Slm Unit 06 Mbf201

Financial Management Unit 6

Sikkim Manipal University Page No. 106

Unit 6 Leverage

Structure:

6.1 Introduction

Learning objectives

6.2 Operating Leverage

Application of operating leverage

6.3 Financial Leverage

Uses of financial leverage

6.4 Combined Leverage

Uses of DTL

6.5 Summary

6.6 Solved Problems

6.7 Terminal Questions

6.8 Answers to SAQs and TQs

6.1 Introduction

A company uses different sources of financing to fund its activities. These

sources can be classified as those which carry a fixed rate of return and

those whose returns vary. The fixed sources of finance have a bearing on

the return on shareholders. Borrowing funds as loans have an impact on the

return on shareholders and this is greatly affected by the magnitude of

borrowing in the capital structure of a firm.

Leverage is the influence of power to achieve something. The use of an

asset or source of funds for which the company has to pay a fixed cost or

fixed return is termed as leverage. Leverage is the influence of an

independent financial variable on a dependent variable. It studies how the

dependent variable responds to a particular change in independent variable.

There are three types of leverage as shown in the following diagram 6.1 –

operating, financial and combined.



Figure 6.1: Types of leverage

Operating leverage is associated with the asset purchase activities, while

financial leverage is associated with the financial activities. However,

combined leverage is the combination of operating leverage and the

financial leverage.

6.1.1 Learning objectives

After studying this unit, you should be able to:

Explain the meaning of leverage

Mention the different types of leverage

Discuss the advantages of leverage

6.2 Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses

in the firm’s income flows. A company’s operating costs can be categorised

into three main sections as shown in figure 6.2 – fixed costs, variable costs

and semi-variable costs.

Figure 6.2: Classification of operating costs

Fixed costs

Fixed costs are those which do not vary with an increase in production or

sales activities for a particular period of time. These are incurred

irrespective of the income and value of sales and generally cannot be

reduced.



For example, consider that a firm named XYZ enterprises is planning to

start a new business. The main aspects that the firm should concentrate

at are salaries to the employees, rents, insurance of the firm and the

accountancy costs. All these aspects relate to or are referred to as ―fixed

costs‖.

Variable costs

Variable costs are those which vary in direct proportion to output and

sales. An increase or decrease in production or sales activities will have

a direct effect on such types of costs incurred.

For example, we have discussed about fixed costs in the above context.

Now, the firm has to concentrate on some other features like cost of

labour, amount of raw material and the administrative expenses. All

these features relate to or are referred to as ―Variable costs‖, as these

costs are not fixed and keep changing depending upon the conditions.

Semi-variable costs

Semi-variable costs are those which are partly fixed and partly variable

in nature. These costs are typically of fixed nature up to a certain level

beyond which they vary with the firm’s activities.

For example, after considering both the fixed costs and the variable

costs, the firm should concentrate on some-other features like production

cost and the wages paid to the workers which act at some point of time

as fixed costs and can also shift to variable costs. These features relate

to or are referred to as ―Semi-variable costs‖.

The operating leverage is the firm’s ability to use fixed operating costs to increase

the effects of changes in sales on its earnings before interest and taxes (EBIT).

Operating leverage occurs any time a firm has fixed costs. The percentage change

in profits with a change in volume of sales is more than the percentage change in

volume.



The illustration clearly tells us that when a firm has fixed operating expenses, an

increase in sales results in a more proportionate increase in earnings before interest

and taxes (EBIT) and vice versa. The former is a favourable operating leverage and

the latter is unfavourable.

Another way of explaining this phenomenon is examining the effect of the degree of

operating leverage (DOL). The DOL is a more precise measurement. It examines

the effect of the change in the quantity produced on earnings before interest and

taxes (EBIT).

DOL = % change in EBIT / % change in output

Solved Problem -1

A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per

unit and fixed expenses amount to Rs. 5000 p.a. Show the various

levels of EBIT that result from sale of 1000 units, 2000 units and 3000

units.

