Slide 1

LeveragesThe ability to influence a system, or an environment, in a way that multiplies the outcome of one's efforts without a corresponding increase in the consumption of resources. In other words, leverage is the advantageous condition of having a relatively small amount of cost yield a relatively high level of returns.

Meaning2What is Leverage?Leverage is the use of fixed costs to magnify the potential return to a firm.

Types of fixed costs:fixed operating costs = rent, amortization of equipment and other long-lived assets.fixed financial costs = interest costs from debt.3What is Leverage?3 types of leverage:-- Operating Leverage = the extent to which capital assets and associated fixed costs are utilized-- Financial Leverage = the amount of debt used in the capital structure (debt/equity mix)--Composite Leverage = the entire income of the concern.

4Operating LeverageOne 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.5Impact of Operating Leverage on Profits Firm F Firm V Firm 2FSales1011 19.5Operating CostsFixed 7 2 14 Variable 2 7 3Operating Profit 1 2 2.5FC/total costs .78 .22 .82 FC/sales .70 .18 .72(in thousands)6Impact of Operating Leverage on ProfitsNow, 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.7Impact of Operating Leverage on Profits Firm F Firm V Firm 2FSales15 16.5 29.25Operating Costs Fixed 7 2 14 Variable 310.5 4.5Operating Profit 5 4 10.75Percentage Change 400% 100% 330%in EBIT*(in thousands)* (EBITt - EBIT t-1) / EBIT t-18Impact of Operating Leverage on ProfitsFirm 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.9Break-Even AnalysisWhen studying operating leverage, profits refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments.Break-Even Analysis -- A technique for studying the relationship among fixed costs, variable costs, sales volume, and profits. Also called cost/volume/profit (C/V/P) analysis.10Break-Even ChartQUANTITY PRODUCED AND SOLD0 1,000 2,000 3,000 4,000 5,000 6,000 7,000Total RevenuesProfitsFixed CostsVariable CostsLossesREVENUES AND COSTS($ thousands)175250100 50Total Costs11Break-Even (Quantity) PointHow to find the quantity break-even point: EBIT = P(Q) - V(Q) - FC EBIT = Q(P - V) - FC P = Price per unit V = Variable costs per unit FC = Fixed costs Q = Quantity (units) produced and soldBreak-Even Point -- The sales volume required so that total revenues and total costs are equal; may be in units or in sales dollars.12Degree of Operating Leverage (DOL)DOL at Q units of output (or sales)Degree of Operating Leverage -- The percentage change in a firms operating profit (EBIT) resulting from a 1 percent change in output (sales).=Percentage change in operating profit (EBIT)Percentage change in output (or sales)13Computing the DOLDOLQ unitsCalculating the DOL for a single product or a single-product firm.=Q (P - V)Q (P - V) - FC=QQ - QBE14Computing the DOLDOLS dollars of salesCalculating the DOL for a multiproduct firm.=S - VCS - VC - FC=EBIT + FCEBIT15Financial LeverageFinancial leverage is acquired by choice.Used as a means of increasing the return to common shareholders.Financial Leverage -- The use of fixed financing costs by the firm. The British expression is gearing.16EBIT-EPS Break-Even, or Indifference, AnalysisCalculate EPS for a given level of EBIT at a given financing structure.EBIT-EPS Break-Even Analysis -- Analysis of the effect of financing alternatives on earnings per share. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives.(EBIT - I) (1 - t) - Pref. Div.# of Common SharesEPS=17Financial LeverageFinancial leverage is acquired by choice.Used as a means of increasing the return to common shareholders.Financial Leverage -- The use of fixed financing costs by the firm. The British expression is gearing.18Impact of Financial LeverageA firm is considering two plans with a view to examining their impact on earnings per share (EPS) the total funds required in assets are Rs 5,00,000.

Financial plansDebt (Interest @ 10% p.a) 4,00,000 1,00,000 Equity Shares(Rs 10 each) 1,oo,ooo 4,00,000 Total Finances required 5,oo,000 5,00,000 No. of equity shares 10,000 40,000 The earnings before interest and tax are assumed as Rs. 50,000 , Rs. 75,000 , Rs. 1,25,000 .The rate of tax be taken at 50% . 19(1) When earnings before interest and tax (EBIT) are Rs. 50,000 plan (1) plan (2)Earnings before interest and tax (EBIT )Less : Interest on debt Earnings before tax (EBT) Less : Tax @ 50% Earnings after Interest and tax No. of equity shares

Earning per share (EPS) 50,000 40,000 10,000 5,000 5,000 10,000 5,000 10,000 =0.50 Paisa 50,000 10,000 40,000 20,000 20,000 40,000 20,000 40,000 =0.50 Paisa20(2) When earnings before interest and tax (EBIT) are Rs. 75,000

PLAN (1) PLAN(2)Earnings before interest and tax (EBIT )Less : Interest on debt Earnings before tax (EBT) Less : Tax @ 50% Earnings after Interest and tax No. of equity shares

