FINANCIAL MANAGEMENT
CHAPTER – 3
LEVERAGE
Introduction:
In business context, leverage refers to the use of fixed costs in an attempt to increase profitability. Leverage is used for the upliftment of the economic welfare of the shareholders who are the real owners of the company. By using leverage the firm tries to increase the ability of the business to increase the return to its shareholders by using fixed cost. Thus, we can say that leverage arises from the existence of fixed costs. Leverage helps in determining the influence of changes in the level of sales on the returns available to shareholders. A high degree of leverage implies that there will be a large change in profits due to a relatively small change in sales. There are two kinds of leverage – operating leverage and financial leverage. Operating leverage arises from the firm’s fixed operating costs such as salaries, depreciation, insurance, rents, and advertisement expenses. Financial leverage arises from the firm’s fixed financing costs such as interest on debentures and interest on loan funds.
Operating leverage:
Operating leverage arises from the existence of fixed operating expenses. When a firm has fixed expenses, 1% changes in unit sales leads to more than 1% change in earnings before interest and taxes (EBIT). A firm will not have operating leverage in the absence of fixed operating costs. Operating leverage can be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its EBIT.
The sensitivity of EBIT to changes in unit sales is referred to as degree of operating leverage. It can be computed using the following formula:
DOL = % change in EBIT
% change in sales
OL = Contribution
EBIT
DOL can be positive or negative depending on whether the EBIT is positive or negative.
Since DOL depends on fixed operating costs, it logically follows that larger is the fixed cost, the higher is the firm’s operating leverage and its operating risk. High operating leverage is good when revenues are rising and bad when they are falling. Operating risk is the risk of the firm not being able to cover its fixed operating costs.
Financial leverage:
Financial leverage arises from the existence of fixed interest expenses. When a firm has fixed interest expenses, 1% changes in EBIT leads to more than 1% change in EBT. A firm will not have financial leverage in the absence of debt element in the capital structure. It is also known as trading on equity or capital gearing. It is known as trading on equity because by using the equity base an attempt is made to increase earnings per share. The main objective of using financial leverage is to increase earnings per share by using debt capital at the rate of interest lower than rate of return earned in the business. But, it has got the other side also. If the business rate of return declines below the rate of interest, earnings per share will decline. Therefore, financial leverage is a double edged sword and hence should be used with care and wisdom. Financial leverage can be defined as the firm’s ability to use fixed interest bearing funds to magnify the effects of changes in operating profit on its EPS.
The sensitivity of EPS to changes in operating profit is referred to as degree of financial leverage. It can be computed by using the following formula:
DFL = % change in EPS
% change in EBIT
FL = EBIT
EBT
The financial leverage is said to be high when the fixed interest or dividend bearing securities are more than equity capital in the capital structure of the company. In such a case, interest payment and dividends drastically decrease the pool available to the ordinary shareholders and their earnings per share falls. In the opposite case, the leverage is said to be small.
In case the capital structure comprises of preference shares too, the formula will be as under:
FL = Earnings before Interest &Tax
EBT – (Preference Dividend/1-t)
Combined leverage:
Combined leverage arises from the existence of fixed operating costs and interest expenses. Because of the existence of these costs, 1% change in unit sales leads to more than 1% change in profit before tax.
We know that operating leverage measures percentage change in EBIT due to percentage change in sales. It explains the degree of operating risk. And, financial leverage measures percentage change in EPS due to percentage change in EBIT. It explains the degree of financial risk. Both these leverages are closely concerned with the firm’s ability to meet its fixed costs. If both the leverages are combined, the result obtained will disclose the effect of percentage change in EPS due to percentage change in sales. It measures the total risk of the firm.