Solution

The various levels of EBIT that result from sale of 1000 units, 2000 units

and 3000 units is as shown under in table 6.1

Table 6.1: Various levels of EBIT

Sales in units 1000 2000 3000

Sales revenue Rs. 10000 20000 30000

Variable cost 5000 10000 15000

Contribution 5000 10000 15000

Fixed cost 5000 5000 5000

EBIT 000 5000 10000

If we take 2000 units as the normal course of sales, the results can be summed

as :

A 50% increase in sales from 2000 units to 3000 units results in a

100% increase in EBIT.

A 50% decrease in sales from 2000 units to 1000 units results in a

100% decrease in EBIT.



To put in a different way,

(ΔEBIT/EBIT) / (ΔQ/Q)

EBIT is Q(S—V)—F

Where Q is quantity

S is sales

V is variable cost

F is fixed cost

Substituting this we get,

{Q(S—V)} / {Q(S—V)—F}

Solved Problem -2

Calculate the degree of leverage (DOL) of Guptha Enterprises based

on the information provided in the table 6.2

Table 6.2: Information of Guptha enterprises

Quality produced and sold 1000 units

Variable cost Rs.200 per unit

Selling price per unit Rs. 300 per unit

Fixed expenses Rs.20, 000

Solution

DOL = {Q(S–V)} / {Q(S–V)–F}

= {1000(300–200)}/{1000(300–200)–20000}

= 100000/80000

DOL = 1.25

The degree of operating leverage of Guptha enterprises is 1.25.

If the company does not incur any fixed operating costs, there is no operating

leverage.



Solved Problem -4

The table 6.4 shows the statistics of a firm and its sales requirements.

Compute the degree of operating leverage (DOL) according to the values

given in the table.

Table 6.4: Statistics of a firm

Sales in units 1000

Sales revenue Rs. 10000

Variable cost 5000

Contribution 5000

Fixed cost 0

EBIT 5000

Solution

DOL= {Q(S—V)} / {Q(S—V)—F}

{1000(5000)} / {1000(5000) – 0}

= 5000000/5000000

= DOL=1

The degree of operating leverage according to the values given in the

table is 1.

Solved Problem - 3

Calculate the degree of leverage (DOL) of Utopia Enterprises based on

the information provided in the table 6.3

Table 6.3: Information of Utopia Enterprises

Quality produced and sold 2000 units

Variable cost Rs.300 per unit

Selling price per unit Rs. 400 per unit

Fixed expenses Rs.25, 000

Solution

DOL = {Q(S–V)} / {Q(S–V)–F}

= {2000(400–300)}/{2000(400–300)–25000}

= 200000/175000

DOL = 1.14

The degree of operating leverage of Utopia Enterprises is 1.14.



As operating leverage can be favourable or unfavourable, high risks are attached to

higher degrees of leverage. As DOL considers fixed expenses, a larger amount of

these expenses increases the operating risks of the company and hence a higher

degree of operating leverage. Higher operating risks can be taken when income

levels of companies are rising and should not be ventured into when revenues

move southwards.

6.2.1 Application of Operating Leverage

The applications of operating leverage are as follows:

Business risk measurement

Production planning

Measurement of business risk

Solved Problem - 5

The table 6.5 given below shows the statistics of a firm and its sales

requirements. Compute the degree of operating leverage (DOL)

according to the values given in the table.

Table 6.5: Statistics of a firm

Sales in units 2000

Sales revenue Rs. 20000

Variable cost 10000

Contribution 6000

Fixed cost 0

EBIT 6000

Solution

DOL= {Q(S—V)} / {Q(S—V)—F}

{2000(10000)} / {2000(10000) – 0}

= 2000000/2000000

= DOL=1

The degree of operating leverage according to the values given in the

table is 1.



Risk refers to the uncertain conditions in which a company performs. A

business risk is measured using the degree of operating leverage (DOL)

and the formula of DOL is:

DOL = {Q(S–V)} / {Q(S–V)–F}

Greater the DOL, more sensitive is the earnings before interest and tax

(EBIT) to a given change in unit sales. A high DOL is a measure of high

business risk and vice versa.

