Commerce Financial Management Lesson: Leverage Analysis Author: Mr. Vinay Kumar, College/Dept: Aryabhatta College University of Delhi

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1 Commerce Financial Management Lesson: Leverage Analysis Author: Mr. Vinay Kumar, College/Dept: Aryabhatta College University of Delhi Institute of Lifelong Learning, University of Delhi Page 1

2 Table of Content: 1. Learning Objectives 2. Introduction 3. Concept of Leverage 4. Types of Leverage and their Calculation 4.1. Operating Leverage 4.2. Financial Leverage 4.3. Combined Leverage 5. Importance of Leverages 6. EBIT-EPS Analysis 7. Review Illustrations Summary Glossary Exercises References Institute of Lifelong Learning, University of Delhi Page 2

3 1. Learning Objectives: After reading this lesson, you should be able to: understand the concept of leverage, explain various types of leverages, understand the relationship among various leverages, identify the reasons for occurrence of financial,operating and combined leverage, appreciate the importance of leverage analysis in capital structure decisions, compute various leverages using simple information. 2. Introduction: Figure 1: Finance Manager Every finance manager is faced with two important financial decisions to maximise shareholders wealth. First, how much finance is needed? Second, how to raise the finance through debt and equity capital? The first problem can easily be tackled with proper estimation of long term financial needs of the company. Second problem of raising the fund in different proportion is more difficult than the previous one. It basically relates to determining capital structure of the firm. Figure 2: Components of Capital Structure Institute of Lifelong Learning, University of Delhi Page 3

4 There are two components of the capital structure viz., debt and equity. Both are important and have their own merits and demerits. The use of debt and equity depends upon numerous factors. The debt financing results in fixed financial charge on the income of the firm but does not interfere in the decision making of the firm as debt holders have no voting rights whereas equity does not involve any fixed financial charge but results in division of the ownership right. Either of two financing source cannot be good for a company in all circumstances. Therefore, finance manager needs to ascertain and review from time to time the best suited proportion of debt and capital in its capital structure. The best mix of debt and equity which leads to maximisation of shareholders wealth through maximisation of market price of equity share is known as optimum capital structure. There are two techniques to calculate the impact of debt and equity in overall capital structure of the firm viz. EBIT-EPS analysis and leverage analysis. Value Addition 1: Video Benefits of Investing in Equity, Debt and Liquid Instruments Click on the link below to gain an insight into the benefits of investing in equity, debt and liquid instruments. Source: Value Addition 2: Know More Debt vs. Equity Click on the link below to know more about the advantages and disadvantages of debt and equity. Source: 3. Concept of Leverage: In general terms, leverage means relationship between two interrelated variables. While studying the concept of leverage, it is to be remembered that the two variables are related to each other i.e., where one variable depends on the other variable. The dependent variable is shown as a numerator whereas independent variable is shown as a denominator. In financial world, these variables can be cost and profit, sales and profit, EBIT-EPS, etc. Therefore, leverage may be defined as a % change in one variable (dependent) divided by % change in another variable (independent). Alternatively, it can be shown as Leverage = % Change in Dependent Variable % Change in Independent Variable Thus, leverage may be defined as a % change in one variable because of % change in some other interrelated variable. It can also be explained as a responsiveness of a dependent variable due to a change in the independent variable. Institute of Lifelong Learning, University of Delhi Page 4

5 For example, a firm is able to increase its sales revenue from Rs to Rs (i.e. 100% increase) in a particular month by increasing advertisement expenditure form Rs 2000 to Rs 3000 (20% increase). The leverage between the advertisement expenditure and sales revenue may be shown as: Leverage = % Change in Sales Revenue /% Change in Advertisement Expenditure = 100% 20% = 5 The above calculations show that sales revenue increases 5 times the increase in the advertisement expenses. It means there is Rs 5 increase in sales revenue because of one rupees increase in advertisement expenses. 4. Types of Leverage Analysis: Leverage analysis in financial management can be divided into three sections: Figure 3: Types of Leverage Analysis 4.1. Operating Leverage: Operating leverage measures the impact of sales revenue on the operating profits of the firm (EBIT). It can be defined as the % change in EBIT divided by the % change in sales revenue. Therefore, operating leverage studies the relationship between the firm s sales revenue and its earnings before interest and tax. It can be expressed as Operating Leverage= % Change in EBIT/ % Change in Sales As discussed above, operating leverage shows the responsiveness of firm s EBIT with respect to a change in firm s sales. Operating leverage is an indicator of the business risk of the firm. Business risk means variability in the EBIT of the firm because of employment of fixed operating cost. Business risk of the firm depends upon internal as well as external factors. Internal factors may include investment decisions of the firm and management policies while external factors include general economic conditions, Institute of Lifelong Learning, University of Delhi Page 5

6 government policies, competition, technological changes and natural calamities. These external factors may be peculiar to a particular company or may be common to all the companies. Normally, business risk is unavoidable. Operating leverage will occur only when firm is incurring fixed operating expenses. Therefore, existence of fixed operating cost in the overall cost structure of the firm will have magnifying effect of percentage increase in sales over EBIT. Higher operating cost results in higher business risk therefore higher operating leverage. Thus, operating leverage is an index of business risk of the firm. If there is no fixed operating cost then operating leverage will not exist. Thus, no business risk to the firm. Illustration 1: A company sells Rs per unit. The variable cost of production is Rs. 5 per unit. Calculate Operating Levearge. Solution 1: The operating profits (EBIT) of the firm will be (10-5)*2000 = Rs 10,000. Suppose if the sales of the firm increased by 50%. Then, new equation will be Sales 3000 Rs 10 per unit. So, profit will be (10-5)* 3000= Rs Operating Leverage can be obtained as = % Change in EBIT % Change in Sales = Change in EBIT/EBIT = 50%/50% = 1 Change in Sales/Sales So operating leverage is 1, which denotes that there is no magnifying effect of increase in sales over EBIT. Thus, in the absence of fixed operating cost in the cost structure of the firm any increase or decrease in the sales will have no magnifying effect over EBIT. Therefore, one can say that operating leverage does not exist in present case. Continuing with the same example, Institute of Lifelong Learning, University of Delhi Page 6

