LEVERAGE ANALYSIS

LEVERAGE-ANALYSIS Leverage is the employment of an asset/ source of finance for which firm pays fixed cost or fixed return. There are three types of Leverage:
Operating Leverage Financial Leverage Combined Leverage

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 EBIT. In other words it means the effect of change in sales revenue on the level of EBIT.

Degree of Operating Leverage =

% change in EBIT / % change in sales or

Contribution / EBIT

FINANCIAL LEVERAGE
Financial leverage is the extent to which debt (liability) is used in the Capital Structure (financing) of the firm. Capital Structure refers to the relationship between assets, debt (liability) and equity. The financial leverage measures relationship between the EBIT & EPs and it reflects the effect of change in EBIT on the level of EPS. The more debt a firm has relative to equity the greater the financial leverage (these firms have a higher Debt to Asset ratios).

 Degree of Financial Leverage = EBIT/EBT or % change in EPS/ % Change in EBIT

Amendment in formula of DFL

This formula is applicable if preference shares are given: DFL = EBIT EBT- preference dividend/(1-tax rate)

COMBINED LEVERAGE
When financial leverage is combined with operating leverage the effect of a change in output (sales) iSmagnified in the change in earning per share (EPS). Operating leverage gives us the change in EBIT with a change in sales and financial leverage gives us the change in EPS with a change in EBIT. We can then see the change in EPS for a change in sales (volume of output). The combining both concepts as can be seen below: Operating Leverage is: Change in sales leads to a change in EBIT Financial Leverage is: Change in EBIT leads to a change in EPS Therefore, Combined Leverage is: Change in sales leads to a change in EPS.

 Degree of Combined Leverage =

% Change in EPS/% change in Sales

or

Contribution/EBT
or OL * FL

1. Calculate the degree of operating leverage , degree of financial leverage and degree of combined leverage for the following firms and interpret the result. Particulars A Output (units) 60000 Fixed cost 7000 Variable cost per unit .20 Interest on borrowed fund 4000 Selling price per unit .60 Firms B 15000 14000 1.5 8000 5

C 100000 1500 .02 -.10

2. ABC Corporation has estimated that for a new product its B.E.P. is 2000 units if the items are sold for Rs.14/unit and variable cost is Rs.9/unit. Calculate the degree of operating leverage for sales volume of 2500 units and 3000 units. What do you infer from the operating leverage at the sales volume of 2500 & 3000 units and their difference if any?

3. The Balance-Sheet of XYZ Ltd. is as follows:

Liabilities Equity Share Capital Retained Earnings 10% Long Term Debt Current Liabilities Total

Amount 60000 20000 80000 40000 200000

Assets Fixed Assets Current Assets

Amount 150000 50000

Total

200000

The companys total asset turnover ratio is 3, its fixed operating cost is Rs.100000 and its variable cost is 40%. The income tax rate is 50%. Calculate different types of leverages given that face value of share is Rs.10.

4. The capital structure of the PQR Ltd. consist of ordinary share capital of Rs.1000000 (share of Rs.100 each) and Rs.1000000 of 10% Debentures. The selling price is Rs.10/unit, variable cost Rs.6/unit and fixed expenses amounts to Rs.200000. The income tax rate is assumed to be 50%.The sales level is expected to increase from 100000 to 120000 units. (a) Calculate different types of leverages and comment on them. (b) % increase in E.P.S.

5. XYZ Ltd. has three financial plans: Plan 1 , 2 & 3. Calculate 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. Production 800units Selling price/unit Rs.15 Variable cost/unit Rs.10 Fixed cost Situation A Rs.1000 Situation B Rs.2000 Situation C Rs.3000 Capital Structure Plan I Plan II Plan III Equity share capital Rs.5000 Rs.7500 Rs.2500 12% Debt Rs.5000 Rs.2500 Rs.7500

6. A firm has sales of Rs.2000000, variable cost of Rs.1400000 and fixed cost of Rs.400000 inclusive of interest of Rs.100000. (a) Calculate operating, financial and combined leverage. (b) If the firm decides to double its EBIT, how much of a rise in sales would be needed on a percentage basis.

7. The capital structure of PQR Ltd. consists of ordinary share capital of Rs.500000 (equity share capital of Rs.100 each) and Rs.500000 (10% debenture of Rs.100 each). The sales of the firm are 50000 units per annum at selling price of Rs.12 per unit and the variable cost is Rs.8 per unit. The fixed cost amounts to be Rs.100000. The company pays tax at 50%. If the sales increased by 10000 units, calculate: (a) Percentage increase in E.P.S. (b) Calculate different types of leverages for both the situations.