Production planning

A change in production method increases or decreases DOL. A firm can

change its cost structure by mechanising its operations, thereby reducing its

variable costs and increasing its fixed costs. This will have a positive impact

on DOL. This situation can be justified only if the company is confident of

achieving a higher amount of sales thereby increasing its earnings.

6.3 Financial Leverage

Financial leverage as opposed to operating leverage relates to the financing

activities of a firm and measures the effect of earnings before interest and

tax (EBIT) on earnings per share (EPS) of the company.

A company’s sources of funds fall under two categories –

Those which carry a fixed financial charges like debentures, bonds and

preference shares and

Those which do not carry any fixed charges like equity shares

Debentures and bonds carry a fixed rate of interest and have to be paid off

irrespective of the firm’s revenues. Though dividends are not contractual

obligations, dividend on preference shares is a fixed charge and should be paid off

before equity shareholders are paid any. The equity holders are entitled to only the

residual income of the firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital

structure of the firm. This results from the presence of fixed financial

charges in the company’s income stream. Such expenses have nothing to

do with the firm’s performance and earnings and should be paid off

regardless of the amount of earnings before income and tax (EBIT).



It is the firm’s ability to use fixed financial charges to increase the effects of

changes in EBIT on the EPS. It is the use of funds obtained at fixed costs

which increase the returns on shareholders.

A company earning more by the use of assets funded by fixed sources is

said to be having a favourable or positive leverage. Unfavourable leverage

occurs when the firm is not earning sufficiently to cover the cost of funds.

Financial leverage is also referred to as “Trading on Equity”.

Solved Problem -6

The EBIT of a firm is expected to be Rs. 10000. The firm has to pay

interest at a rate of 5% on debentures of worth Rs. 25000. It also has

preference shares worth Rs. 15000 carrying a dividend of 8%. How

does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may

be taken as 40% and number of outstanding shares as 1000.

Solution

The various changes of EPS if EBIT is Rs. 15,000, Rs. 10,000 and

Rs. 5,000 is shown under in table 6.6

Table 6.6: Various changes of EPS

EBIT 5000 10000 15000

Interest on debt 1250 1250 1250

EBT 3750 8750 13750

Tax 40% 1500 3500 5500

EAT 2250 5250 8250

Preference div. 1200 1200 1200

Earnings available to equity holders

1050 4050 7050

EPS 1.05 4.05 7.05

Interpretation

A 50 % increase in EBIT from Rs.10,000 to Rs.15,000 results in

74% increase in EPS

A 50 % decrease in EBIT from Rs.10,000 to Rs.5,000 results in

74% decrease in EPS



This example shows that the presence of fixed interest source funds leads to a

value more than that occurs due to proportional change in EPS. The presence of

such fixed sources implies the presence of financial leverage. This can be

expressed in a different way. The degree of financial leverage (DFL) is a more

precise measurement. It examines the effect of the fixed sources of funds on EPS.

DFL = %change in EPS

%change in EBIT

DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}

Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}

I is Interest, Dp is dividend on preference shares, T is tax rate.



Solved Problem -7

Kusuma Cements Ltd. has an EBIT of Rs. 5,00,000 at 5000 units of

production and sales. The capital structure of the company is briefly

described in table 6.7

Table 6.7: Capital structure of the company

Capital structure Amount Rs.

Paid up capital 500000 equity shares of Rs. 10 each

5000000

12% Debentures 400000

10% Preference shares of Rs. 100 each 400000

Total 5800000

Corporate tax rate may be taken at 40%

Solution

EBIT 500000

Less Interest on debentures 48000

EBT 452000

DFL= EBIT ÷ {EBIT—I—{Dp/(1-T)}}

500000/(500000—48000—{40000/(1—0.40)}

DFL=1.30

The degree of financial leverage of Kusuma Cements Ltd. is found to

be 1.30.



