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Effects of operating and financial Leverages

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leverage explanation with explanation
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  • 1. BY ROLL NO ;- 25

2. MEANING OF FINANCIAL LEVERAGE The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners equity in the capital structure, is described as financial leverage or gearing or trading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners equity. The rate of return on the owners equity is levered above or below the rate of return on total assets. 2 3. MEASURES OF FINANCIAL LEVERAGE Debt ratio Debtequity ratio Interest coverage The first two measures of financial leverage can be expressed either in terms of book values or market values. These two measures are also known as measures of capital gearing. The third measure of financial leverage, commonly known as coverage ratio. The reciprocal of interest coverage is a measure of the firms income gearing. 3 4. DEGREE OF FINANCIAL LEVERAGE The degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT: 4 5. EPS AND ROE CALCULATIONS For calculating ROE either the book value or the market value equity may be used. 5 6. EXAMPLE SHOWING IMPACT OF FINANCIAL LEVERAGES ON THE EARNINGS PER SHARE All - equity Debt - equity 1 Investment 5,00,000 5,00,000 2 Equity capital 500000 250000 3 Debt capital @ 15 % 0 250000 4 Earning before interest and tax 120000 120000 5 Less: interest 0 37500 Profit before tax 120000 82500 6 Less: [email protected]% 60000 41250 Profit after tax 60000 41250 7 No. of equity shares 50000 25000 8 Earning per share(5 -:- 6) 1.20 1.65 This indicates that EPS increases as debt is introduced in capital structure. 7. 7 FINANCIAL LEVERAGE OF TEN LARGEST INDIAN COMPANIES, 2008 8. ANALYZING ALTERNATIVE FINANCIAL PLANS: CONSTANT EBIT The firm is considering two alternative financial plans: (i) either to raise the entire funds by issuing 50,000 ordinary shares at Rs 10 per share, or (ii) to raise Rs 250,000 by issuing 25,000 ordinary shares at Rs 10 per share and borrow Rs 250,000 at 15 per cent rate of interest. The tax rate is 50 per cent. 8 Effect of Financial Plan on EPS and ROE: Constant EBIT Financial plan All-equity Debt- equity 1. Earnings before interest and tax , EBIT 1,20,000 1,20,000 2. Less : interest 3. Profit before taxes, PBT = EBIT - INT 1,20,000 82,500 4. Less : taxes 5. Profit after tax 60,000 41,250 6.T otal earning of investor PAT + INT 60,000 78,750 7. No of ordinary shares 50,000 25,000 8. EPS= (EBIT - INT) (1- T)/N 1.20 1.65 9. ROE = (EBIT - INT)(1- T)/E 12.0 16.5% 9. ANALYZING ALTERNATIVE FINANCIAL PLANS: CONSTANT EBIT The firm is considering two alternative financial plans: (i) either to raise the entire funds by issuing 50,000 ordinary shares at Rs 10 per share, or (ii) to raise Rs 250,000 by issuing 25,000 ordinary shares at Rs 10 per share and borrow Rs 250,000 at 15 per cent rate of interest. The tax rate is 50 per cent. 9 Effect of Financial Plan on EPS and ROE: Constant EBIT 10. INTEREST TAX SHIELD The interest charges are tax deductible and, therefore, provide tax shield, which increases the earnings of the shareholders. 10 11. EFFECT OF LEVERAGE ON ROE AND EPS Favourable ROI > i Unfavourable ROI < i Neutral ROI = i 11 ROE- Return on equity ;, EPS- Earnings' per share ;, ROI - Return on investment 12. OPERATING LEVERAGE Operating leverage affects a firms operating profit (EBIT). The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales. 12 % Change in EBIT DOL % Change in Sales EBIT/EBIT DOL Sales/Sales 13. OPERATING LEVERAGE One potential effect caused by the presence of operating leverage is that a change in the volume of sales results in a more than proportional change in operating profit (or loss). Operating Leverage -- The use of fixed operating costs by the firm. 14. IMPACT OF OPERATING LEVERAGE ON PROFITS Firm F Firm V Firm 2F Sales $10 $11 $19.5 Operating Costs Fixed 7 2 14 Variable 2 7 3 Operating Profit $ 1 $ 2 $ 2.5 FC/total costs .78 .22 .82 FC/sales .70 .18 .72 (in thousands) 15. IMPACT OF OPERATING LEVERAGE ON PROFITS Now, subject each firm to a 50% increase in sales for next year. Which firm do you think will be more sensitive to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)? [ ] Firm F; [ ] Firm V; [ ] Firm 2F. 16. IMPACT OF OPERATING LEVERAGE ON PROFITS Firm F Firm V Firm 2F Sales $15 $16.5 $29.25 Operating Costs Fixed 7 2 14 Variable 3 10.5 4.5 Operating Profit $ 5 $ 4 $10.75 Percentage Change in EBIT* 400% 100% 330% (in thousands) * (EBITt - EBIT t-1) / EBIT t-1 17. IMPACT OF OPERATING LEVERAGE ON PROFITS Firm F is the most sensitive firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT. Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage. 18. RISK-RETURN TRADE-OFF If the firm wants higher return (EPS or ROE) for the shareholders for a given level of EBIT, it will have to employ more debt and will also be exposed to greater risk (as measured by standard deviation or coefficient of variation). In fact, the firm faces a trade-off between risk and return. Financial leverage increases the chance or probability of insolvency. 18 19. THE END

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