIT required to have the value of the EPS as zero is Rs 1,50,000, that is, the interest charges payable on 10% debentures of Rs 15,00,000. Therefore, the starting point of 50 per cent equity financing plan is away from the point of the origin (i.e. it starts from Rs 1.5 lakh). The point at which the two lines intersect is the indifference point (IP). When we draw a perpendicular to the X-axis from the point of intersection, we have EBIT required for the IP. A line drawn from the point of intersection and joined with the Y-axis determines the EPS at the indifference point of EBIT.
An important point to be remembered in relation to the drawing of 33 per cent preference share financial plan (Fig. 2), is that EPS would not be zero if the firm’s EBIT is Rs 1,30,000, because dividend payable on preference share is not tax-deductible. The firm must earn so much more than Rs 1,30,000 that it is left with Rs 1,30,000 after paying taxes. This amount can be calculated dividing Rs 1,30,000 by (1 – t). The required amount is Rs 2,00,000 [Rs 1,30,000) ÷ (1 – 0.35)]. Thus, the starting point of preference share financial plan would be Rs 2 lakh.
The indifference points of Figs. 1 and 2 correspond to what we have determined through the algebraic approach. But the utility of the EBIT-EPS chart lies in its being more informative regarding the EBIT-EPS relationship. It gives a bird’s eye view of EPS at various levels of EBIT. The EPS value at the estimated level of EBIT can be promptly ascertained. Moreover, it more easily explains why an equity financing plan is better than other plans requiring debenture and/or preference shares for the EBIT level below the IP. For instance, Fig. 2 indicates that for all EBIT levels below Rs 6 lakh, the EPS under equity alternative is greater than 33 per cent preference share financing plan and for all EBIT levels above Rs 6 lakh, the EPS is greater under 33 per cent financing plan than 100 per cent equity financing. The IP can be compared with the most likely level of EBIT. If the likely level of EBIT is more than the IP, the use of fixed cost financing plan may be recommended, otherwise equity plan would be more suitable. To sum up, the greater the likely level of EBIT than the indifference point, the stronger is the case for using levered financial plans to maximise the EPS. Conversely, the lower the likely level of EBIT in relation to the indifference point, the more useful the unlevered financial plan would be from the view point of EPS. In other words, financial leverage will be favourable and shareholders will get higher EPS if the return on total investment is more than the fixed cost (interest and preference dividend). If the return is less than the fixed financial charge, the EPS will decline with the use of debt and the leverage will be unfavourable. The financial leverage will have no effect on EPS in case the return on investment is exactly equal to the fixed financial costs.
The indifference point may be computed in another way using market value as the basis. Since the operational objective of financial management is the maximisation of share prices, the market price of shares of a firm with two different financial plans should be identical. Thus, on the basis of level of EBIT which ensures identical market price for alternative financial plans, the indifference point can be symbolically computed by Equation 10.
where PE1 = P/E ratio of unlevered plan and P/E2 = P/E ratio of levered plan.
)10(
N
Dt1IXE/P
N
t1XE/P
2
p
2
1
1
Example 8
Determine the indifference point at which market price of equity shares of a corporate firm will be the same from the following data:
1. Funds required, Rs 50,000.2. Existing number of equity shares outstanding, 5,000 @ Rs 10 per share.3. Existing 10% debt, Rs 20,0004. Funds required can be raised either by (a) issue of 2,000 equity shares,
netting Rs 25 per share or (b) new 15 per cent debt.5. The P/E ratio will be 7 times in equity alternative and 6 times in debt
Financial leverage measures the degree of the use of debt and other fixed-cost sources of fund to finance the assets the firm has acquired. As shown above, the use of debt has a magnifying effect on the earnings per share. It can be said that the higher the proportion of debt in the capital structure, the higher is the financial leverage and vice-versa. Broadly speaking, financial leverage can be measured in two ways: (i) stock terms, and (ii) flow terms.
1) Stock Terms
It can be measured either by (a) a simple ratio of debt to equity, or (b) by the ratio of long-term debt plus preference share to total capitalisation. Each of these measures indicates the relative proportion of the funds to the total funds of the firm on which it is to pay fixed financial charges.
2) Flow Terms
The financial leverage can be measured either by (a) the ratio of EBIT to interest payments or (b) the ratio of cash flows to interest payment, popularly called the debt service capacity/coverage. These coverage ratios are useful to the suppliers of the funds as they assess the degree of risk associated with lending to the firm.
In general, the higher the ‘stock’ ratios and the lower the ‘flow’ ratios, the greater is the risk and vice-versa.
Combined leverage is the product of operating leverage and financial leverage.
Total risk is the risk associated with combined leverage.
