ANALYSIS OF LEVERAGE

TEAM :-ISHA

S.YUSRA JAMALSAMRJEET KAUR

Introduction

• Leverage provides the Framework for Financing Décisions of a Firm.

• It May Be définie as the Employment of an Assest or Source of Funds for which the Firm has to pay a Fixed Cost , or Fixed Return.

• Deleveraging is the action of reducing borrowings.

• A key measure of leverage is the debt to GDP ratio.

Break-Even (BE) Point

• Quantity where Total Revenue equals Total Cost

• Company has no Profit or Loss• BE = FC / P – VC• A leveraged firm has a high BE

point• A non-leveraged firm has a low

BE point

Risk in the Context of Leverage

• Leverage influences stock priceAlters the risk/return relationship in

an equity investment• Measures of performance

Operating income (EBIT or Earnings Before Interest and Taxes)

• Unaffected by leverage because it is calculated prior to the deduction for interest

Return on Equity (ROE) is Earnings after Taxes Stockholders’ Equity

Earnings per Share (EPS) is Earnings after Taxes number of shares

• Investors regard EPS as an important indicator of future profitability

Risk in the Context of Leverage

• Redefining Risk for Leverage-Related Issues

• Leverage-related risk is variation in ROE and EPS:

1. Business risk—variation in EBIT2. Financial risk—additional variation in

ROE and EPS brought about by financial leverage.

• An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point)

• A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)

Business and Financial Risk

Operating Leverage• It is associated with asset acquisition or

investment activities.• It may be defined as the ability to use fixed

operating costs to magnify the effect of changes in sales on its operating profits(EBIT).

• Refers to the amount of fixed costs in the cost structure.

• Fixed and Variable Costs and Cost Structure.• Fixed costs don’t change with the level of

sales, while variable costs do– Fixed costs include rent, depreciation,

utilities, salaries– Variable costs include direct labor,

direct materials, sales commissions• The mix of fixed and variable costs in a firm’s

operations is its cost structure

The Effect of Operating Leverage

• As volume moves away from Breakeven(Used to determine the level of activity a firm must achieve to stay in business in the long run), profit or loss increases faster with more operating leverage

• The Risk EffectMore operating leverage leads to larger

variations in EBIT, or business risk• The Effect on Expected EBIT• Thus, when a firm is operating above breakeven,

more operating leverage implies higher operating profit

If a firm is relatively sure of its operating level, it is in the firm’s best interests to trade variable costs for fixed cost (assuming the firm is operating above breakeven)

• a in Sales a larger in EBIT (or OI)

Breakeven Diagram at High and Low Operating Leverage

The Degree of Operating Leverage (DOL)—A

Measurement• Operating leverage amplifies changes

in sales volume into larger changes in EBIT

• DOL relates relative changes in volume (Q) to relative changes in EBIT.

DOL = %change in EBT %change in SalesDOL = Sales – Variable Costs EBIT

exampleA company is perfectly selling 5000

units of a product @ Rs 20 per unit. If variable cost is Rs 6 per unit & fixed operational cost are Rs 80000. Find DOL

sol :- sales = 20*5000 = 100000 VC = 30000contribution = 70000(-) FC = 80000EBIT = 10000therefore, DOL = 70000/10000 =

7%

Financial Leverage• Measure of the amount of debt used by a firm.• a in EBIT (or OI) a larger in EPS.• Financial Leverage measures the sensitivity of a

firm’s earnings per share to a in operating income.

• Used as a means of increasing the return to common shareholders.

• Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS

• The degree of financial leverage (DFL) relates relative changes in EBIT to relative changes in EPS.

• An easier method of calculating DFL is:-

EBITDFL =

EBIT - Interest

Degree of Financial Leverage (DFL)

• Degree of Financial Leverage -- The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in operating profit.

DFLDFL =

Percentage change in earnings per share (EPS)

Percentage change in operating profit (EBIT)

% EPSDFL = or % EPS = DFL % EBIT

% EBIT

Financial Risk

• Financial Risk -- -- The added variability in earnings per share (EPS) -- plus the risk of possible insolvency -- that is induced by the use of financial leverage.

• Debt increases the probability of cash insolvency over an all-equity-financed firm.

Total Firm Risk

The Compounding Effect of Operating Leverage and Financial Leverage

example

Ques :- a company’s EBIT= 10000 & it has 5% bonds for Rs 40000 & preference shares = 20000. Calculate DFL

Sol:- EBIT = 10000 (-) Interest = 2000 EBT = 8000Therefore DFL = 10000/8000 =

1.25

Example

Ques :-A co. having a total capital of Rs 10 lacs with 60% as bonds @10% as equity. The expected sales of firm = 20000 units @20 per unit, VC = 10 per period, fixed operational cost = Rs 50000, calcualte DOL, DFL & DCL

Sol:- Sales = 400000VC = 200000Contri = 200000

(-) FC = 50000

Example contd....

EBIT = 150000(-) Int =60000 EBT = 90000 Therefore, DOL = 200000/150000

= 1.33DFL = 150000/90000 = 1.67DCl = DFL*DOL = 2.22