6. A firm has sales of Rs.2000000, variable cost of Rs.1400000 and fixed cost of Rs.400000 inclusive of interest of Rs.100000. (a) Calculate operating, financial and combined leverage. (b) If the firm decides to double its EBIT, how much of a rise in sales would be needed on a percentage basis. 7. The capital structure of PQR Ltd. consists of ordinary share capital of Rs.500000 (equity share capital of Rs.100 each) and Rs.500000 (10% debenture of Rs.100 each). The sales of the firm are 50000 units per annum at selling price of Rs.12 per unit and the variable cost is Rs.8 per unit. The fixed cost amounts to be Rs.100000. The company pays tax at 50%. If the sales increased by 10000 units, calculate: (a) Percentage increase in E.P.S. (b) Calculate different types of leverages for both the situations.

8. Calculate operating, financial and combined leverage from the following data under situation I and situation II and financial plan A & B. Installed capacity 4000 units Actual production & sales 75% of capacity Selling price Rs.30 per unit Variable cost Rs.15 per unit Fixed Cost Under situation I Rs.15000 Under situation II Rs.20000 Particulars Financial plans A B Equity Shares 10000 15000 20% debentures 10000 5000 20000 20000

9. A firms sales, variable cost and fixed cost amount to Rs.7500000, Rs.4200000 and Rs.600000 respectively. It has borrowed Rs.4500000 at 9% and its equity share capital is Rs.5500000. Calculate: Firms R.O.I. Does it have favorable financial leverage? If firm belongs to an industry whose asset turnover is 3, does it have low or high asset leverage. Different types of leverages. If sales drop to 5000000 what will be new EBIT. At what level EBT of firm equals zero.

10. Operating income of Hypothetical Ltd. is Rs.186000. It pays 35% tax. Capital structure consists of the following: 14% debentures 15% preference share Equity shares Total Rs.500000 Rs.100000 Rs.400000 Rs.1000000

Calculate: Firms E.P.S. Determine degree of financial leverage at current level of EBIT. Determine % change in E.P.S. associated with 30% change (both increase & decrease) in EBIT. What additional data do you need to compute operating as well as combined leverage? (MU MMS 2012)

11. The following figures are available for ABC Ltd. Net Sales Rs. 2,000(lakhs) EBIT as percentage of Net Sales 12% Capital Employed: Equity Rs. 600 lakhs Preference shares Rs. 150 lakhs bearing 14% rate of divivdend Debt @ 16% - Rs. 400 lakhs You are required to calculate1. Return on Equity of the Company. 2. Operating leverage of the company given that its combined leverage is 3. (MU MMS 2011)

12. Following information is collected from Y Ltd:

Particulars Sales Less: Variable Cost Contribution Less: Fixed Cost EBIT Less: Interest EBT Amount Rs. In lakhs 3020 1200 1820 700 1120 800 320

Calculate: 1.DOL 2.DFL 3.DCL 4.% change in EPS if sales increase by 5%. (MU MMS 2011 ATKT)

13. A firm has total sales of Rs. 15,00,000 with 40% variable cost and total cost of Rs. 9,00,000. It also has debt of Rs. 8,00,000 at 10% rate of interest. If tax rate is 45%, calculate: Operating Leverage Financial Leverage Combined Leverage (MU MMS 2010)

14. Calculate Operating Leverage, Financial Leverage and Combined Leverage for the following firm from the information given below:
Output Total Operating Cost Variable cost per unit 10% Borrowed Capital Selling Price per Unit Tax Rate 15,000 Units Rs.3,65,000 30% of selling price Rs. 8,00,000 Rs.50 40%

(MU MMS 2010 ATKT)

15. A firm has sales of Rs. 10,00,000, variable cost is 70%, total cost is Rs. 9,00,000 and Debt of Rs. 5,00,000 at 10% rate of interest. If tax rate is 40% calculate: Operating Leverage Financial Leverage Combined Leverage If the firm wants to double up its earnings before interest & tax (EBIT), how much of a raise in sales would be needed on a percentage basis? (MU MMS 2009)