DCL = DOL * DFL
DCL = % change in EPS
% change in sales
CL = Contribution
EBT
In case the capital structure comprises of preference shares too, the formula will be as under:
DCL = CONTRIBUTION
EBT – (PD/1-t)
Format of income statement:
Sales
Less: Variable expenses
Contribution
Less: Fixed expenses
Earnings before Interest & Tax
Less: Interest
Earnings before Tax
Less: Tax
Earnings after Tax
Less: Preference Dividend
Earnings available to Equity Shareholders
Other Important Formulae:
Earnings per share (EPS) = Earnings available to equity shareholders
Number of equity shares
Price Earnings Ratio (P/E) = Market Price per share
Earnings per share
Practical Examples:-
1. The installed capacity of a manufacturing concern is 1200 units. Actual capacity used is 800 units. Selling price per unit is Rs. 10 & variable cost is Rs. 7 per unit. Compute operating leverage when fixed cost is Rs. 300, Rs. 800 and Rs. 1200.
2. A firm has a choice of the following 3 financial plans. Compute the financial leverage in each of the situation and interpret it.
Particulars
|
A
|
B
|
C
|
Equity Capital
|
4000
|
2000
|
6000
|
Debt
|
4000
|
6000
|
2000
|
Operating profit EBIT
|
800
|
800
|
800
|
Interest on debt
|
10%
|
10%
|
10%
|
3. A firm’s capital structure comprises of the following securities:
10% Preference Share Capital Rs. 200000
Equity Share Capital (shares of Rs. 10 each) Rs. 200000
The operating profit of the firm is Rs. 80000. The firm is in 50% tax bracket. Calculate the financial leverage of the firm. What would be the new financial leverage in case the operating profit enhances to Rs. 100000 and interpret your results.
4. A firm’s capital structure comprise of the following securities:
Equity Share Capital (FV Rs. 10) Rs. 200000
10% Preference Share Capital Rs. 200000
9% Debentures Rs. 250000
The present EBIT is Rs. 100000. Assuming that the firm is in 50% tax bracket, compute Financial Leverage.
5. The capital structure of the firm is as under:
20000 equity shares of Rs. 10 each Rs. 200000
4000 10% preference shares of Rs. 100 each Rs. 400000
4000 10% debentures of Rs. 100 each Rs. 400000
Compute the EPS for the EBIT of Rs. 150000, Rs. 120000 & Rs. 200000. The firm is in 50% tax bracket. Also calculate financial leverage.
6. A firm’s sale is Rs. 200000. The variable cost is 30% of sales. The fixed operating cost is Rs. 50000. The amount of interest on long term debt is Rs. 15000. Compute the composite leverage and illustrate its effect in case sales increase by 10%.
7. Calculate DOL, DFL & DOL for the following firms and interpret the result:
Particulars
|
P
|
Q
|
R
|
Output in units
|
300000
|
75000
|
500000
|
Fixed costs
|
Rs. 350000
|
Rs. 700000
|
Rs. 75000
|
Variable cost per unit
|
1.00
|
7.50
|
0.10
|
Interest expenses
|
25000
|
40000
|
NIL
|
Selling price per unit
|
3.00
|
25.00
|
0.50
|
8. A company has sales of Rs. 1000000, variable cost of Rs. 700000, Fixed Cost of Rs. 200000 and a debt of Rs. 500000 at 10% interest rate. Calculate OL, FL & CL. If the company wants to double its EBIT, how much rise in sales would be needed on a percentage basis?
9. A firm has estimated that for a new product its break-even point is 3000 units, in case the item is sold for Rs. 15 per unit. It has been currently identified by the cost accounting department that variable cost is Rs. 10 per unit. Compute DOL for sales volume of 3500 units and 4000 units. What do you infer from the DOL at the sales volume of 3000 units and 4000 units and their differences if any?
10. The following data relate to Ambica Ltd.
Sales 400000
30% variable expenses 120000
Contribution 280000
Fixed operating expenses 130000
EBIT 150000
Interest 50000
EBT/ Taxable income 100000
a. Using the concept of leverage, by what % will taxable income increase in case sales increases by 10%
b. Using the concept of OL, by what % will EBIT increase in case there is a 15% increase in Sales?
c. Using the concept of FL, by what % will taxable income increase in case EBIT enhances by 10%?