7 If we take fixed element of cost as Rs Then EBIT before and after will be Situation A Situation B Sales@ 10/unit VC@ 5/unit Fixed Cost = % Change in EBIT/ % Change in Sales = 55.55%/50% = 1.11 In the present case, operating leverage is 1.11 which shows that 1% increase in sales will result in 1.11% increase in EBIT. Therefore, one can say that because of existence of fixed operating cost, operating leverage exists. Higher operating cost results in higher operating leverage. Though higher operating leverage may not be good but every firm must have some element of fixed operating cost in order to have magnifying effect of sales on EBIT. Whenever % change in EBIT is greater than % change in sales, the operating leverage exists and relationship is called Degree of operating leverage (DOL). If DOL is more than 1, there is Operating Leverage. DOL can also be measured for a particular sales level with the help of following formula: DOL = Contribution/EBIT or Sales-VC/EBIT The DOL for two different sales levels will be different. The behaviour of operating leverage will depend upon the position of sales vis-a-vis break even sales of the firm. If the present level of sales is more than breakeven level of sales the DOL will decrease with every increase in sales level and vice versa. This is because, increase in fixed cost is relatively smaller then increase in sales level. The DOL is undefined at break even sales level as shown below DOL = Contribution/ EBIT (We know EBIT is zero at Break Even Sales) so DOL will be infinitive or undefined. Institute of Lifelong Learning, University of Delhi Page 7

8 Figure 4: Operating Leverage and EBIT Concluding Points of DOL a. OL is the % change in EBIT because of % change in sales. It measures the magnifying effect of change in EBIT because of change in sales, which results because of fixed operating cost. b. If there is no fixed operating cost, then there will be no operating leverage or degree of operating leverage will be one. c. A positive operating leverage means firm is operating at a higher level than breakeven point. d. A negative operating leverage means firm is operating at lower level than break-even point and firm s EBIT will be negative. Importance of Operating Leverage: The study of operating leverage helps the finance manager in a. To show impact of changes in sales on the level of operating profits (EBIT) of the firm b. In case of higher DOL, a firm can earn huge profits by increasing sales volume. Firm will incur losses if there is substantial decrease in sales volume. Therefore firm should avoid operating under high DOL. c. Higher DOL represents higher operating risk thereby increasing overall risk of the firm. The study of DOL helps manager to take calculated risk. Institute of Lifelong Learning, University of Delhi Page 8

9 INTERACTIVE Financial Leverage: Financial leverage represents the relationship between EPS and EBIT. Financial leverage measure the % change in EPS because of % change in EBIT. Therefore, financial leverage measures the responsiveness of EPS because of change in EBIT. According to Hampton, Financial leverage exists whenever firm has debt or other sources of fund carrying fixed charge in its capital structure The use of cheaper source of finance debt, although results in financial leverage or trading on equity which helps in maximising the earning per share to the equity shareholders, will also increase the financial risk of the firm. Financial risk occurs because of inability of the firm to pay its fixed financial costs. If firm is not earning enough to pay interest or their fixed payments the financial risk as well as overall risk of the firm will increase, So, finance manager should consider the level of debt in the capital structure while taking financial decisions. If the firm is financed through equity capital, then there will be no financial risk. But firm will be losing benefit of tax deductibility of debt finance. So, higher the debt proportion in the capital structure, higher the payment of interest, resulting in higher financial risk. Thus, financial leverage is an indicator of financial risk of the company. It means financial leverage occurs because of existence of fixed financial cost of the firm in their capital structure. It can be calculated as FL= % Change in EPS/% Change in EBIT Whenever % change in EPS is greater than % change in EBIT, the financial leverage exists and relationship is called Degree of financial leverage (DFL). If DFL is more than 1, there is financial Leverage. DFL can also be measured for a particular sales level with the help of following formula DFL = EBIT/EBT or = EBIT/EBT-PD/(1-T) ( In case firm is using Preference Share Capital) Illustration 2: If a firm is having EBIT of Rs and it pays interest on loan of Rs.2000 (fixed financial charge). The total number of equity share of the firm is 1000 shares. Assume EBIT of the firm increases by Rs and rate of income tax is 40%. Calculate financial leverage. Solution 2: Institute of Lifelong Learning, University of Delhi Page 9

10 The financial leverage of the firm can be calculated as % Change in EBIT= Change in EBIT/ EBIT =5000/10000*100= 50% % Change in EPS= Change in EPS/ EPS Where t= tax rate PD= Preference dividend EBIT= Earnings before Interest and Tax Now EPS will be (before increase) EPS (after increase in EBIT) Now % Change in EPS is Financial Leverage EPS =(EBIT-I)(1-t)-PD/ No of Equity Shares = ( )(1-.4)/ 1000 = Rs 4.8/Equity Share = ( )(1-.4)/1000 = 7.8/share = 3/ 4.8*100 = 62.5% = 62.5%/50% = 1.25 In above example, percentage change in EBIT is 50% whereas percentage change in EPS is 62.5%. Thus, financial leverage is 1.25 which denotes that EPS will change by 1.25 times the change in EBIT. If the firm is using cheaper source of finance i.e. debt in its capital structure then, any given increase in EBIT will result in more than proportionate increase in the EPS. Figure 5: Financial Leverage Institute of Lifelong Learning, University of Delhi Page 10

