Leverage

Operating,
Operating, Financial
Financial
and
and combined
combined
Leverage
Leverage
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 Leverage

Leverage is used to describe the ability of a firm

employing long term funds having a fixed cost to
enhance the return to its owners.
“ The employment of an asset or sources of funds
which the firm has to pay a fixed cost or return”
C. Vanhorne
The presence of fixed cost has considerable influence
on the earnings available to equity shareholders
when the volume of output or sales is increased.

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 Operating Leverage
It can be defined as the tendency of operating profit
to change disproportionately with the volume of
sale.

◆ It occurs when in a firm with fixed costs, the percentage

change in operating profits is greater than the percentage
change in sales

◆ Computation:
Operating leverage = Contribution/operating profit
Contribution = sales – variable cost
Operating profit = sales – variable cost – fixed cost (EBIT)
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 Example:

Sales = 800units, Selling price per unit = 10, variable cost per unit = 6
Calculate operating leverage when fixed cost is rs. 2,400
Solution:
Sales (800 units @ 10 per unit) = 8,000
Less: Variable cost (800*6) = 4,800
Contribution = 3,200
Less: Fixed cost = 2,400
Operating Profit = 800
Operating Leverage = Contribution/ operating profit
3,200/800 = 4 Ans.

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 Degree of Leverage
DOL:
% change in operating profit / % change in sales
Favourable OL = Contribution > Fixed cost
Unfavourable OL = Contribution < Fixed cost

Example:
A firm’s sales increased from 8,000 to 16,000 (100%) & operating profit
increased from 800 to 3,200 (400%). Calculate Degree of Leverage

DOL = 400% / 100% = 4 Ans.

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 Impact of Operating
Leverage on Profits
(in thousands) Firm X Firm Y Firm Z
Sales 10 11 19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit 1 2 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72
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 Interpretation of the DOL
◆ DOL is a quantitative measure of the
“sensitivity” of a firm’s operating profit to
a change in the firm’s sales.
◆ The closer that a firm operates to its break-
even point, the higher is the absolute value
of its DOL.
◆ When comparing firms, the firm with the
highest DOL is the firm that will be most
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“sensitive” to a change in sales.
 Significance of operating
leverage:
◆ Selection
of an appropriate
technology of production
◆ Fixation of selling price
◆ Useful
in understanding the
change in operating profit
◆ Measurement of business risk
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 Financial Leverage
Financial Leverage –arises on account of
existence of fixed interest or fixed
preference dividend bearing securities in the
total capital structure of the firm .
◆ Financial leverage is acquired by choice.
◆ Used as a means of increasing the return to
common shareholders.
◆ It indicates the changes that takes place in the
residual net income as a result of change in
EBIT.
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 Computation:
◆ Financial leverage = EBIT/EBT
EBIT = Earning Before Interest & Tax
EBT = Earning Before Tax
EBT = EBIT – Fixed Interest Charges
◆ Favorable financial leverage (Trading on
equity) = Cost of funds < Returns on funds
◆ Unfavorable financial leverage = Cost of
acquiring funds > Returns on funds

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 Degree of financial leverage

DOFL:
% change in EPS
_____________________________________________________

% change in EBIT
EPS = Earning Per Share

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 EBIT-EPS Chart
6
Earnings per Share ($)

4 Common
3

0
0 100 200 300 400 500 600 700

EBIT ($ thousands)
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 EBIT-EPS Chart
6 Debt
Earnings per Share ($)

5
Indifference point
between debt and
4
common stock
Common
3 financing

0
0 100 200 300 400 500 600 700
EBIT ($ thousands)
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 EBIT-EPS Chart
6 Debt Preferred
Earnings per Share ($)

4 Common
3
Indifference point
2
between preferred
stock and common
1 stock financing

0
0 100 200 300 400 500 600 700
EBIT ($ thousands)
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 EBIT-EPS Calculation with
New Debt Financing
Long-term Debt Alternative
EBIT $500,000 $150,000*
$150,000
Interest 100,000 100,000
EBT $400,000 $ 50,000
Taxes (30% x EBT) 120,000 15,000
EAT $280,000 $ 35,000
Preferred Dividends 0 0
EACS $280,000 $ 35,000
# of Shares 50,000 50,000
EPS $5.60 $0.70
6-15 * A second analysis using $150,000 EBIT rather than the expected EBIT.
 EBIT-EPS Calculation with
New Preferred Financing
Preferred Stock Alternative
EBIT $500,000 $150,000*
$150,000
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000 45,000
EAT $350,000 $105,000
Preferred Dividends 90,000 90,000
EACS $260,000 $ 15,000
# of Shares 50,000 50,000
EPS $5.20 $0.30
6-16 * A second analysis using $150,000 EBIT rather than the expected EBIT.
 Significance of financial
leverage
◆ Understanding changes in
earning before tax
◆ Planning of capital structure for
the firm
◆ Measurement of financial risk
◆ Profit planning
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 Limitations of financial leverage
or Trading on equity
◆ It is a double edged weapon
◆ Increase in risk and rate of interest
◆ Harmful in case of fluctuation in
earnings
◆ Restrictions from financial
institutions

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 What is an Appropriate
Amount of Financial Leverage?
Debt Capacity -- The maximum amount of debt
(and other fixed-charge financing) that a firm
can adequately service.
◆ Firms must first analyze their expected future
cash flows.
◆ The greater and more stable the expected future
cash flows, the greater the debt capacity.
◆ Fixed charges include:
include debt principal and
interest payments, lease payments, and
preferred stock dividends.
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 Combined or composite
leverage
◆ Depicts the relationship between
revenue on account of sales and the
EBT. It reveals the change in EBT on
account of change in contribution.
Combined leverage = contribution/EBT
OR
Operating Leverage * financial leverage

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 Degree of Total OR
Combined Leverage
Degree of Total Leverage -- The
percentage change in a firm’s earnings
per share (EPS) resulting from a percent
change in output (sales).

Degree of Percentage change in

composite = earnings per share (EPS)
leverage Percentage change in
output (or sales)
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 Significance of combined
leverage:
◆ Understanding changes in EPS
◆ Assessment of Total Risk
◆ Helpfulin establishing a proper
combination of operating &
financial leverage

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 Total Firm Risk
Total Firm Risk -- The variability in earnings per
share (EPS). It is the sum of business plus
financial risk.

Total firm risk = business risk + financial risk

◆ EPS is a measure of relative total firm risk
◆ EBIT is a measure of relative business risk
◆ The difference, EPS- EBIT,
EBIT is a measure of
relative financial risk
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