Download - Leverages Ppt

7/31/2019 Leverages Ppt

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Leverage

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


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DEBT EQUITY

Decisions about leverage

Too much Equity = underleveraged firm


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DEBT EQUITY


Too much debt = overleveraged firm


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DEBT EQUITY


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

policy that minimizes risks and maximizes returns


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Types of Leverages

Return on Investment Leverage

Asset Leverage

Operating Leverage

Financial Leverage

Total Leverage

Fixed charges Leverage

Combined Leverage


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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.


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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.


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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


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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.


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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.


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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


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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%.


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Solution


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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

share.

Stock-

holdersEBIT EPSSales


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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


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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?


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Indifference Point


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