DCL = DOL X DFL (11)
Thus, the DCL measures the percentage change in EPS due to percentage change in sales. If the degree of operating leverage of a firm is 6 and its financial leverage is 2.5, the combined leverage of this firm would be 15(6 x 2.5). That is, 1 per cent change in sales would bring about 15 per cent change in EPS in the direction of the change in sales. The combined leverage can work in either direction. It will be favourable if sales increase and unfavourable when sales decrease because changes in sales will result in more than proportionate returns in the form of EPS.
A plastic manufacturing company is planning to expand its assets by 50 per cent. All financing for this expansion will come from external sources. The expansion will generate additional sales of Rs 3 lakh with a return of 25 per cent on sales before interest and taxes. The finance department of the company has submitted the following plans for the consideration of the Board.
Plan 1: Issue of 10% debentures.
Plan 2: Issue of 10% debentures for half the required amount and balance in equity shares to be issued at 25 per cent premium.
Plan 3: Issue equity shares at 25 per cent premium.
Balance sheet of the company as on March 31
Liabilities Amount Assets Amount
Equity capital (Rs 10 per share) Rs 4,00,000 Total assets Rs 12,00,000
(a) Determine the number of equity shares that will be issued if financial plan 3 is adopted.
(b) Determine indifference point between (i) plans 1 and 2, (ii) plans 1 and 3, and (iii) plans 2 and 3.
(c) Assume that the price earnings ratio is expected to remain unchanged at 8 if plan 3 is adopted, but is likely to drop to 6 if either plan 1 or 2 is used to finance the expansion. Determine the expected market price of the shares in each of the situations.
G Manufacturing company is an important producer of lawn furniture and decorative objectives for the patio and garden. The last year’s income statement and balance sheet are as follows:
Income statement
SalesVariable costsContributionFixed costsEarnings before interest and tax (EBIT)InterestEarnings before tax (EBT)TaxationNet Income after tax
Normal asset turnover 1.2 : 1. Normal profit margin 20 per cent
For the current year, the forecasted sales are Rs 80,00,000 and it is likely that variable costs will remain at approximately the same percentage of sales as was in the last year. (Figures could be rounded off). Fixed costs will rise by 10 per cent.
G has short-listed the following two product lines to be sold through its existing distribution channels:
(1)Production and sale of metal table and chair unit that will be sold for issue around swimming pools. This will require an investment of Rs 20,00,000, which would involve installation of manufacturing and packaging machinery. Sales forecast are Rs 15,00,000 per annum, variable costs account for 2/3rd of sales value, fixed costs are Rs 2,00,000 and no additional working capital is needed.
(2)Hardwood planter with three separate components, will be appropriate for medium sized shrubs. This will require an investment of Rs 30,00,000 with forecasted sales per annum of Rs 25,00,000, variable costs 64 per cent of sales value and fixed costs of Rs 5,00,000.
The company is said to have favourable financial leverage if it earns more on the assets purchased (with debt funds) than the interest it pays on debt. For the purpose, ROR on capital employed is computed. It is (Rs 14,60,000/Rs 72,00,000) = 20.28 per cent. This return is higher than 10 per cent interest payable on long-term debt. Evidently, the firm is having positive financial leverage.
(2) Income statement showing earnings of two projects, DOL and assets leverage
Particulars Projects
Metal table and chair unit
Hardwood planter
Sales revenue Rs 15,00,000 Rs 25,00,000
Less: Variable costs 10,00,000 16,00,000
Contribution 5,00,000 9,00,000
Less: Fixed costs 2,00,000 5,00,000
EBIT 3,00,000 4,00,000
DOL (Contribution/EBIT) 1.667 2.25
Assets leverage (Sales/Total assets) 0.75 0.83
To determine other leverages, it will be useful to extend income statement to include the impact of financing costs.
It is apparent that acceptance of the Hardwood Planter project will adversely affect risk level (reflected in higher DOL, DFL and DCL). While the acceptance of Metal Table project decreases operating risk (lower DOL), it increases total risk (as DCL is 4.15). The asset leverages are also very low.
Though the ROR on capital employed is higher for both the projects than the interest rate paid, the acceptance of these projects will decrease the firm’s overall rate of return on capital employed (the existing ROR on capital employed is 20, 28 per cent).
(3) The impact of financing alternatives on company’s future EPS:
Financial plan (a): Since the rate of return on capital employed is higher (for both the projects) than the rate of interest (9 per cent) payable on funds borrowed, the projects will increase EPS.
Financing plan (b): Under this plan, funds are to be raised by the issue of Rs 30 lakh cumulative 10 per cent Preference shares, the EPS will decrease as payment of 10 per cent preference dividend requires 20 per cent pre-tax return on Rs 30 lakh; the projected pre-tax return is 17.33 per cent (Rs 5,20,000/Rs 30,00,000). In fact, taking two projects in a combined manner, the firm has negative returns for equity-holders. As a result, this financial plan will have depressing effect on the EPS and is not desirable.
In sum, the firm should go for both projects only when debt financing is possible for both such projects.