LEVERAGE-ANALYSIS

Leverage is the employment of an asset/ source of finance for which firm pays fixed cost or fixesd return. OPERATING LEVERAGE Operating leverage is a measure of the extent to which, fixed operating costs are being used in an organization. The operating leverage measures the relationship between the sales revenue and E !T. !n other words it means the effect of change in sales revenue on the level of E !T. Formula(s) for calculating O !rating l!"!rag! #
Percent Change in Operating Income Percent Change in Sales

"egree of Operating Leverage # or

"egree of Operating Leverage # Earnings Before Interest and Taxes or "egree of Operating Leverage #
Total Sales TotalVariable Cost Total SalesTotal Variable Cost Total Operating Fixed Cost

Contribution Margin

FINAN$IAL LEVERAGE $inancial leverage is the extent to which debt %liability& is used in the 'apital (tructure %financing& of the firm. 'apital (tructure refers to the relationship between assets, debt %liability& and e)uity. The financial leverage measures relationship between the E !T * E+s and it reflects the effect of change in E !T on the level of E+(. The more debt a firm has relative to e)uity the greater the financial leverage %these firms have a higher "ebt to ,sset ratios&. E%am l! # Let us say both companies have the following capital structure$om an& A "ebt %./0& (h. E)uity %,E" ./ par& %1,/// shares& Total 'apital .//,/// 1/,/// 222222222 .1/,/// $om an& ' "ebt %./0& (h. E)uity %,E" ./ par& %./,/// shares& Total 'apital 1/,/// .//,/// 2222222222 .1/,///

(ubstantial use of debt will place a great burden on the firm at low levels of profitability %low E !T, since interest must be paid&. 3owever, it will also help to magnify %enlarge& increases in earning per share %E+(& as the E !T or operating income increases.

"egree of $inancial Leverage # or

Percent Change in Earnings Per Share Percent Change in Operating Income

"egree of $inancial Leverage # Earnings Before Interest and Taxes Interest $O('INE) LEVERAGE 4hen financial leverage is combined with operating leverage the effect of a change in output %sales& in magnified in the change in earning per share %E+(&. Operating leverage gives us the change in E !T with a change in sales and financial leverage gives us the change in E+( with a change in E !T. 4e cam then see the change in E+( for a change in sales %volume of output&. The combining both concepts as can be seen belowO !rating L!"!rag! is$*ang! in sal!s l!a+s to a change in EBIT Financial L!"!rag! is'hange in EBIT leads to a c*ang! in EPS Therefore, 'ombined Leverage is$*ang! in sal!s l!a+s to a c*ang! in EPS, 5ow, we can determine the effect of a change in output %sales& on earnings per share %E+(&. !n this way, we can better depict the relative influence of the two types of leverage for the firm. 4e can determine and examine the effect of adding financial leverage on top of operating leverage. "egree of 'ombined Leverage # or "egree of 'ombined Leverage # !! egree!of!Operating!!x!! egree!of!Financial!!!! "everage !!!!"everage
Percent Change in Earnings Per Share Percent Change in Sales %or volume&

Earnings Before Interest and Taxes

LE6E7,8E 9 ,5,L:(!( .. 'alculate the degree of operating leverage , degree of financial leverage and degree of combined leverage for the following firms and interpret the result. +articulars , Output %units& ;//// .</// $irms ' ./////

$ixed cost 6ariable cost per unit !nterest on borrowed fund (elling price per unit

=/// .>/ 1/// .;/

.1/// ..< ?/// <

.<// ./> 22 ../

>. , ' 'orporation has estimated that for a new product its .E.+. is >/// units if the items are sold for 7s..1/unit and variable cost is 7s.@/unit. 'alculate the degree of operating leverage for sales volume of ><// units and A/// units. 4hat do you infer from the operating leverage at the sales volume of ><// * A/// units and their difference if anyB A. The alance2(heet of C:D Ltd. is as followsLiabilities E)uity (hare 'apital 7etained Earnings ./0 Long Term "ebt 'urrent Liabilities Total ,mount ;//// >//// ?//// 1//// >///// ,ssets $ixed ,ssets 'urrent ,ssets Total ,mount .<//// <//// >/////

The companyEs total asset turnover ratio is A, its fixed operating cost is 7s..///// and its variable cost is 1/0. The income tax rate is </0. 'alculate different types of leverages given that face value of share is 7s../. 1. The capital structure of the +F7 Ltd. consist of ordinary share capital of 7s..////// %share of 7s..// each& and 7s..////// of ./0 "ebentures. The selling price is 7s..//unit, variable cost 7s.;/unit and fixed expenses amounts to 7s.>/////. The income tax rate is assumed to be </0.The sales level is expected to increase from .///// to .>//// units. %a& 'alculate different types of leverages and comment on them. %b& 0 increase in E.+.(.