6.3.1 Use of Financial Leverage

Studying the degree of financial leverage (DFL) at various levels makes

financial decision-making, on the use of fixed sources of funds, for funding

activities easy. One can assess the impact of change in earnings before

interest and tax (EBIT) on earnings per share (EPS).

Like operating leverage, the risks are high at high degrees of financial leverage

(DFL). High financial costs are associated with high DFL. An increase in financial

costs implies higher level of EBIT to meet the necessary financial commitments.

Solved Problem - 8

XYZ Enterprises Ltd. has an EBIT of Rs. 2,00,000 at 4000 units of production

and sales. The capital structure of the company is briefly described in table 6.8

Table 6.8: Capital structure

Capital structure Amount Rs.

Paid up capital 200000 equity shares of Rs. 10 each

2000000

10% Debentures 500000

5% Preference shares of Rs. 100 each 500000

Total 3000000

Corporate tax rate may be taken at 50%

Solution

EBIT 200000

Less Interest on debentures 50000

EBT 150000

DFL= EBIT ÷ {EBIT—I—{Dp/(1-T)}}

200000/(200000—50000—{25000/(1—0.50)}

DFL=2.0

The degree of financial leverage of XYZ Enterprises is found to be 2.0.



A firm which is not capable of honouring its financial commitments may be forced to

go into liquidation by the lenders of funds. The existence of the firm is shaky under

these circumstances.

On one side the trading on equity improves considerably by the use of borrowed

funds and on the other hand, the firm has to constantly work towards higher EBIT to

stay alive in the business. All these factors should be considered while formulating

the firm’s mix of sources of funds.

One main goal of financial planning is to devise a capital structure in order to

provide a high return to equity holders. But at the same time, this should not be

done with heavy debt financing which drives the company on to the brink of winding

up.

Impact of financial leverage

Highly leveraged firms are considered very risky and lenders and creditors

may refuse to lend them further to fuel their expansion activities. On being

forced to continue lending, they may do so with their own conditions like

earning a minimum of X% EBIT or stipulating higher interest rates than the

market rates or no further mortgage of securities.

Financial leverage is considered to be favourable till such time that the rate

of return exceeds the rate of return obtained when no debt is used.



The company not using debt to finance its assets has a higher DFL compared to

that of a company using it. Financial leverage does not exist when there is no fixed

charge financing.

6.4 Total or combined leverage

The combination of operating and financial leverage is called combined

leverage. Operating leverage affects the firm’s operating profit EBIT and

financial leverage affects PAT or the EPS. These cause wide fluctuations in

EPS. A company having a high level of operating or financial leverage will

find a drastic change in its EPS even for a small change in sales volume.

Companies whose products are seasonal in nature have fluctuating EPS,

but the amount of changes in EPS due to leverages is more pronounced.

Solved Problem - 9

The following table 6.9 displays the balance sheets of two firms – firm A

and firm B.

Table 6.9: Balance sheets of firms A and B

Balance sheet of A Balance sheet of B

Equity capital

100000 Assets 100000 Equity capital

40000 Assets 100000

Debt @ 15%

60000

Total 100000 Total 100000 Total 100000 Total 100000

Both the companies earn an income before interest and tax of

Rs. 40000. Calculate the DFL and interpret the results thereof.

Solution

DFL= )}}T1/(Dp{IEBIT{

EBIT

Company A = 10040000

40000

Company B = 29.10900040000

40000

The degree of financial leverage of the companies A and B are 1 and

1.29.



The combined effect is quite significant for the earnings available to ordinary

shareholders. Combined leverage is the product of degree of operating

leverage (DOL) and degree of financial leverage (DFL).

DTL = )}T1/(Dp{IF)VS(Q

)VS(Q

Solved Problem -10

Calculate the DTL of Pooja Enterprises Ltd., given the information

regarding the expenses, shares and sales of the company in table 6.10

Table 6.10: Details of Pooja Enterprises Ltd.

