FINANCIAL MANAGEMENT

UNIT 3 – FINANCING DECISION

PROBLEMS ON LEVERAGES
MEANING OF LEVERAGE
Leverage has been defined as “the action of a lever, and mechanical advantage
gained by it”. A lever is a rigid piece that transmits and modifies force or motion
where forces are applied at two points and turns around the third.

In simple words, it is a force applied at a particular point to get the desired result.

DEFINITION OF LEVERAGE
According to James Horne, “ Leverage is the employment of an asset or funds for
which the firm pays a fixed cost or fixed return”.

Christy and Roden define leverage as the tendency for profits to change at a faster
rate than sales. It is a relationship between equity share capital and securities and
creates fixed interest and dividend charges. It is also known as “gearing”.

The term Gearing explains the relationship between the equity capital and fixed
bearing securities. This helps the business units in finalizing the issues of
capitalization. Gearing gears up the effect on earnings of any change at the trading
profit level.

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE
 MASTER TABLE TO CALCULATE THE LEVERAGES
Particular Amount
Sales XXXX
Less: Variable cost XXXX
Contribution XXXX
Less: Fixed cost XXXX
Operating profit/EBIT XXXX
Less: Interest XXXX
Earnings Before Tax(EBT) XXXX
Less: Tax XXXX
Earnings After Tax(EAT) XXXX
Less: Preference Dividend XXXX
Earnings Available to Equity Shareholders XXXX
Note : EBIT – Earnings Before Interest and Tax
TYPES OF LEVERAGES
1. FINANCIAL LEVERAGES : The used of fixed interest bearing securities,
such as debt and preference capital along with owners equity in the capital
structure is described as ‘financial leverage’ or ‘Trading on Equity’. This
decision is most important from the point of view of financing decisions. By
having debt and equity in the capital mix, a company will have an opportunity
of deploying certain amount of debt (Instead of whole equity capital) with an
intention to enjoy the benefit of reduction in the percentage of tax (as
interest is debited to profit and loss account). The benefit so enjoyed will be
passed on to the equity shareholders in the form of high percentage of
dividend.

FORMULA TO CALCULATE FINANCIAL LEVERAGE :

Financial leverage = Operating profit/EBIT

Taxable Income/ EBT

OR

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE
 EBIT
EBIT-I

EBIT = EARNINGS BEFORE INTEREST AND TAX

EBT = EARNINGS BEFORE TAX

2.OPERATING LEVERAGE
Operating leverage emphasis on the relationship between the contribution and the
operating profit. It emphasizes on the role of fixed operating cost and its influence
on the profitability of the firm. The operating leverage signifies the role of fixed
cost in a given operation and suggests the comprehensive measures to control the
fixed operating cost.
Operating leverage shows the ability of a firm to use fixed operating cost to
increase the effect of change in sales on its operating profits.

FORMULA TO CALCULATE OPERATING LEVERAGE :

Operating leverage = Contribution

Operating profit/EBIT

3.COMBINED LEVERAGE
This leverage shows the relationship between a change in sales and the
corresponding variation in taxable income.
The total leverage is the combination of financial leverage and operating leverage
of a given business firm. Combined leverage may be defined as the potential use
of fixed costs, both operating and financial, which magnifies the effect of social
volume change on the EPS of the firm.

Combined leverage = Contribution

Taxable Income/ EBT
OR

Combined leverage = OPERATING LEVERAGE X FINANCIAL LEVERAGE

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE
PROBLEMS

1. From the following calculate Financial, Operating and Combined leverage.

Sales 10,000 units, at Rs 25 per unit as selling price. Variable cost Rs 5 per unit, Fixed
cost Rs 30,000 and interest Rs 15,000.

MASTER TABLE TO CALCULATE THE LEVERAGES

Particular Amount
Sales (10000x25 per unit) 2,50,000
Less: Variable cost (10000 x 5 per unit) 50000
Contribution 200000
Less: Fixed cost 30000
Earnings Before Interest and Tax 170000
Less: Interest 15000
Earnings Before Tax(EBT) 1,55,000

Financial leverage = Earnings Before Interest and Tax (EBIT)

Earnings Before Tax (EBT)

= 170000 = 1.097 Times

155000

Operating leverage = Contribution = 200000 = 1.176

EBIT 170000

Combined leverage = Contribution = 200000 = 1.29 Times

EBT 155000

OR

Combined Leverage = FINANCIAL LEVERAGE X OPERATING LEVERAGE

= 1.097X 1.176 =1.29 Times

2. From the following calculate Financial, Operating and Combined leverages.

Interest Rs 10000, Sales 15000 units at Rs 10 per unit and variable cost Rs 4 per unit
and Fixed cost Rs 20000.