<. C:D Ltd. has three financial plans- +lan . , > * A. 'alculate operating, financial * combined leverage for the firms on the basis of the basis of the following information and also find out the highest and lowest value of combined leverage. +roduction ?//units (elling price/unit 7s..< 6ariable cost/unit 7s../ $ixed cost (ituation , 7s../// (ituation 7s.>/// (ituation ' 7s.A/// 'apital (tructure +lan ! +lan !! +lan !!! E)uity share capital 7s.</// 7s.=<// 7s.><// .>0 "ebt 7s.</// 7s.><// 7s.=<// ;. , firm has sales of 7s.>//////, variable cost of 7s..1///// and fixed cost of 7s.1///// inclusive of interest of 7s../////. %a& 'alculate operating, financial and combined leverage. %b& !f the firm decides to double its E !T, how much of a rise in sales would be needed on a percentage basis. =. The capital structure of +F7 Ltd. consists of ordinary share capital of 7s.<///// %e)uity share capital of 7s..// each& and 7s.<///// %./0 debenture of 7s..// each&. The sales of the firm are <//// units per annum at selling price of 7s..> per unit and the variable cost is 7s.? per unit. The fixed cost amounts to be 7s../////. The company pays tax at </0. !f the sales increased by .//// units, calculate%a& +ercentage increase in E.+.(. %b& 'alculate different types of leverages for both the situations. ?. 'alculate operating, financial and combined leverage from the following data under situation ! and situation !! and financial plan , * . !nstalled capacity 1/// units ,ctual production * sales =<0 of capacity (elling price 7s.A/ per unit 6ariable cost 7s..< per unit $ixed 'ost Gnder situation ! 7s..</// Gnder situation !! 7s.>//// +articulars E)uity (hares >/0 debentures $inancial plans , .//// .</// .//// </// HHHHH HHHH >//// >////

@. , firmEs sales, variable cost and fixed cost amount to 7s.=</////, 7s.1>///// and 7s.;///// respectively. !t has borrowed 7s.1<///// at @0 and its e)uity share capital is 7s.<</////. 'alculate%i& $irmEs 7.O.!. %ii& "oes it have favorable financial leverageB %iii& !f firm belongs to an industry whose asset turnover is A, does it have low or high asset leverage. %iv& "ifferent types of leverages. %v& !f sales drop to <////// what will be new E !T. %vi& ,t what level E T of firm e)uals zero. ./. Operating income of 3ypothetical Ltd. is 7s..?;///. !t pays A<0 tax. 'apital structure consists of the following.10 debentures 7s.<///// .<0 preference share 7s..///// E)uity shares 7s.1///// Total HHHHHHH 7s..////// 'alculate%i& $irmEs E.+.(. %ii& "etermine degree of financial leverage at current level of E !T. %iii& "etermine 0 change in E.+.(. associated with A/0 change %both increase * decrease& in E !T. %iv& 4hat additional data do you need to compute operating as well as combined leverageB ((- ((S ./0.) ... The following figures are available for , ' Ltd. 5et (ales 7s. >,///%laIhs& E !T as percentage of 5et (ales .>0 'apital Employeda. E)uity 7s. ;// laIhs b. +reference shares 7s. .</ laIhs bearing .10 rate of divivdend c. "ebt J .;0 2 7s. 1// laIhs :ou are re)uired to calculate2 .. 7eturn on E)uity of the 'ompany. >. Operating leverage of the company given that its combined leverage is A. ((- ((S ./00) .>. $ollowing information is collected from : Ltd+articulars (ales Less- 6ariable 'ost 'ontribution Less- $ixed 'ost E !T Less- !nterest E T

,mount 7s. !n laIhs A/>/ .>// .?>/ =// ..>/ ?// A>/

'alculatea. "OL b. "$L c. "'L d. 0 change in E+( if sales increase by <0. ((- ((S ./00 AT1T) .A. , firm has total sales of 7s. .<,//,/// with 1/0 variable cost and total cost of 7s. @,//,///. !t also has debt of 7s. ?,//,/// at ./0 rate of interest. !f tax rate is 1<0, calculatea. Operating Leverage b. $inancial Leverage c. 'ombined Leverage ((- ((S ./0/) .1. 'alculate Operating Leverage, $inancial Leverage and 'ombined Leverage for the following firm from the information given belowOutput Total Operating 'ost 6ariable cost per unit ./0 orrowed 'apital (elling +rice per Gnit Tax 7ate .<,/// Gnits 7s.A,;<,/// A/0 of selling price 7s. ?,//,/// 7s.</ 1/0 ((- ((S ./0/ AT1T) .<. , firm has sales of 7s. ./,//,///, variable cost is =/0, total cost is 7s. @,//,/// and "ebt of 7s. <,//,/// at ./0 rate of interest. !f tax rate is 1/0 calculatea. Operating Leverage b. $inancial Leverage c. 'ombined Leverage d. !f the firm wants to double up its earnings before interest * tax %E !T&, how much of a raise in sales would be needed on a percentage basisB ((- ((S .//2)