Quantity sold 10,000 units

Variable cost per unit Rs.100 per unit

Selling price per unit Rs.500 per unit

Fixed expenses Rs.10,00,000

Number of equity shares 1,00,000

Debt Rs.10,00,000 @ 20% interest

Preference shares dividend 10,000 shares of Rs.100 each @ 10%

Tax rate 50%

Solution


)VS(Q

}5.0/100000{2000001000000)100500(10000

)100500(10000

DTL=1.53

Cross verification:

DOL = }F)VS(Q{

)}VS(Q{

1000000)100500(10000

)100500(10000

DOL=1.33



EBIT = [Q(S-V)-F}

DFL= )}}T1/(Dp{IEBIT

EBIT

}5.0/100000{2000003000000

3000000

DFL=1.15

DTL=DOL*DFL

1.53 =1.33*1.15

Hence the degree of total leverage of Pooja Enterprises Ltd. is 1.54.

Solved Problem -11

Calculate the degree of total leverage of Utopia Enterprises Ltd., given

the following information regarding the expenses, shares and sales of the

company in table 6.11.

Table 6.11: Details of Utopia Enterprises Ltd.








Tax rate 40%



Solution


)VS(Q

}6.0/400000{4000002000000)200600(20000

)200600(20000

DTL=1.62

Cross verification:

DOL= }F)VS(Q{

)}VS(Q{

2000000)200600(20000

)200600(20000

DOL=1.33


EBIT

}6.0/400000{4000006000000

6000000

DFL=1.22

DTL=DOL*DFL

1.62 = 1.33*1.22

Hence the degree of total leverage of Utopia enterprises Ltd. is 1.60



Solved Problem -12

Calculate the degree of total leverage of CMA Enterprises Ltd., given the

following information regarding the expenses, shares and sales of the

company in table 6.12

Table 6.12: Details of CMA Enterprises Ltd.








Tax rate 30%

Solution


)VS(Q

}7.0/1200000{9000003000000)300700(30000

)300700(30000

DTL=1.88

Cross verification:

DOL= }F)VS(Q{

)}VS(Q{

3000000)300700(30000

)300700(30000

DOL=1.33


EBIT

}7.0/1200000{9000006000000

6000000

DFL=1.77

DTL=DOL*DFL

1.33*1.77=2.35

Hence the degree of total leverage of CMA enterprises Ltd. is 2.35



6.4.1 Uses of degree of total leverage (DTL)

Degree of total leverage (DTL) measures the total risk of the company as

DTL is a combined measure of both operating and financial risk

Degree of total leverage (DTL) measures the variability of EPS

6.5 Summary

Leverage is the use of influence to attain something else. The advantage a

company has, with the current status of the leverage can be used to gain

other benefits. There are three measures of leverage – operating leverage,

financial leverage and total or combined leverage. Operating leverage

examines the effect of change in quantity produced upon EBIT and is useful

to measure business risk and production planning. Financial leverage

measures the effect of change in EBIT on the EPS of the company. It also

refers to the debt-equity mix of a firm. Total leverage is the combination of

operating and financial leverages.

Self Assessment Questions

Fill in the blanks:

1. __________ arises due to the presence of fixed operating expenses in

the firms income flows

2. EBIT is calculated as _______.

3. Higher operating risks can be taken when ______ of companies are

rising.

4. Dividend on _________ is a fixed charge.

5. Financial leverage is also referred to as ___________.

6. Operating leverage is categorised into _____, ____ and _______.

7. The three types of leverage a company faces are ______, ________

and __________.



6.6 Solved Problems

13. The information, shown in table 6.13, has been collected from

the annual report of Garden Silks. What is the degree of financial

leverage?

Table 6.13: Annual report of Garden silks

Total sales Rs.14,00,000

Contribution ratio 25%


Outstanding bank loan Rs.4,00,000 @ 12.5%

Applicable tax rate 40%

Solution

DFL = EBIT / (EBIT-I) = 200000/200000-50000 = 1.33

EBIT = Sales*25% less fixed expenses

1400000*25% = 350000-150000 = 200000

14. Suppose X and Y have provided the information regarding the

sales and the cost of their expense in table 6.14. Which firm do you

consider to be risky?

