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Leverages Final

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    - S H R U T H I S H R E E S H I V A G U R U

    LEVERAGES

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    MEANING OF LEVERAGES

    A general meaning of the term leverage refers to anincreased means of accomplishing some purposeleverages allows you to accomplish certain things

    which are otherwise not possible like lifting of heavyobjects with the help of leverage. This conceptapplies to business also.

    In financial management the term leverage is used

    to describe the firms ability to use fixed cost assetsor funds to increase the return to its ownersi.e,equity shareholders.

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    Definition

    According to JAMES HORNE

    the employment of an asset or sources of funds forwhich the firm has to pay a fixed cost or fixed return

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    Format for leverage calculation

    PARICULARS RS

    Sales(-) variable costCONTRIBUTION(-)fixed costEBIT(-)interest

    EBT(-)TaxEAT

    XXXXXXXXXXXXXXXXXX

    XXXXXXXXX

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    Types of leverages

    There are 3 types of leverages:-

    Financial leverage or trading on equity

    Operating leverage

    Composite leverage

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    Financial leverage

    A firm needs funds to run and manage its activities.The funds are first needed to set up an enterpriseand then to implement expansion, diversificationand other plans. A decision has to be made regardingthe composition of funds. The funds may be raisedthrough two sources : owners, called owners equityand outsiders, called creditor's equity.

    The use of long term fixed interest bearing debt andpreference share capital along with equity sharecapital is called as financial leverage

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    Computation of financial leverage

    Financial leverage = EBIT

    EBT

    (OR)

    =EBITEBIT-I

    WHERE,

    EBIT= earning before interest and taxEBT = earning before tax

    I = interest.

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    problem

    Sales = 2,00,000

    Variable cost =70,000

    Fixed cost = 1,00,000

    Interest expenditure =3,668Calculate the financial leverage.

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    SOLUTION

    Sales = 2,00,000(-) variable cost 70,000CONTRIBUTION 1,30,000

    (-)fixed cost 1,00,000EBIT 30,000

    (-)interest 3668EBT 26,332

    FINANCIAL LEVERAGE = EBITEBT

    30,00026,332

    = 1.13 times.

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    Significance of financial leverage

    Planning of capital structure : it is concerned withraising of long term funds from shareholders andcreditors. A financial manager should decide the ratio

    between the fixed cost funds and ESC. The effects ofborrowing on cost of capital and financial risk have to be

    discussed before selecting a financial capital structure. Profit planning: The EPS is affected by the degree of

    financial leverage. If the profitability of the concern isincreasing then fixed cost funds will help in increasingthe availability of profits for equity stock holders.

    Therfore, financial leverage is impt for profit planningthe level of sales and resultant profitability is helpful inprofit planning.

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    Limitations of financial leverage

    1) DOUBLE-EDGED WEAPON-trading on equity is adouble edged weapon. It can be successfully employedto increase the earnings of the shareholders only whenthe rate of earnings of the company is more than thefixed rate of interest/dividend on

    debentures/preference shares.2) BENEFICIAL ONLY TO COMPANIES HAVING

    STABILITY OF EARNINGS-Trading on equity isbeneficial only to the companies having stable andregular earnings. This is so because interest on

    debentures is a recurring burden on the company and acompany having irregular income cannot pay intereston its borrowings during lean years.

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    3) INCREASES RISK AND RATE OF INTEREST.-Another limitation of trading on equity is on account ofthe fact that every rupee of extra debt increases the riskand hence the rate of interest on subsequent loans alsogoes on increasing. It becomes difficult for the company

    to obtain further debts without offering extra securitiesand higher rates of interest reducing their earnings.

    4) RESTRICTIONS FROM FINANCIALINSTITUTIONS- The financial institutions also imposerestrictions on companies which resort to excessive

    trading on equity because of the risk factor and tomaintain a balance in the capital structure of thecompany.

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    Operating leverage

    Operating leverage results from the presence of fixedcost that helps in magnifying the operating income.In simple words, fixed cost remaining the sameincrease in the sales increases the operating profit.

    Hence, the operating leverage occurs only whenthere is fixed cost.

    If a firm does not have fixed costs then there will be nooperating leverage. The percentage change in sales

    will be equal to percentage change in profit. Whenfixed costs are there, the percentage change in profits

    will be more than the percentage in sales volume.

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    Computation of operating leverage

    OPERATING LEVERAGE = CONTRIBUTION

    EBIT

    (OR)

    CONTRIBUTION= SALES- VARIABLE COSTOPERATING PROFIT = CONTRIBUTION FIXED

    COST

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    PROBLEM ON OPERATING LEVERAGE

    Following information is taken from the records of ahypothetical company.