.;. The alance2(heet of !nternational Trade Ltd. ,s on A.st march >//? is as underLiabilities E)uity 'apital %7s. ./ per share& ./0 Long Term "ebt 7etained Earings 'urrent Liabilities ,mount ,ssets %7s.in laIhs& @/ uilding .>/ A/ ;/ A// 3// Kachinery (tocI "ebtors 'ash ,mount %7s .in laIhs& .</ =< </ >/ < 3//

The total asset turnover ratio of the company is A, its fixed operating cost is ./; of sales and variable operating cost is </0 of sales. The corporate tax rate is A<0. :ou are re)uired toi. 'alculate Operating Leverage, $inancial Leverage and 'ombined Leverage. ii. 'alculate marIet price of the share if the +/E multiple is >.<. iii. 'alculate the level of E !T if the E+( isa. .< b. >< ((- ((S .//4) .=. The following data relate to , ' Ltd7s. (elling +rice %per unit& .// 6ariable cost %per unit& ;/ $ixed operating 'ost 1/,/// (ales 6olume .,>// Gnits 4hat is the financial leverage of the company if ./0 change in sales will bring about @/0 changes in E+(B 4hat percentage increase in variable cost will result in =</0 in the existing operating leverageB .?. The following data are available in respect of three companies C ltd, : Ltd. * D ltd+articulars C Ltd. : Ltd. D Ltd. Gnits >/,/// ./,/// A,/// (elling +rice per unit %7s.& >/ </ .// 6ariable cost per unit %7s& .< A/ 1/ $ixed 'osts %7s.& 1/,/// =/,/// .,//,/// !nterest %7s& ./,/// >/,/// 1/,/// "ividend on preference shares %7s.& <,/// <,/// ./,/// 5o. of E)uity (hares ./,/// .>,/// .<,/// Tax 7ate 1/0 </0 ;/0 'alculate in the case of each companyi. E !T ii. E+( iii. Operating E+ iv. $inancial E+ v. Overall E+ vi. OL vii. $L viii. 'L .@. a& 7etained Earnings of a firm are 7s. .,>;,///.!ts pay2out ratio is A/0. !t pays 1/0 tax on income. !ts $l * OL are 1.A * ..<repectively. The variable cost to sales revenue is 1/0. "etermine the sales revenue. b& !f sales increases by </0 while variable cost element, fixed cost, interest amount, tax rate and payout ratio remain unchanged, what will be i. The new "OL * "$L ii. The new retained earningsB iii.

>/. The financial manager of a company has formulated various financial plans to finance 7s. A/,//,/// re)uire to implement various capital budgeting proLectsi. Either e)uity capital of 7s. A/,//,/// or 7s. .<,//,/// ./0 debentures and 7s. .<,//,/// e)uity. ii. Either e)uity capital of 7s. A/,//,/// or .A0 preference shares of 7s. ./,//,/// and 7s. >/,//,/// e)uity. iii. Either e)uity capital of 7s. >/,//,///and ./0 debentures of 7s. ./,//,/// or .A0 preference shares of 7s. ./,//,///, ./0 debentures of 7s. ?,//,/// and 7s. .>,//,/// e)uity :ou are re)uired to determine the indifference point for each financial plan, assuming A<0 tax rate and face value of e)uity shares as 7s. .//. >.. , plastic manufacturing company is planning to expand its assets by </0. ,ll financing for the expansion will come from external sources. The expansion will generate additional sales of 7s. A,//,/// with a return of ><0 on sales before interest * taxes. The finance department of the company has submitted the following plans for the consideration of the board. +lan .-!ssue of ./0 debentures. +lan >-!ssue of ./0 debentures for half the re)uired amount and balance in e)uity shares to be issued at ><0 premium. +lan A-!ssue E)uity shares at ><0 premium. 'alanc!-S*!!t as on 30st (arc* Lia5iliti!s Amount Ass!ts E)uity 'apital %7s. ./ per share& 1,//,/// Total ,ssets ?0 "ebentures A,//,/// 7etained Earnings >,//,/// 'urrent Liabilities A,//,/// 0.6//6/// !ncome2(tatement for the year Karch A. +articulars ,mount (ales .@,//,/// Less- Operating 'ost .;,//,/// E !T A,//,/// Less- !nterest >1,/// E T >,=;,/// Less- Tax @;,;// E,T .,=@,1// E+( 11? a. "etermine the number of e)uity share that will be issued if financial plan A is adopted. b. "etermine indifference point between %i& +lan . * > %ii& +lan . * A %iii& +lan > * A c. ,ssume that the price earnings ratio is expected to remain unchanged at ? if plan A is adopted, but is liIely to drop to ; if either plan . or > is used to finance the expansion. "etermine the expected marIet price of the shares in each of the situations.

Amount .>,//,///

0.6//6///