KAILAS SREE CHANDRAN

M100447ME
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» The employment of an asset or source of funds
for which the firm has to pay a fixed cost or
fixed return may be termed as Leverage.
» If the earnings before interest and taxes
exceeds the fixed return requirement, the
leverage is called favorable.
» Leverage:
 Operating Leverage
 Financial Leverage

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» Financial Leverage results from the presence of
fixed financial charges in the firm’s income
stream.
» Kinds of Sources of funds:
1. Those which carry a fixed financial charge
2. Those which do not involve any fixed charge.

» Financial Leverage involves the use of funds

obtained at a fixed cost in the hope of
increasing the return to the share holders.

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» EBIT= `10,000
» Bonds @ 5%= `40,000
» Preference Share @10% = `20,000
» Tax= 35%
» Ordinary shares = 1,000
» Case1, EBIT= `6000 (-40%)
» Case2, EBIT= `14000 (+40%)

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 Case 1 Base Case 2
EBIT `6,000 `10,000 `14,000
Less: Interest on bonds 2,000 2,000 2,000
Earnings before taxes(EBT) 4,000 8,000 12,000
Less: Taxes(35%) 1,400 2,800 4,200
Earning after taxes(EAT) 2,600 5,200 7,800
Less: Preference Dividend 2,000 2,000 2,000
Earnings available for share holders 600 3200 5800
Earnings Per Share 0.6 3.2 5.8

-81.25% +81.25%

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 Case 1 Base Case 2
EBIT `6,000 `10,000 `14,000
Less: Interest on bonds 2,000 2,000 2,000
Earnings before taxes(EBT) 4,000 8,000 12,000
Less: Taxes(35%) 1,400 2,800 4,200
Earning after taxes(EAT);
Earnings available for share holders 2,600 5,200 7,800

Earnings Per Share 2.6 5.2 7.8

-50%
-50%

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 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
DFL = >1
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐸𝐵𝐼𝑇
DFL =
𝐸𝐵𝐼𝑇− 𝐼−𝐷𝑝/(1−𝑡)

81.25
Example Case 1 & 2: = 2.03
40
1% change in EBIT will cause 2.03% change in EPS.
50
Example Case 1 & 2(w/o Preference dividend): = 1.25
40

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» Method to study the effect of leverage.
» It involves the comparison of alternative
methods of financing.
» Choices to raise funds:
1. Equity Capital
2. Debentures
3. Preference Capital
4. Combination of above

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A firm has a capital structure of ordinary shares
amounting to `10 lakhs. Now the firm wishes to
raise additional `10 lakhs. The firm has four
alternative financial plans:
a) Entire Equity Capital
b) 50% Equity capital- 50% debentures @ 5%.
c) Entire Debentures @ 6%.
d) 50% Equity capital- 50% Preference capital @ 5%.

Existing EBIT: `1.2 lakhs. Tax rate: 35%. Ordinary

shares: 10,000. Market Price/share: `100.

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 Particulars Financing Plans
A B C D
EBIT `120,000 `120,000 `120,000 `120,000
Less: Interest - 25,000 60,000 -
Earnings before taxes 120,000 95,000 60,000 120,000
Taxes 42,000 33,250 21,000 42,000
Earnings after taxes 78,000 61,750 39,000 78,000
Less: Preference dividend - - - 25,000
Earnings available to 78,000 61,750 39,000 53,000
ordinary share holders
Number of shares 20,000 15,000 10,000 15,000
Earnings per share 3.9 4.1 3.9 3.5

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» `80,000 (4% return on total assets)
» `100,000 (5% return on total assets)
» `130,000 (6.5% return on total assets)
» `160,000 (8% return on total assets)
» ` 200,000 (10% return on total assets)

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 Particulars Financing Plans
A B C D
EBIT 80,000 80,000 80,000 80,000
Less: Interest - 25,000 60,000 -
EBT 80,000 55,000 20,000 80,000
Less: Taxes 28,000 19,250 7,000 28,000
EAT 52,000 35,750 13,000 52,000
Less: Preference Dividend - - - 25,000
EAT for equity-holders 52,000 35,750 13,000 27,000
Number of shares 20,000 15,000 10,000 15,000
EPS 2.6 2.38 1.3 1.8

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Earnings Per Share Financing Plans

EBIT A B C D

`80,000 2.6 2.38 1.3 1.8

`100,000 3.25 3.25 2.6 2.67

`130,000 4.22 4.55 4.55 3.97

`160,000 5.2 5.8 6.5 5.3

`200,000 6.5 7.6 9.1 7

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