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Effects of operating and financial Leverages

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EFFECTS OF FINANCEING AND OPERATING LEVERAGES BY ROLL NO ;- 25
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Page 1: Effects of operating and financial Leverages

EFFECTS OF

FINANCEING

AND OPERATING

LEVERAGES

BY ROLL NO ;- 25

Page 2: Effects of operating and financial Leverages

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

Page 3: Effects of operating and financial Leverages

MEASURES OF FINANCIAL LEVERAGE

Debt ratio Debt–equity 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 firm’s income gearing.

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Page 4: Effects of operating and financial Leverages

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:

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Page 5: Effects of operating and financial Leverages

EPS AND ROE CALCULATIONS

For calculating ROE either the book value or the market value equity may be used.

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Page 6: Effects of operating and financial Leverages

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: taxes@50% 60000 41250

Profit after tax 60000 41250

7 No. of equity shares 50000 25000

8 Earning per share(5 -:- 6) 1.20 1.65This indicates that EPS increases as debt is introduced in capital structure.

Page 7: Effects of operating and financial Leverages

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FINANCIAL LEVERAGE OF TEN LARGEST INDIAN COMPANIES, 2008

Page 8: Effects of operating and financial Leverages

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.

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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

-0 -37,500

3. Profit before taxes, PBT = EBIT - INT

1,20,000

82,500

4. Less : taxes

-60,000 - 41,250

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%

Page 9: Effects of operating and financial Leverages

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.

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Effect of Financial Plan on EPS and ROE:Constant EBIT

Page 10: Effects of operating and financial Leverages

INTEREST TAX SHIELD

The interest charges are tax deductible and, therefore, provide tax shield, which increases the earnings of the shareholders.

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Page 11: Effects of operating and financial Leverages

EFFECT OF LEVERAGE ON ROE AND EPS

Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i

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ROE- Return on equity ;, EPS- Earnings' per share ;, ROI - Return on investment

Page 12: Effects of operating and financial Leverages

OPERATING LEVERAGE

Operating leverage affects a firm’s 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.

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% Change in EBITDOL

% Change in Sales

EBIT/EBITDOL

Sales/Sales

Page 13: Effects of operating and financial Leverages

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.

Page 14: Effects of operating and financial Leverages

IMPACT OF OPERATING LEVERAGE ON PROFITS

Firm F Firm V Firm 2F

Sales $10 $11 $19.5Operating Costs

Fixed 7 2 14

Variable 2 7 3Operating Profit $ 1 $ 2 $

2.5

FC/total costs .78 .22 .82

FC/sales .70 .18 .72

(in thousands)

Page 15: Effects of operating and financial Leverages

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.

Page 16: Effects of operating and financial Leverages

IMPACT OF OPERATING LEVERAGE ON PROFITS

Firm F Firm V Firm 2FSales $15 $16.5 $29.25Operating Costs

Fixed 7 2 14 Variable 3 10.5 4.5Operating Profit $ 5 $ 4 $10.75Percentage Change in EBIT* 400% 100% 330%

(in thousands)

* (EBITt - EBIT t-1) / EBIT t-1

Page 17: Effects of operating and financial Leverages

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.

Page 18: Effects of operating and financial Leverages

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.

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Page 19: Effects of operating and financial Leverages

THE END


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