Investment/

Financing Decisions

S.CLEMENT
 LEVERAGES
 Financing decisions involve in deciding
capital or financial structure.
 It involves mix of capital and debt

 Effects of various mix debt & equity on the

share holders return in the capital.
 Company can increase or decease the
debt unlike equity .
 More capital reduces the return for share
holders.
 LEVERAGES
 Leverage arises because of presence of
fixed cost . when the firm uses assets or
funds for which it pays fixed cost. It may
be operating or financial.
 When a firm uses fixed asset like
machinery, it has a fixed cost which is
fixed operating cost.
 Usage of funds for investing in fixed
assets create fixed financial cost (interest)
 Proportion between fixed cost and sales
give rise to leverage.
 Why leverage
 Leverage indicates relative change in
profits due to change in sales.
 Proportionate change in change in
sales may not result same
proportionate change in profits
 Operating Leverage
 Cost can be fixed or variable
 Fixed cost can be operating(manufacturing) or financial
 Operating cost arise when a fixed asset is put to use to
produce goods.
 When fixed operating cost is more than VC, company
leverage will be high and vice versa.
 E.g if sales increase by 25%/ profit may go up by 100 %
(due to high operating leverage) and vice verca.
 In absence of any operating cost , there is no leverage.
Profit will increase in direct proportion to increase in sales.
 Company should use fixed cost assets to bring about
positive co relation between sales and EBIT and EBIT to
EBT
 COMPUTATION OF OperatingLeverage =CONTRIBUTION/
EBIT
 Operating Leverage
 Production Planning – to modify
cost structure. E.g. installation of
machinery to save labour cost but
increases FC (operating) and
decrease in VC.
 Question before finance manager –
what will be the probability of
increase in sales?
 Operating Leverage
 OL relates to implies the use of FA
 OL explains the relationship regarding
changes in sales visa-à-vis profit (EBIT)
 It measures a firms’ ability to use FA to
manage & maximize EBIT
 It relates to asset side of the B/S

 It is concerned with investing decision

 It is a first stage leverage

 Operating Leverage
A company produces & sells 1000
units p.a. SP @ Re 200 and VC @ Re
70 per unit. FC (operating) Re
50,000. What is OL.
 OL = Contribution/EBIT
 Operating Leverage
 Sales (1000*200) 200000
 Less Vc (1000*70) 70000
 Contribution (sales – VC)130000

 Less FC 50000
 EBIT 80000
 OL 130000/80000 = 1.625
 CASE STUDY
A company sells 80,000 units of a
products. SP per unit Re 8 and VC @
2. FC Re 330000.what wil be the
profit if the company sells
 A) 96,000 units

 B) 64,000 units
units 80000 96000 64000

Sales 640000 768000 512000

Less VC 160000 192000 128000
Contribution 480000 576000 384000
Less FC 330000 330000 330000

EBIT 150000 246000 54000

% change in - 128/640 128/640
sales *100= *100 =
20%(+) 20 (-)
% change in 96/150 96/150*
EBIT *100= 100 =
+64% -64%
 Degree of OL
 It measures the ratio of percentage
change in EBIT to percentage change in
sales.
 Degree of OL = % of change in EBIT/% of
change in sales
 E.g. increase in sales is 20% and profit
@ 64%.
 Degree of OL = 64/20 = 3.2.
 If sales increase by RE 1,profit will
increase by Re 3.2. & vice versa
 Degree of OL
 Estimated BE production is 2000 @
SP of RE 14 per unit. VC Re 9 per
unit. Calculate degree of OL if
 A) production @ 2500 units

 B) production @ 3000 units

 FC - (2000*14) – (2000*9)

 Re 28000 – 18000 = 10000

Particulars 2500 units 3000 units
Sales @ 14 p.u. 35000 42000

Less VC 22500 27000

Contribution 12500 15000
Less FC 10000 10000

EBIT 2500 5000

OL 12500/2500 = 15000/5000 =
5 3
% change in - 7000/35000
sales *100 =20%
% ch.in profits - 2500/2500
*100 = 100%
 Degree of OL
 % of change in profits 100 % (2500 to
5000)
 % of change in sales 20% (35000 to
42000)
 OL = % change in EBIT/% change in sales

 OL 100/20 = 5

 Conclusion – 20% increase in sales result

in 100 % in profits. Highly leveraged
company.
 Financial Leverage
 It relates to fixed financial cost such
as interest on TL/Debentures/Pref.
Dividend etc
 It establishes relationship between
EBIT&EBT
 It measures firms’ ability use fixed FC
optimize EBT
 It is concerned with financing
decision
 It is second stage leverage
 FL is favorable when FC < earnings
 Financial Leverage
 Financial arises from fixed financial
cost. E.g. Debentures/Term loans –
rate of interest is fixed.
 FL measures the firms ability to use
fixed FC to bring about changes in
EBIT/EBT .
 FL is favorable when earnings is
more than FC and vice versa.