11. A Company has to make a choice between debt issue for its expansion program. Its current position is as follows:
Debt 5% 40000
Equity Capital @ Rs. 10 per share 100000
Reserves & surpluses 60000
Total capitalization 200000
Sales 600000
Less: total costs 500000
EBIT 100000
Less: interest 2000
EBT 98000
Less: tax @ 50% 49000
EAT 49000
The expansion programme is estimated to cost RS. 100000. In case this is financed through debt, the rate of new debt will be 6% and the price earnings ratio will be 6 times. If the expansion programme is financed through equity shares, the new shares can be sold netting Rs. 20 per share, and the price earnings ratio will be 7 times. The expansion will generate additional sales of 200000 with a return of 10% on sales before interest and taxes. If the company follow a policy of maximizing the market value of its shares, which form of financing should it chose?
12. The capital structure of Narmada Ltd is as under:
20000 equity shares of Rs. 10 each fully paid and 1600, 10% debentures of Rs. 100 each. EBIT is Rs. 100000 and tax rate is 50%. Calculate EPS
13. An analytical statement of a company is as under:
Sales 960000
Variable cost 560000
Contribution 400000
Fixed cost 240000
Fixed cost 240000
EBIT 160000
Interest 60000
EBT 100000
Tax 50000
Net income 50000
Calculate all the three types of leverage.
14. Tapi ltd has an EBIT of Rs. 160000. Its capital structure comprises the following securities:
10% Debentures 500000
12% Preference Shares 100000
Equity Shares of Rs. 100 each 400000
The company is in 55% tax bracket. You are required to ascertain:
i. EPS
ii. % change in EPS associated with 30% increase and 30% decrease in EBIT
iii. DFL
15. A firm has sales f Rs. 1000000, variable cost of Rs. 700000, fixed costs of Rs. 200000 and debt of Rs. 500000 at 10% rate of interest. What are the operating, financial and combined leverages? If the firm wants to double the EBIT how much rise in sales would be needed on percentage basis?
16. From the following information of the companies calculate EPS of each one:
Particulars
|
Ganga
|
Jamuna
|
Saraswati
|
Equity capital of Rs. 10 each
|
1000000
|
600000
|
200000
|
10% debentures
|
Nil
|
400000
|
400000
|
12% preference shares
|
Nil
|
Nil
|
400000
|
Total capitalization
|
1000000
|
1000000
|
1000000
|
EBIT
|
200000
|
200000
|
200000
|
Tax rate
|
40%
|
40%
|
40%
|
17. The required financial data for three companies are as follows:
Particulars
|
Amar
|
Akbar
|
Anthony
|
Variable expenses as % of sales
|
66.66%
|
75%
|
50%
|
Interest cost
|
200
|
300
|
1000
|
Rom
|
5
|
6
|
2
|
FL
|
3
|
4
|
2
|
Tax rate
|
35%
|
35%
|
35%
|
Prepare income statement of the companies and comment on the financial position and structure of the companies.
18. Calculate OL for each of the following three firms Sun, Moon and Star from the following data. What conclusions can you draw with respect to levels of fixed cost and the degree of operating leverage result? Assume 5000 units are sold.
Particulars
|
Sun
|
Moon
|
Star
|
Selling price per unit
|
20
|
50
|
70
|
Variable cost per unit
|
6
|
20
|
50
|
Fixed operating cost
|
80000
|
200000
|
Nil
|
19. The capital structure of Sindhu Ltd consists of Rs. 1000000(shares of Rs 100 each) and 10% Debentures of Rs. 1000000. The unit sales increased by 20% from 100000 units to 120000 units. The selling price is Rs. 10 per unit; variable expenses are Rs. 6 per unit and fixed expenses Rs. 200000. The taxes are 35%. You are required to calculate the percentage increase in EPS, FL and OL.