11 Financial leverage may be favourable or unfavourable. If firms EBIT level is higher than the fixed financial charge then financial leverage will be positive and termed as favourable financial leverage. If the firms EBIT level is less than fixed financial charge then financial leverage will be negative. Negative financial leverage will result in losses to firm and substantial decrease in EPS. But if the firm is operating at EBIT level of Rs ( i.e. just equal to recover fixed financial charge) then entire EBIT will be used for the payment of interest and no profit will be available for equity shareholders. This is known as financial breakeven point. Financial leverage will be undefined at financial breakeven point as shown below Financial Leverage= EBIT/EBT = Undefined INTERACTIVE 2 = 2000/ Nil Importance of Financial Leverage: Figure 6: Factors affecting Financial Leverage Institute of Lifelong Learning, University of Delhi Page 11

12 Financial leverage helps in taking financial decisions of the firm. Financial leverage depends on two important factors viz. rate of return and cost of debt. If return on investment(roi) of the firm is more than cost of debt capital then FL will be favourable and finance manager can use more debt capital to increase the earning available to equity shareholders. If the FL is unfavourable i.e. cost of debt is more than return on investment then it is not advisable to use debt in its capital structure. Although it can be argued that if firm s ROI is more than cost of debt, then firm can use more and more debt capital. Higher debt content will increase financial risk which may lead to insecurity of equity shareholder. Therefore, an optimum mix of debt and equity in capital structure will result in wealth maximisation of equity share capital. INTERACTIVE Combined Leverage: Figure 7: Types of Leverages and Risks Institute of Lifelong Learning, University of Delhi Page 12

13 As discussed in previous pages, Operating Leverage determines the operating risk of the firm and financial leverage determines the financial risk of the firm, but finance manager or investor is concerned with the overall risk of the firm. Combined leverage helps in ascertaining overall risk of the firm. Combined leverage can be defined as percentage change in EPS for a given percentage change in Sales. Combined leverage can also be obtained by product of financial leverage and operating leverage as shown below: CL= OL*FL Or CL= % Change in EBIT/ % Change in Sales * % Change in EPS/ % Change in EBIT Or % Change in EPS/ % Change in Sales Degree of Combined Leverage (DCL) can be calculated as DCL= DOL*DFL Value Addition 3: Know More Relationship between Leverage and Business Risk Click on the link below to gain an insight into the relationship between Leverage and Business Risk. Source: INTERACTIVE 1 Combined leverage takes into account both fixed operating and fixed financial cost. Combined leverage helps in studying the behaviour of EPS because of a change in sales Institute of Lifelong Learning, University of Delhi Page 13

14 revenue. A finance manager can measure the impact of an increase or decrease in sales over earning per share. As given above, combined leverage helps the finance manager calculate the overall risk of the firm. If the manager wants to take high financial risk then he has to reduce its operating risk so that overall risk of the firm does not go beyond limits. On the basis of above arguments a firm can be categorised into 3 categories: Figure 8: Leverages and Types of Firms Risky Firms: Those firms which are running under high financial and operating leverage are called risky firms. The combined leverage is also high in this case. Normal Firms: A firm having either high financial leverage and low operating leverage or high operating leverage and low financial leverage. The combined leverage is normal in this case. Ideal Firms: The firms which have both financial and operating leverage at the lowest point. INTERACTIVE 6 Value Addition 4: Quiz Multiple Choice Questions Click on the link below to take a quiz on Operating and Financial Leverage Source: 5. EBIT-EPS Analysis: EBIT-EPS analysis is a very strong and important tool in the hands of the finance manager. This is an alternative technique to measure the impact of financial leverage on Institute of Lifelong Learning, University of Delhi Page 14

15 the returns available to equity shareholders. Under EBIT-EPS analysis, an attempt is made to analyse the impact of change in the capital structure on earnings available to equity shareholders. Thus, EBIT-EPS analysis shows the relationship between EBIT and EPS at various financing pattern i.e. debt equity ratio. The financing mix, which yields the maximum EPS to equity shareholders under assumed EBIT level, is regarded as the best mix or the optimum capital structure. There are two ways to analyse the relationship of EBIT and EPS. These two ways are: Figure 9: Relationship between EBIT and EPS (1) Constant EBIT with Changing Financing Pattern (2) Varying EBIT with Changing Financing Pattern Constant EBIT with Changing Financing Pattern: In this section, we will try to analyse the impact of various financing patterns on the return available to equity shareholders assuming constant level of EBIT. The return available to equity shareholders is the residue part of the profit. The total operating profit is divided into various claimants. These are four claimants of EBIT as shown below: Figure 10: Claimants of EBIT Institute of Lifelong Learning, University of Delhi Page 15

16 After payment to the first three claimants, the remaining portion is distributed as equity dividend by dividing the amount available to equity shareholders by the total number of equity shares. The statement of calculation of EPS can be prepared as follows: Particulars Amount (Rs.) EBIT Less: Interest EBT Less: Tax XXX XXX XXX XXX EAT Less: Preference Dividend XXX XXX Earnings Available to Equity Shareholders XXX Number of Equity Shares EPS (Earnings to ESH/ No of Equity Shares) XXX XXX Institute of Lifelong Learning, University of Delhi Page 16