    Installed capacity 1,000 units

    Operating capacity 800 units

    Selling price per unit RS 10Variable cost per unit RS 7

    Calculate operating leverage under the following situation:

    Fixed cost:

    Situation A RS 800

    Situation B RS1,200

    Situation C RS1,500

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    solution

    SITUATION A(RS)

    SITUATION B(RS)

    SITUATION C(RS)

    Sales

    (-) variable cost

    CONTRIBUTION

    (-) fixed cost

    OPERATING PROFIT (EBIT)

    OPERATING LEVERAGE (C/OP)

    BREAK EVEN POINT (F/C)*S

    MARGIN OF SAFETY (OP/C)

    8000

    5600

    2400

    800

    1600

    1.5

    2.667

    66.7%

    8000

    5600

    2400

    1200

    1200

    2.0

    4.000

    50%

    8000

    5600

    2400

    1500

    900

    2.67

    5.000

    37.5%

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    COMPOSITE LEVERAGE

    While operating leverage is the result of production,financial leverage is the result of capital structure orfinancial decision. Both explain different types ofrisk of a business, put together they determine theoverall risk.

    In simple terms, combined leverage explains thebusiness risk as a whole.

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    Computation of composite leverage

    Composite leverage = financial leverage* operatingleverage.

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    Problem on composite leverage

    A simplified income statement of ZENITH ltd is given below.Calculate and interpret its degree of operating leverage,degree of financial leverage and degree of composite leverage.

    Income statement of ZENITH ltd for the year ended 31st march2005.

    Sales 10,50,000

    Variable cost 7,67,000

    Fixed cost 75,000

    EBIT 2,08,000

    Interest 1,10,000

    Taxes (30%) 29,000

    Net income 38,000

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    solution

    (a) OPERATING LEVERAGE = CONTRIBUTION

    EBIT

    contribution = sales variable cost

    =10,50,000 7,67,000= RS 2,83,000

    =2,83,000/2,08,000 =1.36

    Operating leverage of 1.36 indicates that 1% change insales is likely to result in 1.36% change in earnings

    before interest and tax

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    .

    (b) FINANCIAL LEVERAGE = EBIT/EBTEBT= EBIT I = 2,08,000 1,10,000

    =98,000FL= 2,08,000/98,000 =2.12

    Financial leverage of 2.12 indicates that 1% change in EBIT is likely tocause a change of 2.12% in the net income of the company.

    (c) COMBINED LEVERAGE = OL * FL=1.36*2.12

    =2.88

    Combined leverage of 2.88 indicates that 1% change in sales is likely toresult in 2.88% change in the net income of the company.

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    problem

    A firm has sales of rs.75,00,000 variable cost ofrs.42,00,000 and fixed cost of rs.6,00,000. it has a debtof rs.45,00,000 at 9% and equity of rs.55,00,000.

    1. What is the firms ROI?

    2. Does it have favorable financial leverage?3. If the firm belongs to an industry whose asset turnover

    is 3, does it have a high or low asset leverage?

    4. What are the operating, financial and combined

    leverage of the firm?5. If the sales drop to rs.50,00,000, what will be the the

    new EBIT?

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    Solution- calculation of EBIT and EBT

    SALES 75,00,000

    (-) VARIABLE COST 42,00,000CONTRIBUTION 33,00,000(-)FIXED COST 6,00,000EBIT 27,00,000(-)INTEREST (45,00,000*9/100) 4,05,000EBT 22,95,000i. ROI = EBIT *100

    CAPITAL EMPLOYEDCAPITAL EMPLOYED=EQUITY+ DEBT

    =55,00,000+45,00,000=1,00,00,000

    ROI= 27,00,000/1,00,00,000 *100=27%

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    (2) DFL = EBIT/EBT = 27,00,000/22,95,000

    =1.176

    AS THE FIRMS ROI (27%) IS MUCH HIGHER THANTHE COST OF DEBT 9%), IT HAS A FAVOURABLEFINANCIAL LEVERAGE.

    (3) ASSET TURNOVER =NET SALES/TOTAL ASSET

    =75,00,000/1,00,000

    =0.75 TIMES

    AS THE FIRMS ASSET TURNOVER (0.75) IS MUCH

    LOWER THAN THAT OF INDUSTRY (3 TIMES), ITHAS VERY LOW ASSET LEVERAGE.

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    CALCULATION OF LEVERAGES

    a) DOP= CONTRIBUTION/EBIT

    =33,00,000/27,00,000 =1.222

    b) DOF = EBIT/EBT

    =27,00,000/22,95,000=1.176

    c) DCL =DOP*DOF

    =1.222*1.176= 1.437

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    CALCULATION OF NEW EBIT WHEN SALESDROP TO RS.50,00,000

    SALES 50,00,000

    (-)VARIABLE COST 28,00,000

    (50,00,000*42,00,000/75,00,000)CONTRIBUTION 22,00,000

    (-)FIXED COST 6,00,000NEW EBIT 16,00,000

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