20. Koel Ltd’s balance sheet is as follows:
Liabilities
|
Amount
|
Asset
|
Amount
|
Equity Shares of Rs. 10 each
|
60000
|
Net Fixed Assets
|
150000
|
10% Long Term Debt
|
80000
|
Current Assets
|
50000
|
Retained Earnings
|
20000
| ||
Current Liabilities
|
40000
| ||
Total
|
200000
|
Total
|
200000
|
The company’s total asset turnover is 3, its fixed operating costs are Rs. 100000 and the variable operating cost ratio is 40%. The rate of income tax is 35%. Calculate all the three types of leverages. Calculate the level of EBIT if EPS is Rs. 3.
21. Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to Rs. 1000000. The firm now wishes to raise additional Rs. 1000000 for expansion. The firm has 4 alternative financial plans:
i. Raise entire amount in the form of equity capital
ii. Raise 50% as equity capital and 50% debentures @ 5% interest
iii. Raise entire amount by debentures @ 6% interest
iv. Raise 50% as equity capital and 50% as preference capital @ 5% dividend
Further assume that the existing EBIT are Rs. 120000, tax rate is 35%, outstanding ordinary shares are 10000 and market price per share is 100 under all the four alternatives. Which financing plan should be selected?
22. Calculate FL & OL under situation A & B and financial plan I & II respectively from the following data:
Installed capacity 1000 units
Actual production & sales 800 units
Selling price per unit 20
Variable cost per unit 15
Fixed costs: Situation A 800
Situation B 1500
Capital Structure financial plans
I II
Equity 5000 7000
Debt @ 10% 5000 2000
23. Kavya Ltd has the following Balance Sheet as on 31st March, 2012
Liabilities
|
Amount
|
Asset
|
Amount
|
Equity share capital of Rs. 10 each
|
1600000
|
Fixed assets
|
2000000
|
10% Debentures
|
1200000
|
Current assets
|
1800000
|
Retained Earnings
|
700000
| ||
Current Liabilities
|
300000
| ||
Total
|
3800000
|
Total
|
3800000
|
Income Statement:
Sales 680000
Less: Operating Expenses (including Depreciation of Rs. 120000) 240000
EBIT 440000
Less: Interest 120000
EBT 320000
Less: Tax 160000
Net Earnings 160000
You are required to determine DOL, DCL at the current sales level, if all expenses other than depreciation are variable costs. What will be the EPS if sales increase by 20%?
24. From the following data, calculate combined leverage:
Share capital – 50000 shares of Rs. 10 each
Sales – 1000000
Variable cost – 60% of sales
Fixed operating cost – Rs. 200000
Fixed financial charges – Rs. 100000
Ignore Taxes. Calculate the changes in EPS as a result of 5% change in sales.
25. Calculate OL, FL & CL from the following data under situation I & II and financial plan A & B
Installed capacity 4000 units
Actual production & sales 75% of the installed capacity
Selling price per unit Rs. 30
Variable cost per unit Rs. 15
Fixed costs: Under situation I Rs. 15000
Under situation II Rs. 20000
Capital Structure A B
Equity 10000 15000
20% Debt 10000 5000
26. A simplified income statement of Kangan Ltd is given below. Calculate & interpret DFL, DCL & DOL:
Sales 1050000
Variable cost 767000
Fixed cost 75000
EBIT 208000
Interest 110000
Taxes @ 30% 29400
Net income 68600
27. The following data is related to Kashish Ltd:
Sales 300000
Less: Variable Cost (40%) 120000
Contribution 180000
Fixed cost 90000
EBIT 90000
Less: Interest 30000
Taxable Income 60000
Using the concept of leverage:
i. Compute % change in EBIT if there is 20% change in Sales
ii. Calculate % change in taxable income if there is 20% change in EBIT
iii. Calculate % change in taxable income if there is 10% change in Sales
28. The financial manager of a company expects that its EBIT in the current year would be Rs. 10000. The firm has 5% bonds aggregating Rs. 40000, while 10% preference shares amount to Rs. 20000. What would be EPS? Assuming EBIT being 6000 & 14000, how EPS would be affected? The number of outstanding equity shares is 1000
29. A company needs Rs. 1200000 for the installation of a new factory which would yield an annual EBIT of Rs. 200000. The company has the objective of maximizing EPS. It is considering the possibility of issuing equity shares plus debt of Rs. 200000, Rs. 600000 or Rs. 1000000. The current market price per share is Rs. 40, which is expected to drop to Rs. 25 per share if the market borrowings were to exceed Rs. 750000. Cost of borrowings are indicated as under:
Upto Rs. 250000 10% pa
Between 250000 & 625000 14% pa
Between 625000 & 1000000 16% pa
Assuming tax rate of 50% work out the EPS and suggest the scheme which would meet the objective of the management.