17 The EPS will be different for different financing patterns assuming constant level of EBIT. It is because the interest paid is tax deductible which resulted in tax benefits to equity share holders. Thus, interest on debt capital can be used to increase the return to equity shareholders. However it should be remembered that interest is a liability i.e. fixed financial charge on the earning of the company. It increases the risk perception of the investor. So, it s not possible to keep increasing the level of debt content in the capital structure of the company. The ratio of debt in capital structure will depend on various factors like nature of business, market conditions, economic conditions, earning pattern of the company and cost of the debt. But the two important factors which determine the level of debt content in the capital structure are rate of interest on debt capital and rate of return on overall capital. If the rate of interest is higher than the rate of return to the firm, it is better to use less amount of debt content in the capital structure. In such a case, equity shareholders will bear a part of cost of debt and EPS will decline. Similarly, when rate of return on capital exceeds rate of interest on debt, higher amount of debt can be used in the capital structure which will result in disproportionate increase in the earnings available to equity shareholders (ESH) and EPS will increase. Illustration 3: A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs. 10,00,000. Company is in need of Rs. 8,00,000 for its expansion activities. Company can raise this amount by either equity shares capital or 12% preference share capital or 10% debentures. The company is considering the following financing patterns: a. 10,00,000 through issue of Equity Shares at par; b. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue of Debentures; c. 5,00,000 through Equity Shares and 2,50,000 through 12% Preference Share Capital and remaining 2,50,000 through 10% Debentures.; d. 5,00,000 through Debt and 2,50,000 through Equity Shares and remaining 2,50,000 through 12% Preference Share Capital. Find out the best financing mix assuming 50% tax rate. Solution 3: Capital Structure Plan I Plan II Plan III Plan IV Equity Share of 100 each 10,00,000 5,00,000 5,00,000 2,50,000 12% Preference Share ,50,000 2,50,000 10% Debt ,00,000 2,50,000 5,00,000 Total Capital Employed 10,00,000 10,00,000 10,00,000 10,00,000 Particulars Plan I Plan II Plan III Plan IV Institute of Lifelong Learning, University of Delhi Page 17

18 EBIT (ROI 25%) 5,00,000 5,00,000 5,00,000 5,00,000 Less: Interest ,000 25,000 50,000 EBT 5,00,000 4,50,000 4,75,000 4,50,000 Less: Tax (50%) 2,50,000 2,25,000 2,37,500 2,25,000 EAT 2,50,000 2,25,000 2,37,500 2,25,000 Less: Preference Dividend ,000 30,000 Earnings to Equity Shareholder 2,50,000 2,25,000 1,87,500 1,95,000 Number of shares 10,000 5,000 5,000 2,500 EPS(Rs.) In the above example, alternative IV seems to be best alternative with EPS of Rs. 78. The EPS is Rs. 25 when no debt is used in the capital structure. The EBIT of Rs. 5,00,000 on investment of RS 10,00,000 turn out to be 50%. After tax ROI will be 25%. But the use of cheaper source of finance such as debt at 10% cost and preference share at 12% cost will increase earnings per share. Thus, use of more and more debt or fixed payment capital will lead to increase in EPS to the shareholders. Thus, we can conclude the followings: a. Financial leverage (use of debt) has a favourable impact on the EPS only when ROI is more than cost of debt (net of tax). b. The EPS keeps increasing with the use of debt content in the capital structure till ROI is more than cost of debt. c. Financial leverage will have unfavourable impact on EPS if ROI is less than cost of debt at any point of time. Varying EBIT with Different Financing Patterns: In the previous section, we got an insight into the impact of financing pattern on constant EBIT levels. But in reality, it is impossible to have constant EBIT in all economic conditions. Therefore, varying levels of EBIT will be more practical approach to consider and analyse the impact of different financing patterns. The following example will explain: Illustration 4: A company having equity share capital of Rs. 4,00,000 divided into shares of Rs. 100 each. The company wants to raise additional fund of Rs. 2,00,000 for its diversification programme. The company has following alternatives for raising the fund: Institute of Lifelong Learning, University of Delhi Page 18

19 Plan I: Issue of 20,000 Equity Shares of 100 each Plan II: Issue of 20,000 Preference Shares of 100 each Plan III: Issue of 10% Debentures of Rs. 100 each The expected current EBIT level of the company in present scenario is Rs. 1,00,000. The EBIT will change according to general economic conditions as given below: Good Conditions: EBIT Rs. 1,20,000 Bad Conditions: EBIT Rs. 80,000 Calculate EPS in all the cases and analyse the results. Assume tax rate of 50%. Solution 4: Capital Structure of the Company Particulars Present CS Proposed Capital Structure Plan I Plan II Plan III Equity Shares 4,00,000 6,00,000 4,00,000 5,00,000 12% PSC ,00, % Debntrure ,00,000 Total Capital 4,00,000 6,00,000 6,00,000 6,00,000 Case A: When EBIT is Rs. 1,00,000 (Present Scenario) Particulars Present CS Proposed Capital Structure Plan I Plan II Plan III EBIT 1,00,000 1,00,000 1,00,000 1,00,000 Less: Interest ,000 EBT 1,00,000 1,00,000 1,00,000 80,000 Less: Tax 50,000 50,000 50,000 40,000 EAT 50,000 50,000 50,000 40,000 Less: Pref. Dividend , Earnings to ESH 50,000 50,000 26,000 40,000 Number of Shares 4,000 6,000 4,000 4,000 Institute of Lifelong Learning, University of Delhi Page 19

