Leverage

SUBMITTED BY:

PIYALI DASGUPTA

Meaning of leverage

In general ,leverage refers to accomplish certain things which are otherwise notpossible i.e. lifting of heavy objects with the help of lever. This concept of leverageis valid in business also .

In finance ,the term ‘leverage’ is used to describe the firm’s ability to use fixed costassets or funds to increase the return to its owners; i.e. equity shareholders. Inother words, the fixed cost funds i.e. debentures & preference share capital act asthe fulcrum , which assist the lever i.e. the firm to lift i.e. to increase the earningsof its owner i.e. the equity shareholders.

If earnings less the variable costs exceed the fixed costs i.e. preference dividend &interest on debenture, or earnings before interest and taxes exceed the fixedreturn requirement, the leverage is called favorable . when they do not ,the resultis unfavorable leverage .

Leverage is also the influence which an independent variable has over adependent/related variable i.e. rainfall over production. In financial context, sales& fixed cost over profit.

Fixed cost fund

LEVER

FULCRUM

Increasing the

earnings

LIFTING

DIAGRAMLeverage in physics Leverage in finance

TYPES OF LEVERAGE

OPERATING LEVERAGE

The leverage associated with investment (asset acquisition)activities is referred as operating Leverage.

Formula : operating leverage=contribution/operating profit

Where , contribution=sales-variable cost

operating profit=sales-variable cost-fixed cost

Operating leverage is also defined as the ratio of the percentagechange in operating income for a given percentage change in sales.

DOL=%change in operating income/%change in sales

The risk associated with operating leverage is called operating risk . It is the risk of not being able to cover fixed operating costs by firm

ILLUSTRATION

• Following is the cost information of a firm:

• Fixed cost=Rs.50000

• Variable cost=70%of sales

• Sales=Rs.250000

• Now , Operating Leverage=contribution/operating profit

=75000/25000

=3

BREAK EVEN ANALYSIS

A break-even analysis shows the relationship between the costs and profits with sales volume.

The sales volume which equates total revenue with related costs and results in neither profit nor loss is called the break –even volume or point.

At break – even point the fixed costs are fully recovered , any increase in sales beyond this level will increase profit.

OPERATING BREAK EVEN

The operating break even point is defined as that level of sales (either units or money value)at which EBIT (operating profit) is equal to zero:

Sales-VC-FC =0

or

Q(P-V)-FC =0

Where ,VC is total variable cost , FC is total fixed cost ,Q is the quantity , P is the selling price per unit & V is the variable cost per unit

A firm operating with a high degree of leverage and above break even point earn good amount of profit.

DOL is undefined at the operating break –even point

IF Q is less than the operating break even point ,then DOL will be negative & vice versa

OPERATING BREAK EVEN

Operating break even point in units

Formula:break even point=fixed cost/selling price per unit-variable cost per unit

Operating break even point in terms of money value

Formula :break even sales=(fixed cost/sales-variable cost)*sales

=(fixed cost/contribution)*sales

=fixed cost/P/V ratio

(As, contribution/sales=P/V ratio)

OPERATING BREAK EVEN :AN EXAMPLE

Consider the following information pertaining to Visakha Metals:

Now , operating BEP in units =Fixed cost/selling price per unit-variable cost per unit

=50000000/600000-475000

=50000000/125000

=400 units

or

BEP in terms of money value=(Fixed cost/contribution per unit)* sp per unit

=400*600000

=Rs.240000000

Quantity produced 1000 units

Variable cost per unit Rs.475000

Selling price per unit Rs.600000

Fixed cost Rs.5 crore

FINANCIAL LEVERAGE OR

TRADING ON EQUITY

Leverage associated with financing activities is called financial leverage

The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity

It measures the effect of the change in EBIT(operating profit)on the EPS(earning per share)of the company

The measure of financial leverage is the degree of financial leverageFormula : DFL= %change in EPS /% change in EBIT

or

DFL=EBIT/(EBIT-Interest)-preference dividend/1-tax rate

The risk associated with financial leverage is called financial risk . Financial risk is the risk of not being able to cover fixed financial costs by the firm

FINANCIAL LEVERAGE:AN EXAMPLE

• Given : Total sales=Rs.1400000

Contribution ratio=25%

Fixed expenses=Rs.150000

O/S bank [email protected]%

Preference S/C=Rs.200000@15%

Tax rate=40%

DTL=200000/(200000-50000)-30000/.60

=2

FINANCIAL BREAK EVEN

Financial BEP is the level of EBIT(operating income) which is equal to firm’s fixed financial cost

Financial break even point=(Interest + preference dividend)/1-tax rate

Financial BEP is the level at which EPS(net income) is equal to zero

DFL is undefined at the financial Break –even point

DFL will be negative when the EBIT level goes below the financial Break –even point & vice versa

EPS=EBIT-interest-preference dividend=0

FINANCIAL BREAK EVEN :AN EXAMPLE

• X ltd achieves a sales of Rs. 20 lakh for the year ended2003-04 Thevariable cost ratio is 70% and fixed cost is Rs.5 lakh .The company’s capitalstructure consists of 25000 equity shares, 2000 15%preference shares offace value Rs.100. If the corporate tax rate is 40%,the financial break evenpoint for X ltd is

Financial BEP=(I+ preference dividend)/1-tax rate

=(0+300)/.60

=50000

COMBINED LEVERAGE

Combined leverage is the product of operating leverage andfinancial leverage

The measure of total leverage is the degree of total leverageFormula : DTL=DOL*DFL

=%change in EBIT/%change in sales*%change in EPS/%change in EBIT

or

DTL=contribution/EBIT*EBIT/EBIT-interest=contribution/EBIT-interest

Total risk is the risk associated with combined leverage

COMBINED LEVERAGE: AN EXAMPLE

The Supreme & C o Ltd given the following information:

Equity earnings 230000

Quantity produced 7500 units

Variable cost per unit Rs.300

Selling price per unit Rs.600

No of equity shareholders 700000

Fixed expenses Rs.1000000

Interest Rs. 95000

Preference dividend Rs.35000

Corporate tax 40%

DCL=Contribution/(EBIT-Interest)-preference dividend/1-tax rate

=2250000/(1150000)-35000/.60

=2.05

COMBINED BEP

The overall break-even is that level of output at which the DTL will be undefined and EPS is equal to zero

Formula :Quantity=(Fixed cost +Interest +preference dividend/1-tax rate)/(s-v)

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.

COMBINED BEP :AN EXAMPLE

If the fixed cost is Rs.30000,the operating BEP in units is 3000and financial BEP is Rs.5000,the overall BEP in units

Solution:overall BEP=(f +I +preference dividend/1-tax rate)/s-v

Financial BEP=I +preference dividend/1-tax rate=Rs.5000

Operating BEP=f/s-v=3000 units

Thus , s-v=30000/3000=10

Overall BEP=(5000+30000)/10=3500