Earning per share (EPS) 75,000 40,000 35,000 17,500 17,500 10,000

=1.75 75,000 10,000 65,000 32,500 32,500

40,000

=0.81 21(3) When earnings before interest and tax (EBIT) are Rs. 1,25,000 PLAN(1) PLAN(2) Earnings before interest and tax (EBIT )Less : Interest on debt Earnings before tax (EBT) Less : Tax @ 50% Earnings after Interest and tax No. of equity shares

Earning per share (EPS) 1,25,000 (40,000) 85,000 (42,500)

42,500 10,000

=4.25

1,25,000 (10,000) 1,15,000 (57,500)

57,500 40,000

=1.438

22 Impact of Financial LeverageThe financial leverage is used to magnify the shareholders earnings. It us based on the assumption that the fixed charges or cost funds can be obtained at a cost lower than the firms rate of return on its assets .When the difference between the assets financed by fixed cost funds and the cost of these funds are distributed to the equity stockholders , they will get additional earnings without increasing their own investment .Consequently , the Earning per share (EPS) and the rate of return on equity share capital will go up .The situation in which Earning per share (EPS) and the rate of return on equity share capital will go up , may also be reverse sometimes.if the firm acquires fixed cost funds at a higher cost than the Earnings from those assets . 23Degree of Financial Leverage (DFL)DFL at EBIT of X dollarsDegree of Financial Leverage -- The percentage change in a firms earnings per share (EPS) resulting from a 1 percent change in operating profit.=Percentage change in earnings per share (EPS)Percentage change in operating profit (EBIT)24Computing the DFLDFL EBIT of $XCalculating the DFL=EBITEBIT - I - [ PD / (1 - t) ]EBIT = Earnings before interest and taxesI = InterestPD = Preferred dividendst = Corporate tax rate25Variability of EPSPreferred stock financing will lead to the greatest variability in earnings per share based on the DFL.This is due to the tax deductibility of interest on debt financing.DFLEquity = 1.00DFLDebt = 1.25DFLPreferred = 1.35Which financing method will have the greatest relative variability in EPS?26 Importance of financial leveragePLANNING OF CAPITAL STRUCTURE : A financial manager has to decide about the ratio between fixed costs funds and equity share capital.PROFIT PLANNING: EPS is effected by degree of financial leverage . If the profitability of the concern is increasing than fixed costs funds will help in increasing the availability of profits for the equity stockholders . Therefore , financial leverage is important for profit planning . Limitations of financial leverageDOUBLE- EDGED WEAPON .BENEICIAL ONLY TO COMPANIES HAVING STABILITY OF EARNINGS .INCREASES RISK AND RATE OF RETURN .RESTRICTIONS FROM FINANCIAL INSTITUIONS .Composite LeverageBoth financial and operating leverage magnify the revenue of the firm. Operating leverage affects the income which is result of production. On the other hand, the financial leverage is the result of financial decisions. The composite leverage focuses attention on the entire income of the concern. The risk factor should be properly assessed by the management before using the composite leverage. The high financial leverage may be offset against low operating leverage or vice-versa.

Degree of Composite leverage (DCL).The degree of composite leverage can be calculated as follows:

Degree of composite leverage (DCL) = Percentage change in EPS Percentage Change in Sales

Or, Composite leverage = Operating leverage * Financial leverage Financial RiskDebt increases the probability of cash insolvency over an all-equity-financed firm. For example, our example firm must have EBIT of at least $100,000 to cover the interest payment.Debt also increased the variability in EPS as the DFL increased from 1.00 to 1.25.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.Total Firm RiskCVEPS is a measure of relative total firm riskCVEBIT is a measure of relative business riskThe difference, CVEPS - CVEBIT, is a measure of relative financial riskTotal Firm Risk -- The variability in earnings per share (EPS). It is the sum of business plus financial risk.Total firm risk = business risk + financial riskDegree of Total Leverage (DTL)DTL at Q units (or S dollars) of output (or sales)Degree of Total Leverage -- The percentage change in a firms earnings per share (EPS) resulting from a 1 percent change in output (sales).=Percentage change in earnings per share (EPS)Percentage change in output (or sales)Computing the DTLDTL S dollarsof sales

DTL Q units (or S dollars) = ( DOL Q units (or S dollars) ) x ( DFL EBIT of X dollars )=EBIT + FCEBIT - I - [ PD / (1 - t) ]DTL Q unitsQ (P - V)Q (P - V) - FC - I - [ PD / (1 - t) ]=Summary and ConclusionsLeverage refers to the use of fixed costs to magnify the profits (or losses) of a firm.Management must be aware of the level of risk assumed.Operating leverage refers to using fixed operating costs, such as lease or amortization expense. Asset side related.Financial leverage refers to the fixed financing charge such as interest cost on debt. Liability side related.Composite leverage refers to the combination of both financial and operating leverage.

Thank You Balance Sheet___________________ Assets Liabilities and Equity Current Assets Debt (Loans, bonds, leases)

operating (interest charges) financial

leverage Capital Assets leverage

(fixed charges) Equity (Shares)