20 EPS Case B: When EBIT is Rs. 1,20,000 (Good Conditions) Particulars Present CS Proposed Capital Structure Plan I Plan II Plan III EBIT 1,00,000 1,20,000 1,20,000 1,20,000 Less: Interest ,000 EBT 1,00,000 1,20,000 1,20,000 1,00,000 Less: Tax 50,000 60,000 60,000 50,000 EAT 50,000 60,000 60,000 50,000 Less: Pref. Dividend , Earnings to ESH 50,000 60,000 36,000 50,000 Number of Shares 4,000 6,000 4,000 4,000 EPS Case B: When EBIT is Rs. 80,000 (Bad Conditions) Particulars Present CS Proposed Capital Structure Plan I Plan II Plan III EBIT 1,00,000 80,000 80,000 80,000 Less: Interest ,000 EBT 1,00,000 80,000 80,000 60,000 Less: Tax 50,000 40,000 40,000 30,000 EAT 50,000 40,000 40,000 30,000 Less: Preference Dividend , Institute of Lifelong Learning, University of Delhi Page 20

21 Earnings to ESH 50,000 40,000 16,000 30,000 Number of Shares 4,000 6,000 4,000 4,000 EPS The above results can be summarized as follows: Capital Structure Present Proposed Plan I Plan II Plan III EPS : When Case A: When EBIT is 1,00, Case B: When EBIT is 1,20, Case C: When EBIT is 80, Plan I: It can be seen from the table above that in alternative plan I the percentage increase or decrease in EPS is same as percentage increase or decrease in EBIT. For instance, When EBIT increases form 1,00,000 to Rs. 1,20,000 i.e. 20% increase, EPS also increase in the same ratio from Rs to Rs. 10 i.e. 20% increase. Similarly, when EBIT decrease from 100,000 to Rs. 80,000 ie. 20% decline, EPS also decline by the same percentage from Rs to Rs i.e. 20% decline. Plan II: Similarly in alternative plan II, the increase in EPS is 38.46% as compare to the increase of 20% in the EBIT level. The magnifying effect of cheap source of fund i.e. preference share capital resulted in more than proportionate increase in EPS. Plan III: In alternative plan III, the percentage increase in EPS is 25% while EBIT increases from 1,00,000 to 1,20,000. Thus percentage increase in EPS is more than the percentage increase in EBIT. It is because of leverage or using cheaper source of finance i.e. debt in the capital structure of the company. The after tax cost of debt is 5% (10% (1-t)). Thus the use of cheaper source of finance leads to magnifying effect on the earnings available to equity shareholders. Thus from the above discussions, we conclude: a. When there is fixed financial charge or debt content in the capital structure of the firm, the percentage change in the EPS is equal to percentage change in EBIT as seen in the alternative Plan I. Institute of Lifelong Learning, University of Delhi Page 21

22 b. Use of fixed payment capital like preference shares and debentures results in magnifying effect on the EPS. It means us e of cheap source of finance will lead to more than proportionate increase in the EPS as seen in the alternative (b) and (c) both. c. Us e of leverage (debt and preference shares) in the capital structure will have unfavorable impact on the EPS if return on investment is less than cost of debt. Financial Break -Even Level: The EBIT level at which, firm is able to cover its fixed financial charge (interest and preference dividend) is called financial break -even level. The earnings available to equity shareholders will be zero at financial break -even level. Thus financial break- even level means that level of EBIT which lead to zero EPS. The EPS will be positive above the financial break- even level of EBIT while EPS will go down if EBIT falls below the break - even level. Financial break-even level can be obtained as follows: (i) When debt and preference shares are used in capital structure EBIT= Interest +PD (1-t) Where I= interest payment PD= preference dividend (preference dividend will be adjusted for corporate dividend tax if information is given) T= rate of income tax (ii) When only debt is used in the capital structure EBIT= Interest Illustration 5: A firm has 5,00,000, 10% debentures in their capital structure. The company also pay preference dividend of RS. 50,000. The income tax rate is 40%. Company also pays corporate dividend Find out financial break-even level of EBIT. Solution 5: Financial break-even level when dent and preference shares are used EBIT = I+ PD(including (CDT)/(1-t) = 50, ,000(50,000+10,000)/ (1-.4) = 50, ,000/.6 = 1,50,000Rs. Institute of Lifelong Learning, University of Delhi Page 22

23 Verification: EBIT 1,50,000 Less: Interest 50, EBT 1,00,000 Less: Tax (40%) 40, EAT 60,000 Less: PD (Including CDT) 60,000 EPS NIL Indifference Level of EBIT: Indifference level of EBIT is that level of EBIT where two or more different capital structure leads to same EPS. It means an attempt is made to find out EBIT which will result in equal earning per share for two different financing patterns. Calculation of indifference level of EBIT plays an important role in capital designing decisions. If expected EBIT is more than the indifference level of EBIT, a firm can go for higher debt content in the capital structure as it will lead to increase in the earning per share of the firm. But if expected EBIT is less than indifference level of EBIT, any increase of debt content will lead to decrease in the EPS for shareholders. Thus in later case it is advisable to use more of equity than the debt in capital structure. In this analysis EBIT is taken as dependent variable while EPS is taken as independent variable. Thus students are required to ascertain the indifference level of EBIT in different financing patterns. Calculation of indifference level of EBIT require two steps STEP 1: Calculate EPS in equation form for different financing pattern assuming EBIT as X STEP 2: Compare two financing pattern to calculate EBIT Following are possible financing pattern available to the firm. a. When only equity shares are used for financing EPS = EBIT (1-t) (Equation 1) N1 Where N1 = Number of Shares Institute of Lifelong Learning, University of Delhi Page 23

