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Leverages Ppt

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  • 7/31/2019 Leverages Ppt


  • 7/31/2019 Leverages Ppt



    Leveraging is a way to use funds whereby most of the money is raised by borrowing

    rather than by stock issue (for a company) or use of capital (by an individual). At its

    most basic, leveraging means taking out a loan so that you can invest the money and

    hoping your investment makes more money than you will have to pay in interest on

    the loan.

    The word leverage derived from the word lever, which is an engineering term

    Using lever it is possible to lift greater weights by exerting less efforts

    When highly leveraged organization increases its sales by certain percentage, its profit

    increases by a larger percentage

  • 7/31/2019 Leverages Ppt



    Decisions about leverage

    Too much Equity = underleveraged firm

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    Decisions about leverage

    Too much debt = overleveraged firm

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    Decisions about leverage

    The decision is a tradeoff between Risks and Returns. A firm should adopt a

    policy that minimizes risks and maximizes returns

  • 7/31/2019 Leverages Ppt


    Types of Leverages

    Return on Investment Leverage

    Asset Leverage

    Operating Leverage

    Financial Leverage

    Total Leverage

    Fixed charges Leverage

    Combined Leverage

  • 7/31/2019 Leverages Ppt


    Advantages of leveraged lending

    Two principal advantages of leveraged lending that make it a possible

    solution for these clients are:

    Potential for Accelerated Capital Growth provided by taking advantage of

    compounding investment income.

    The key is to ensure that the leveraged investments produce income mainly

    in the form of capital gains. Note: that compared to interest income, capitalgains income is taxed much more favourably.

    Possible Tax Advantages A clients interest payments may be tax

    deductible if the client borrows to invest in a non-registered investment.

    To benefit, the loan interest rate does not necessarily have to be less than orequal to the investment rate of return due to the tax deductibility that

    reduces the cost of a leveraged lending strategy.* However, the after-tax

    rate of return must be higher than the after-tax cost of the interest.

  • 7/31/2019 Leverages Ppt


    The risks of leveraged lending

    Reduce emotional or financial strain that can result if interest rates rise or cash flow

    changes by minimizing debt-servicing requirements. For example: rather than borrowing to100% of a clients limit, borrow 10% to

    50% of the maximum available.

    Consider loans that do not require margin calls.

    Limitations of Financial Leverage

    1. It may cause dividends to disappear altogether and, indeed, may be responsible for the

    insolvency and even bankruptcy of a corporation.

    2. Companies enjoying a fairly regular income can employ borrowed funds more safely than

    those with widely fluctuating incomes.

    3. Beyond a certain point, additional capital cannot be employed to produce a return in

    excess of the payments which must be made for its use or sufficiently in excess thereof isjustify its employment.

    4. The bigger the amount of funds borrowed, the higher the interest rate of corporation may

    be forced to pay in order to market its successive Issues of bonds.

  • 7/31/2019 Leverages Ppt


    Formula To Calculate DOL

    Degree of operating leverage

    The degree of operating leverage (DOL) is Defined as

    the percentage change in the earning before taxes

    relative to the given percentage change in the sale

    DOL= %Change in EBIT

    %Change in sales

    DOL = Change in EBIT/EBIT

    Change in sales/sales

  • 7/31/2019 Leverages Ppt


    DOL measures the firm business risk

    It helps in understanding the impact ofchange in sales on operating income of thefirm

    It helps to make production planningproper

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    Formula To Calculate DOL

    Degree of Financial leverage

    When the economic conditions are good and the firms EBITis increasing its EPS increases faster with more debt in the

    capital structure .The degree of financial leverage (DFL) is

    defined as percentage change in EPS due to give percentage

    in EBIT

    DFL= %change in EPS

    %change in EBIT

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    Helps in designing appropriate capitalstructure of the firm

    Indicates market prices of the shares.

    Enables understand how EPS wouldchange given a certain change in EBIT.

  • 7/31/2019 Leverages Ppt


    The share capital of the company is Rs 10, 00,000 with share of face

    value of Rs 10.The Company has debt capital of Rs 6, 00,000 at 10%

    rate of interest. The sales of the Firms are3, 00,000 units per annum at

    the selling price of 5 per unit and the variable cost is 3 per unit. The

    fixed cost amount to Rs 2, 00, 000. The company pays taxes at 35%. Ifthe sales increases by 10%,calculate:

    Percentage increase in EPS

    Degree of operating leverage at the two level

    Degree of financial leverage at the two level

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    Combining Effect of Financial and Operating Leverages

    Operating leverage affects a firms operating profit (EBIT),while financial leverage affects profit after tax or the earningsper share.

    The degrees of operating and financial leverages is combined tosee the effect of total leverage on EPS associated with a givenchange in sales.

    In short, combined leverage= Operating leverage * Financialleverage.

  • 7/31/2019 Leverages Ppt


    Combining Effect of Financial and Operating Leverages

    OL causes changes in sales revenue to cause greater changes in EBIT

    FL causes changes in EBIT to create greater changes in EPS

    Combining OL and FL causes rather large variations in EPS

    Source: Pearson Prentice Hall 2011

  • 7/31/2019 Leverages Ppt


    Degree of combined leverage

    Definition of DCL:-A degree of combined leverage that summarizes the combined effectthe degree of operating leverage (DOL), and the degree of financialleverage has on earnings per share (EPS), given a particular changein sales.

    For illustration, the formula is:

    As long as the DCL is greater than 1, there is combined leverage .

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    Degree of Combined Leverage

    If we have the data, we can use this formula:

    DCL = Sales - Variable CostsEBIT - INT

    Q(S - V)___

    Q(S - V) - F -INT=

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    Problem Set

    A firm selling price of its product is $100 per unit. The variable cost

    per unit is $50 and the fixed operating costs are $50,000 per year.

    The fixed interest expenses (non-operating) are $25,000 and thefirm has 10,000 shares outstanding. Let us calculate the percentage

    change in EPS and evaluate the degree of combined leverage

    resulting from sale of

    1) 2000 units &

    2) 3000units.Tax rate =35%.

  • 7/31/2019 Leverages Ppt



  • 7/31/2019 Leverages Ppt


    What does this tell us?

    If DCL = 4, then a 1% increase in sales will result in a 4% increase in

    earnings per share.

    A small change in sales is magnified into a larger change in earnings per



    holdersEBIT EPSSales

  • 7/31/2019 Leverages Ppt


    EBIT EPS Analysis :Choice of Best Plan

    comparison of alternative methods of financing

    under various assumptions of EBIT

    choice to raise funds for financing:

    (i) exclusively use equity capital

    (ii) exclusively use debt,

    (iii) exclusively use preference capital,

    (iv) use any combination of any different proportions.

    Largest EPS

  • 7/31/2019 Leverages Ppt


    IllustrationSuppose a firm has a capital structure exclusively comprising of

    ordinary shares amounting to $ 10,00,000. The firm now wishes toraise additional $ 10,00,000 for expansion.

    The firm has four alternative financial plans:

    (A) It can raise the entire amount in the form of equity capital.

    (B) It can raise 50 per cent as equity capital and 50 per cent as 5%debentures.

    (C) It can raise the entire amount as 6% debentures.

    (D) It can raise 50 per cent as equity capital and 50 per cent as 5%preference capital.

    Further assume that the existing EBIT are $ 1,20,000, the tax rate is35 per cent, outstanding ordinary shares 10,000 and the market priceper share is $ 100 under all the four alternatives. Which financingplan should the firm select?

  • 7/31/2019 Leverages Ppt


    Indifference Point

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