 Financial Leverage - Effect
 Share holders earnings – depends upon
relationship between EBIT and Fixed FC. If
EBIT is more than FC, it will hace positive
imapct on EPS.
 Financial Risk – more the the proportion of
debt, more the financial risk. E.g. 10%
increase operating profit results in 20%
increase in EPS and 10% drop in OP, will
result in 20% drop in EPS.
 Financial Leverage
 Company capital structure
-1000,10% debentures of Re 100
each & 5000 equity shares of RE 10
each.
 EBIT – 50000,80000 & 20000.

 What is the impact on EPS ?

 Financial Leverage
 FL = EBIT/EBT
 Fixed FC - effect on earnings

 EBIT/ EBT (Earnings before Tax but

after Interest)
 , Sales – Rs 50000,

VC – 25000, FC – 15000, Int. 5000

10000/5000 – FL = 2
 CHANGES IN EBIT TO EBT

SALES 50000 60000 40000

VC 25000 30000 20000
CONT. 25000 30000 20000
FC 15000 15000 15000
EBIT 10000 15000 5000
INT. 5000 5000 5000
EBT 5000 10000 0
FL 10/5 2*5000 2*5000
=2 =2*5000 = -1000
+10000
 EBIT LEVELS
1 2 3
EBIT 50000 80000 20000
Less 10000 10000 10000
interest
EBT 40000 70000 10000
Less 20000 35000 5000
tax(50%)
EAT 20000 35000 5000
EPS 4 7 1
%in EBIT - +60% -60%
%chg. EPS - +75% -75%
 EPS for various levels
 XYZ COMPANY –EBIT Re
15000,24000& 6000.
 8% debentures 25000

 10% preference shares 20000

 1000 equity of RE 10000

 Tax rate 50%

 What would be the effect on EPS @

different.
 1 2 3
EBIT 15000 24000 6000
-INT. 2000 2000 2000
EBT 13000 22000 4000
-TAX 6500 11000 2000
-Pref.divnd. 2000 2000 2000
Ear. For esh 4500 9000 Nil
No. of ESH 1000 1000 -
EPS 4.5 9.00 -
%CH.EBIT - +60% -
% CH.EPS - 100% -
FL 15/9=1.67 24/18 = 1.33 -
 Composite leverage
 CL measures composite effect of all
the fixed cost (operating and
financial)
 CL will disclose effect of changes in
sales over cjnage in taxable profit(or
EPS)
 FORMULA – CONTRIBUTION/EBT
 Composite leverage
 SALES – Re 1.00 lac
 VC (40% of sales) 40 000

 Fixed operating cost 30000

 Fixed financial cost 10000

 Calculate CL.

 Calculate CL.IS 5% increase in sales

Sales 100000 105000

VC 40000 42000
Contribution 60000 63000
FC – Operating 30000 30000
EBIT 30000 33000
FC- Financial 10000 10000

PBT 20000 23000

CL 60000/20000 =
3
 Composite leverage
 Sales @100000 .CL is 3
 It indicates 1% increase in sales will
result in 3 in EBT
 Sales 1050000 (5% increase)

 Profit Re 23000 ( 15% increase)

 (23 -20/20 *100)

 Composite leverage
 Capitalstructure of Ever Grow Ltd
 Equity Re 3,00,000 (Re 10 each)
 10% debentures Re 3,00,000
 Increase in sales from 30000 to
36000 units. SP @ Re 10 per unit
 FC 50,000. VC Re 6 per unit.
 Tax rate 50%
 Compute OL,FL & CL.
 30000 36000
UNITS UNITS
sales@10 300000 360000
- VC@6 180000 216000
Contrib. 120000 144000
-FC 50000 50000
EBIT 70000 94000
Interest 30000 30000
EBT 40000 64000
tax@50% 20000 32000
PAT 20000 32000
No.of ES 30000 30000
EPS 0.67 1.07
 OL/FL/CL
 OL 120/70 =1.72 & 144/94 = 1.53
 FL 70/40 = 1.75 & 94/64 = 1.47
 CL 120/40 = 3.00 & 144/64= 2.25
 OL/FL/CL
% of change in sales
 60000/30000*100 =20%

 % of change in EBIT

 24000/70000 *100 = 34.29%

 %of change in EPS

 1.07- .67/.67*100 = 60%`

company Int.cost ( in Int/PBIT PAT(cr
cr) % )r
Escorts 142 78.4 39
India cements 149 74.9 45
BPCL 212 58.3 130
Nagarguna 131 54.3 67
ferti
Arvind mills 130 46.8 127
HPCL 159 27.1 406
Mrpl 188 23.2 372
JSW steel 360 20.8 857
IOC 1022 13.2 4915