24 b. When debt and equity are used for financing: EPS = (EBIT- I)(1-t) N2 (Equation 2) Where N1= Number of Shares (N2 will be different than N1 because of different equity capital in these two different financing pattern) c. When debt, equity and preference shares are used for financing: EPS = (EBIT-I)(1-t)- PD N3 (Equation 3) Where PD= Preference Dividend N3= Number of Shares d. When equity and preference share capital is used for financing: EPS = EBIT (1-t)- PD N4 (Equation 4) Where N4= Number of Shares Note: N1, N2, N3, N4 will depend upon the amount of equity capital used in particular financing mix. Illustration 6: A company is considering a capital structure of RS. 10,00,000 for which following options are available. Calculate indifference level of EBIT in each case; a. Equity share capital of RS. 10,00,000 or 10% debentures of RS. 5,00,000 and remaining amount from equity share capital. b. Equity share capital of Rs. 8,00,000 plus 10% debentures of Rs. 200,000 Or equity share capital of Rs. 7,00,000 plus 12% preference share of Rs. 3,00,000. c. Equity share capital of Rs. 10,00,000 Or equity share capital of Rs. 5,00,000 plus 10% debenture of Rs. 2,50,000 plus 12% preference share of Rs. 2,50,000. Solution 6: Calculation of Indifference Level of EBIT a. The this case all equity financing is compared with debt and equity financing, therefore equation number 1 and 2 will be compared to find out indifference level of EBIT All Equity = Equity + Debt Institute of Lifelong Learning, University of Delhi Page 24

25 EBIT (1-t) = (EBIT- I)(1-t) N1 N2 EBIT (1-.5) 10,000 = (EBIT-50,000)(1-.5) 5,000 On solving, we get EBIT= Rs. 1,00,000. Thus, indifference level of EBIT is RS. 1,00,000. Verification: Particulars Plan I Plan II All Equity Debt + Equity EBIT 1,00,000 1,00,000 Less: Interest - 50, EBT 1,00,000 50,000 Less: Tax(40%) 50,000 25, EAT 50,000 25,000 Less: Preference dividend Earnings available to Equity Shareholders 50,000 25, Number of Equity Shares 10,000 5,000 EPS Rs. 5 Rs.5 Thus at Rs. 100,000 EBIT, both financing plan will lead to equal EPS. b. In this case, equity and debenture financing is compared with equity and preference share capital. Thus equation no 2 and 4 will be compared to find out indifference level of EBIT. (EBIT-I) (1-t) = EBIT(1-t) PD N2 N4 EBIT (1-.5)/ 10,000 = EBIT (1-.5)- 60,000/ 5,000 On solving, we get EBIT= Rs. 3,24,000 Institute of Lifelong Learning, University of Delhi Page 25

26 (Verification may be done as given above) c. This case, all equity financing is compared with equity, debt and preference share capital. Thus equation no 1 and 3 will be compare to find out indifference level of EBIT. EBIT(1-t) = (EBIT-I)(1-t)- PD N1 N3 EBIT(1-.5) = (EBIT-25,000)(1-.5)- 30,000 10,000 5,000 On solving, we get EBIT = Rs. 1,70,000 (Verification may be done) INTERACTIVE 5 7. Review Illustrations: 1. A firm has a sale of Rs. 90 lakh, variable cost of 20 lakh, fixed cost of Rs. 5,00,000. The capital structure of the firm includes 10% debenture of Rs. 20 lakh and equity share capital of Rs. 40 lakh. Calculate operating, financing and combined leverage. Solution 1: Particulars Statement of EBT Amount (Rs.) Sales Less: Variable Cost Contribution 90 lakh 20 lakh lakh Less: fixed Costs EBIT 5 lakh lakh Less: Interest on Debenture EBT 2 lakh lakh (i) Operating Leverage = Contribution/ EBIT = 70 lakh/65 lakh = 1.07 times Institute of Lifelong Learning, University of Delhi Page 26

27 (ii) Financial Leverage = EBIT /EBT = 65 lakh/ 63 lakh = 1.03 times (iii) Combined Leverage = FL OL = = 1.10 times 2. Following information is given; EBIT Preference Dividend Operating Fixed Costs EBT = RS. 10 lakh = Rs.40,000 = Rs. 20 lakh = Rs.2 lakh Tax Rate = 50% Calculate the degree of operating, financing and combined leverage. By what percentage the operating profits would increase if the sales increase by 10%? Solution 2: Calculation of leverages (i) Operating Leverage = Contribution/ EBIT = Fixed operating costs+ EBIT / EBIT = 20lakh+ 10 lakh /10 lakh = 3 times (ii) Financial Leverage = EBIT EBT PD/(1-t) = 10,00,00o ,00,000 40,000/(1.5) = 10,00,000/ 1,20,000 = 8.33 times Institute of Lifelong Learning, University of Delhi Page 27

28 (iii) Combined Leverage = FL OL = =25 times. Percentage increase in Profit if Sales increases by 10% DOL = % increase in EBIT/ % increase in sales 3 = % increase in EBIT / 10% % increase in EBIT = 30 % 3. The Balance Sheet of a company is as follows: Liability Side Equity Share Capital RS. 60,000 Retained Earnings Rs. 10,000 10% Long Term Debt Rs. 100,000 Current Liabilities Rs.30,000 Total 2,00,000 Asset Side Fixed Asset Rs. 160,000 Current Asset Rs. 40,000 Total Rs.2,00,000 The company s total asset turnover ratio is 3. Its fixed operating costs are Rs. 120,000 and its variable operating costs ratio is 50%. The income tax rate is 50%. Calculate all leverages for the company given that the face value of the equity share is Rs.10. Also calculate EPS. Solution 3: Total Asset Turnover Ratio = Sales/ Total Asset Institute of Lifelong Learning, University of Delhi Page 28