30. P Ltd has an average selling price of Rs. 10 per unit. Its variable cost per unit is 7 and fixed costs amounts to Rs. 170000. It finances all its assets by equity funds. It pays 30% tax on its income. Q Ltd is identical to P Ltd except in pattern of financing. The latter finances its assets 50% by equity and 50% by debt funds, interest on which comes to Rs. 20000. Determine OL, FL & CL at Rs. 700000 sales for both the firms.
31. A company is considering different methods to finance its investment proposal. It is estimated that initially Rs. 2000000 will be needed. Two alternatives are available:
(1) To raise Rs. 1000000 by selling equity shares of Rs. 100 each and balance at 18% term loans.
(2) To raise the entire amount by sale of equity shares of Rs. 100 each.
The existing capital structure of the company consists of 25000 equity shares of Rs. 100 each and 17% term loan of Rs. 1000000. The expected EBIT is Rs. 750000. Advice the company on the basis of EPS
32. The following information is available for a company:
EBIT 1120000
PBT 320000
Fixed costs 700000
Calculate % change in EPS if sales are expected to increase by 5%.
33. CL & OL of a company are 2.5 & 1.25 respectively. Find out the financial leverage and prepare an income statement given that Equity Dividend is Rs. 2/share, interest payable is 100000, sales are 1000000 and fixed costs amounted to Rs. 50000.
34. A firm has sales of Rs. 2000000, variable costs of Rs. 1400000 and fixed costs of Rs. 400000 inclusive of interest of Rs. 100000. Calculate OL, FL & CL. If the firm wants to double its EBIT, how much of rise in sales would be needed on a percentage basis?
35. Three financing plans are being considered by ABC Ltd which requires Rs. 1000000 for construction of a new plant. It wants to maximize its EPS and the current market price of the share is Rs. 30. It has a tax rate of 50% and debt financing can be arranged as follows:
Upto Rs. 100000 @ 10%
From 100000 to 500000 @ 14%
Over Rs. 500000 @ 18% The three financing plans and the corresponding EBIT are as follows:
a. Rs. 100000 debt; EBIT Rs. 250000
b. Rs. 300000 debt; EBIT Rs. 350000
c. Rs.600000 debt ; EBIT Rs. 500000
Find out EPS for all the three pans and suggest which plan is better from the point of view of the company.
36. Kanha Ltd has equity share capital of Rs. 500000 (face value Rs. 100). To meet the expenditure of an expansion program, the company wishes to raise Rs. 300000 and is having the following four alternative sources to raise the funds:
(i) To have full money from the issue of equity shares
(ii) To have Rs. 100000 from equity shares and Rs. 200000 from borrowings from financial institution at 10% interest per annum
(iii) To have full money from borrowings @ 10% pa
(iv) To have Rs. 100000 in equity & Rs. 200000 in 8% preference shares.
The company is having present EBIT of Rs. 150000. The corporate tax rate is 50%. Select a suitable plan out of the above.
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