Table 6.14: Information of X and Y

X Ltd. Y Ltd.

Sales in units 40000 40000

Price per unit 60 60

Variable cost p.a. 20 25

Fixed financing cost Rs. 100000 Rs. 50000

Fixed financing cost Rs. 300000 Rs. 200000

Solution:

DOL = Q(S-V) / Q(S-V)-F

Company X: 40000(60-20) / 40000(60-20)-400000

1600000/1200000 = 1.33

Company Y: 40000(60-25) / 40000(60-25)-250000

1400000/1150000= 1.22



15. Calculate EPS with the following information shown in table 6.15.

Table 6.15: Information of a firm

EBIT Rs.11,80,000

Interest Rs.2,20,000

No. of outstanding shares 40,000

Tax rate applicable 40%

Solution:

Earnings per share is calculated using the table 6.16

Table 6.16 Earnings per share

EBIT Rs.11,80,000

Less interest Rs.2,20,000

EBT 9.60,000

Tax @ 40% Rs.3,84,000

EAT Rs.5,76,000

EPS = EAT/no of shares outstanding

576000/40000 = Rs. 14.4

16. The leverages of three firms is as shown in table 6.17 given

below. Which one of the combinations should be chosen for the

combined leverage to be maximum and what are the inferences?

Table 6.17: Leverages of three firms

A B C

Operating leverage 1.14 1.23 1.33

Financial leverage 1.27 1.3 1.33

Solution:

We should calculate the combined leverage to draw inferences.

Combined leverage of A is 1.14*1.27 = 1.45,

Combined leverage of B is 1.23*1.3 = 1.60,

Combined leverage of C is 1.33*1.33 = 1.77

We find that the combined leverage is highest for firm C and this

suggests that this firm is working under very high risky situation.



6.7 Terminal Questions

1. Mishra Ltd. provides the information as shown in the table 6.11. What is

the degree of operating leverage?

Table 6.18: Details of Mishra Ltd.

Output 25,000 units

Fixed costs Rs.15,000

Variable cost per unit Rs. 0.50

Interests on borrowed funds Rs.15,000

Selling price per unit Rs. 1.50

2. X Ltd. provides the following information as shown in table 6.19. What is

the degree of financial leverage?

Table 6.19: Details of X Ltd.

Output 25,000 units

Fixed costs Rs. 25,000

Variable cost Rs. 2.50 per unit

Interest on borrowed funds Rs.15,000

Selling price Rs. 8 per unit

3. The information available in table 6.20 describes the sales, costs and

interests of two firms. Comment on their relative performance through

leverage?

Table 6.20: Sales and costs of two firms A and B

A Ltd. (Rs. In lakhs) B Ltd. (Rs. In lakhs)

Sales 1000 1500

Variable cost 300 600

Fixed cost 250 400

EBIT 450 500

Interest 50 100



4. ABC Ltd. provides the information as shown in table 6.21 regarding the

cost, sales, interests and selling prices. Calculate the DFL.

Table 6.21: Details of ABC Ltd.

Output 20,000 units

Fixed costs Rs.3,500

Variable cost Rs.0.05 per unit

Interest on borrowed funds Nil

Selling price per unit 0.20

6.8 Answers to SAQs and TQs

Answers to Self Assessment Questions

1. Operating leverage

2. Q(S—V)—F

3. Income levels

4. Preference shares

5. Trading on Equity

6. Fixed costs, variable costs and semi-variable costs.

7. Operating leverage, financial leverage and combined leverage.

Answers to Terminal Questions

1. Hint DOL = }F)VS(Q{

)}VS(Q{

2. Hint DFL = )}}T1/(Dp{IEBIT{

EBIT

3. Hint calculate DFL

4. Hint calculate DFL = )}}T1/(Dp{IEBIT

EBIT

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