29 3 = Sales /2,00,000 Hence, Sales = 6,00,000 RS. Statement of Earnings Particulars Amount (Rs.) Sales 6,00,000 Less: Variable Cost 3,00, Contribution 3,00,000 Less: Fixed Operating Costs 1,20, EBIT 1,80,000 Less: Interest on Debenture 10, EBT 1,70,000 Less: Income Tax 85, EAT 85,000 Less: Preference Dividend NIL Earnings available to Equity Shareholders 85, EPS = Earnings Available to Equity Shareholders / Number of Equity Shares = 85,000 / 6000 = Rs per share. (i) Operating Leverage = Contribution/ EBIT = 3, 00,000/ 1, 80,000 = 1.67 times (ii) Financial Leverage = EBIT /EBT = 1, 80,000/ 1, 70,000 = 1.05 times (iii) Combined Leverage = FL OL = = 0.62 times Institute of Lifelong Learning, University of Delhi Page 29

30 4. The following information are given for a company EBIT Rs. 10, 00,000 EBT Rs. 3, 20,000 Fixed Costs Rs. 5, 00,000 Calculate the % change in EPS if the sales are expected to increase by 5%. Solution 4: Calculation of Leverage (i) Operating Leverage = Contribution/ EBIT = 10, 00, , 00,000/ 10, 00,000 = 1.5 times (ii) Financial Leverage = EBIT /EBT = 10, 00,000/ 3, 20,000 = times (iii) Combined Leverage = FL OL = = 4.68 times % Change in EPS DCL = % change in EPS/ % change in Sales 4.68 = % change in EPS/ 5% % change in EPS = % 5. The following data are available for ABC Ltd. Sales Rs.5, 00,000 Variable Cost Rs 2, 00,000 Fixed Costs Rs.1, 50, 0000 Interest Rs. 25,000 EBT Rs. 1, 25,000 a. Using the concept of leverage calculate by what percentage will EBIT increase if there is 10% increase in sales. Institute of Lifelong Learning, University of Delhi Page 30

31 b. Using the concept of leverage calculate by what percentage EPS increase if EBIT increases by 6% c. Using the concept of leverage calculate by what percentage will the EPS increase if the sales increases by 8%. Also, verify the results. Assume number of outstanding shares is 5,000 shares. Solution 5: Statement of EBT or Earnings Particulars Amount (Rs.) Sales 5, 00,000 Less: Variable Cost 2, 00, Contribution 3, 00,000 Less: Fixed Costs 1, 50, EBIT 1, 50,000 Less: Interest on Debenture 25, EBT 1, 25, EPS = EBT/ Number of shares = 1,25,000/ 5000 = Rs.25/share Calculation of Leverages (i) Operating Leverage (ii) Financial Leverage = Contribution/ EBIT = 3, 00,000/ 1,50,000 = 2 times = EBIT /EBT = 1, 50,000/ 1, 25,000 = 1.2 times (ii) Combined Leverage = OL FL = = 2.4 times Institute of Lifelong Learning, University of Delhi Page 31

32 (a) As we know that operating leverages explain the relationship between sales and EBIT so using operating leverage OL = % Change in EBIT /% Change in Sales 2 = % change in EBIT / 10% So % change in EBIT is 20% Verification of Results Particulars Statement of New EBT Amount (Rs.) Sales 5, 50,000 Less: Variable Cost(2 lakh/5 lakh 5.5 lakh) 2, 20, Contribution 3, 30,000 Less: Fixed Costs 1, 50, EBIT 1, 80,000 Less: Interest on Debenture 25, EBT 1, 55, % Change in EBIT = New EBIT- Old EBIT / Old or Base EBIT = 180,000 1, 50,000 / 1, 50,000 = 20% (b) Using the financial leverage we can calculate % change in EPS FL = % change in EPS/% change in EBIT 1.2 = % change in EPS / 6% Hence % increase in EPS is 7.2% Verification: Statement of New Earnings EBIT (6% more than previous) 1, 59,000 Less: Interest on Debenture 25,000 Institute of Lifelong Learning, University of Delhi Page 32

33 EBT 1, 34, New EPS = EBT/ Number of Shares = 1, 34,000 / 5,000 = Rs % Change in EPS = New EPS Old EPS / Old EPS = / 25 = 7.2% (c) Using combined leverage, we can calculate % change in EPS CL = % Change in EPS / % Change in Sales 2.4= % Change in EPS / 8% Hence, % increase in EPS will be 19.2% Verification: Statement of New EBT or Earnings Particulars Amount (Rs.) Sales (8% more) 5, 40,000 Less: Variable Cost 2, 16, Contribution 3, 24,000 Less: Fixed Costs 1, 50, EBIT 1, 74,000 Less: Interest on Debenture 25, EBT 1, 49, New EPS = EBT/ Number of Shares = 1, 49,000/ 5000 = Rs.29.8/share % Change in EPS = New EPS Old EPS / Old EPS = / 25 = 19.2% Institute of Lifelong Learning, University of Delhi Page 33

