leverage

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

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 31^st 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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