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE
 3. From the following calculate Financial, Operating and Combined leverages.
Interest Rs 5000, Sales 75000, Variable Cost Rs 30000 and Fixed cost Rs 20000.

4. Calculate two companies in terms of its financial and operating leverages.

FIRM A (RS) FIRM B(RS)

Sales 20,00,000 30,00,000

Variable Cost 40% of Sales 30% of Sales
Fixed Cost 5,00,000 7,00,000
Interest 1,00,000 1,25,000

5. Consider the following data of XYZ Ltd., Selling price per unit Rs 60, Variable cost per
unit Rs 40, Fixed cost Rs 300000, Interest burden Rs 100000, Tax rate 50%, Preference
dividend Rs 50000. Calculate the three types of leverages if the number of units sold is
10000.

6. A firm has sales of Rs 10, 00,000 Variable cost Rs 7, 00,000 and Fixed cost
Rs 2, 00,000 and Debt of Rs 5, 00,000 at 10 % rate of interest. What are the operating
and financial leverages?

7. The following data are available for X ltd.

Selling price per unit Rs 120
Variable cost per unit Rs 70
Total fixed cost Rs 200000
What is operating leverage when X ltd produces and sells 6000 units.
What percentage change that will occur in the EBIT of X ltd, If output increases by 5%.

8. A company has the following capital structure equity capital at RS. 10 each amount RS.
500000. 15% debt of rupees 5 each, amount Rs.500000. Operating profit Rs. 2,00,000
calculate financial leverage.

9. A company has a choice of three financial plans you are required to calculate
financial leverage in each case

Particulars X Y Z
equity share capital 20000 10000 30000
Debt 20000 30000 10000
Operating Profit 4000 4000 4000
Interest Rate 10% on Debt

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE
10. The Installation capacity of a factory is 700 units the actual capacities 500 units, selling price
per unit is Rs 10 variable cost is Rs 6 per unit. Calculate operating leverage in each of the
following situation when fixed cost is: A- 500, B-1500, C-1100.

11. A company has a Sale of Rs.1,00,000, Variable Cost 40 % of sales, Fixed Cost Rs30000
amount of interest on long term debt is Rs 10000. You are required to Calculate Composite
Leverage and Illustrate the impact of increase in taxable income, when the sales is increase
by 5%.

12. The following data X Limited. Selling price per unit is Rs120, Variable Cost Rs 70 per unit,
total fixed cost Rs 2,00,000.
a) What is the operating leverage when X Limited produces and sells 6000 units?
b) What is the operating leverage and percentage change that will occur in EBIT if the output is
increased by 5%?

13. The company has the following capital structure:

Particular Amount
10,000 equity share of Rs 10 each 1,00,000
2,000, 10% Debt of Rs 100 each 2,00,000
2,000, 10% of preference share of Rs 100 2,00,000
each

Calculate EPS for the following level of EBIT

Plan 1: 1,00,000, Plan 2 : 60000, Plan 3 : 1,40,000.
The company is in 50% tax; also calculate financial leverage by EBIT level.

14. The capital structure of a progressive Capital Limited consists of Equity shares of rupees
10,00,000 at Rs 10 per share and Rs 10,00,000 of 20% debt. Sales increased by 25% from
2,00,000 units, selling price is Rs 10 Per unit, variable cost amount to 6 per unit Fixed expenses
cost Rs 2,50,000 income tax is assumed to be 50% calculate the following:
a) Financial and Operating leverage in both the situation
b) EPS
c) Percentage increase in EPS.

15. XYZ limited has an average selling price of Rs 10 per unit variable cost Rs 7 per unit fixed cost
amount to Rs 1,70,000. It finances its entire asset by equity fund. ABC limited is identical to XYZ limited
except in respect of pattern of finance, ABC limited financed its asset by 50% of equity an 50% of debts.
The interest on which amount Rs 20,000. Determine the degree of financial an combined leverage at Rs
7, 00,000 sales for both the form and interpret the result.

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE
16. . A private company limited has a EBIT of Rs4, 80,000 and its capital structure consists of the
following security

Particular Amount
Equity share capita Rs 100 each 4,00,000
12% preference share 6,00,000
14.5% debt 10,00,000
The Company is facing fluctuation in its sales, what would be the change in EPS?

a) If EBIT of the company increased by 25%

b) If EBIT of the company decreased by 20%
c) Corporate tax is 35%.

PROFESSOR SOGARA BI
KRUPANIDHI DEGREE COLLEGE