34 Value Addition 5: Quiz Multiple Choice Questions Click on the link below to take a quiz on financial and operating leverage. Source: Summary: Leverage can be explained as the relationship between two interrelated variables. Leverage can be of three types viz financial, operating and combines. Operating leverage measure the operating risk of the firm while financial leverages measure financial risk. Operating g leverage occurs because of fixed operating expensed of the firm. Financial leverage occurs because of use of fixed financial costs like interest on debt. Study of leverage helps in capital structure decisions and in controlling overall risk also. Leverage analysis helps in studying the relationship among three important variable like sales, EBIT, and EBT Glossary: Trading on Equity: Use of debt in capital structure to produce gain to the residual owners i.e. equity shareholders. Break Even Sales: It is the sales level where there is no profit and no loss to the company. Thus break even sales is the minimum amount of sales needed for making a profit. If total sales are more than break even sales, it will result into profit. Operating Risk (Business Risk): Basel II defines operating risk as risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Thus business risk occurs because of failed internal management or market conditions which are beyond company control. Financial Risk: Financial risk is the risk caused because of existence of fixed financial payments like interest on debentures or loans. It occurs because of debt content in capital structure. Higher amount of debt content in capital structure will results in higher financial risk. Optimum Capital Structure: It is a capital structure or range of capital structure which results in maximum earning to equity shareholders (EPS). It results because of best mix of debt and equity capital in the overall capital structure of the firm. Exercises: I. Objective Type Questions: A. Fill in the Blanks. Institute of Lifelong Learning, University of Delhi Page 34

35 1. Financial leverage occurs when firm has.in its capital structure. 2. Operating leverage is an index of..risk. 3. DCL (Degree of Combined Leverage) = DOL (Degree of Operating Leverage) 4. Total risk of the firm consists of.risk and Financial risk. 5. Operating Leverage 1.5 denotes that percentage change in EBIT is the percentage changes in Sales. B. State Whether Following Statements are True or False. 1. Operating risk is associated with financial costs. 2. Operating leverage shows the relationship between EBIT and EPS 3. Operating and Financial risk occur because of same reasons. 4. Combined leverage shows the relationship between sales and EPS. 5. A High combined leverages is always beneficial for the company. II. Theoretical Questions: 1. Define leverage. What are different types of leverages? 2. What are importance and limitations of leverage analysis? 3. Differentiate between financial leverage and operating leverage. 4. Explain the causes of financial risk and operating risk. How can these two be measured? 5. Explain the importance of financial leverage in capital structure decisions. III. Numerical Questions: 1. A company has a sales of Rs. 20,00,000, variable cost of Rs. 14,00,000. Fixed cost of Rs. 4,00,000 and debt of Rs, 10,00,000 at 12% rate of interest. What are the operating and financial and combined leverages? 2. Calculate the operating and combined leverage from the following data: Sales 2,00,000 units at Rs. 50 per unit. Variable Cost per unit Rs.25 Fixed Charges Rs. 25,00,000 Interest Charges Rs. 10,00, Following data of a company is given below: Sales 90,00,000 Variable Cost 50,00,000 Fixed Costs 10,00,000 Interest Payment Rs.5,00,000 Calculate degree of operating leverage and financial leverage. By what percentage will EBIT increase if there is 10% increase in sales? Verify the results. 4. Calculate the operating leverage and financial leverage from the following data: EBIT Rs. 10,00,000 PAT Rs.1,00,000 Operating Fixed Cost Rs. 7,00,000 Tax Rate 40% Institute of Lifelong Learning, University of Delhi Page 35

36 If the company wants to increase its PAT by 40%, what should be the percentage rise in the sales? 5. Suri Ltd. is selling its product at R. 2 per unit. The variable cost of manufacturing has been estimated at 75%. While the fixed cost at present sales level of Rs. 1,00,000 unit comes to Rs. 25,000. The company has issued 10% debenture of Rs. 26,000. Find out operating, financial and combined leverage for the firm. Also find out percentage increase in sales if company wants to double its EPS. Answers to Objective Type Questions: A. 1. Debt; 2.Business ; 3.DFL; 4. Business; times/ more than. B. 1.False; 2. False; 3.False; 4.True; 5.False. Answers to Numerical Questions: 1. OL=3 times; FL=2.5 times; CL=7.5 times, 2. OL=2; CL=3.33; 3. DOL=1.33, DFL=1.2, % Change in EBIT=13.33%; 5. OL=2, FL=1.116,CL=2.23, % Change in Sales= 44.8% References: 1. Work Cited and Suggested Readings: Khan, M.Y., & Jain, P.K. (2011). Financial Management Text, Problems and Cases(Sixth edition):tmh Chandra, Prasanna (2008). Financial Management Theory and Practice(seventh edition): TMH Pandey, I.M.,(2010). Financial Management, Vikas Publications Van Horne, James C., John Wachowicz, Fundamentals of Financial Management,Pearson education. Ross, Stephen A., Westerfield, Randolph and Jeffery Jaffe, Corporate Finance,TMH Srivastava, Rajiv and Anil Mishra, Financial Management, Oxford University Press. Singh, Preeti. Financial Management, Ane Books Pvt. Ltd. Brealey, Richard A.,& Stewart C. Myers, Corporate Finance, Capital Investment and Valuation, MGH Singh, S. & Kaur, R., (2012) Basic Financial Management, Mayur Paperbacks. 2. Web Links: Visit the URL to know the best way to access capital for the business. Visit the URL to gain an insight into the concept of optimal capital structure. Visit the URL to gain an insight into the concept of EBIT-EPS Analysis and Leverage. Institute of Lifelong Learning, University of Delhi Page 36

37 3. Video Links: Visit the URL to gain an insight into the concept of financial leverage. Institute of Lifelong Learning, University of Delhi Page 37

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