16. The Balance-Sheet of International Trade Ltd. As on 31st march 2008 is as under:
Liabilities Amount (Rs.in lakhs) Assets Amount (Rs .in lakhs) 150 75 50 20 5 300

Equity Capital (Rs. 10 per share) 10% Long Term Debt Retained Earings Current Liabilities

90 Building 120 30 60 300 300 Machinery Stock Debtors Cash

The total asset turnover ratio of the company is 3, its fixed operating cost is 1/6 of sales and variable operating cost is 50% of sales. The corporate tax rate is 35%. You are required to: 1) Calculate Operating Leverage, Financial Leverage and Combined Leverage. 2) Calculate market price of the share if the P/E multiple is 2.5. 3) Calculate the level of EBIT if the EPS is: 15 25 (MU MMS 2008)

17. The following data relate to ABC Ltd:

Selling Price (per unit) Variable cost (per unit) Fixed operating Cost Sales Volume

Rs. 100 60 40,000 1,200 Units

What is the financial leverage of the company if 10% change in sales will bring about 90% changes in EPS? What percentage increase in variable cost will result in 750% in the existing operating leverage?

18. The following data are available in respect of three companies X ltd, Y Ltd. & Z ltd: Particulars Units Selling Price per unit (Rs.) Variable cost per unit (Rs) Fixed Costs (Rs.) Interest (Rs) Dividend on preference shares (Rs.) No. of Equity Shares Tax Rate Calculate in the case of each company: 1) EBIT 2) EPS 3) Operating BEP 4) Financial BEP 5) Overall BEP 6) OL 7) FL 8) CL X Ltd. 20,000 20 15 40,000 10,000 5,000 10,000 40% Y Ltd. 10,000 50 30 70,000 20,000 5,000 12,000 50% Z Ltd. 3,000 100 40 1,00,000 40,000 10,000 15,000 60%

19. A. Retained Earnings of a firm are Rs. 1,26,000.Its pay-out ratio is 30%. It pays 40% tax on income. Its Fl & OL are 4.3 & 1.5repectively. The variable cost to sales revenue is 40%. Determine the sales revenue. B. If sales increases by 50% while variable cost element, fixed cost, interest amount, tax rate and payout ratio remain unchanged, what will be The new DOL & DFL The new retained earnings?

20. The financial manager of a company has formulated various financial plans to finance Rs. 30,00,000 require to implement various capital budgeting projects: 1.Either equity capital of Rs. 30,00,000 or Rs. 15,00,000 10% debentures and Rs. 15,00,000 equity. 2.Either equity capital of Rs. 30,00,000 or 13% preference shares of Rs. 10,00,000 and Rs. 20,00,000 equity. 3.Either equity capital of Rs. 20,00,000and 10% debentures of Rs. 10,00,000 or 13% preference shares of Rs. 10,00,000, 10% debentures of Rs. 8,00,000 and Rs. 12,00,000 equity You are required to determine the indifference point for each financial plan, assuming 35% tax rate and face value of equity shares as Rs. 100.

21. A plastic manufacturing company is planning to expand its assets by 50%. All financing for the expansion will come from external sources. The expansion will generate additional sales of Rs. 3,00,000 with a return of 25% on sales before interest & taxes. The finance department of the company has submitted the following plans for the consideration of the board. Plan 1:Issue of 10% debentures. Plan 2:Issue of 10% debentures for half the required amount and balance in equity shares to be issued at 25% premium. Plan 3:Issue Equity shares at 25% premium.
Balance-Sheet as on 31st March Liabilities Amount Assets Equity Capital (Rs. 10 per share) 4,00,000 Total Assets 8% Debentures 3,00,000 Retained Earnings 2,00,000 Current Liabilities 3,00,000 12,00,000

Amount 12,00,000

12,00,000

Income-Statement for the year March 31 Particulars Sales Less: Operating Cost EBIT Less: Interest EBT Less: Tax EAT EPS Amount 19,00,000 16,00,000 3,00,000 24,000 2,76,000 96,600 1,79,400 448

A. Determine the number of equity share that will be issued if financial plan 3 is adopted. B. Determine indifference point between (i) Plan 1 & 2 (ii) Plan 1 & 3 C. (iii) Plan 2 & 3 D. Assume that the price earnings ratio is expected to remain unchanged at 8 if plan 3 is adopted, but is likely to drop to 6 if either plan 1 or 2 is used to finance the expansion. Determine the expected market price of the shares in each of the situations.