CHAPTER

Financing Decision: Leverage AnalysSIS

totaloperatingexpenses do
Because someelennentsofoperating expenses are fixed, rise faster than sales
Therefore, operating profits
OrISe asS rapidiy assalesrevenue. interest payments, a r e also relativeb
io7, non-operating expenses such as
rise even faster than
TEed.Hence, net oorporate profits (after interest charges) leverageand
Operating profits. Thesetwo factors are referred toas operating
financialeverage These two leverage factors amplify the effects of the basic
terms of the relationship between
business ycle. Operating Leverage is defined in refers to the nix
xed andvariable operating expenses. The term financial leverage of leverage c a n
of debt and equity used to finance the firm's activities. Thetodegree
equity. Alternatively.
be measured in stock terms by using the ratio of debt payments to
leveragecan bedefined in flow termns, by using the ratio of interest
EBIT"1

SYNOPSIS

Concept of Leverages.
Operating Leverage.
Importance of Operating Leverage.
Financial Leverage.
Importance of Financial leverage.
Combined Leverage.
and Risk of the Firm.
Leverage Analysis
,16 Graded Illustrations in Leverage Analysis.
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. Soloman, Ezra Hall of India Indian Reprint

to Fnancut a u g e r t c l ,
FTenuce (P) Lid.,
Ezra and Pringle, J.J., An Introduction
133
 134 PARTI1: FINANCING DECISION
with respect to EBITis gen
he financing decisions have two components. First, to expected. This uncertainty oa
business risk or operating risk, ne
tions ma
decide as to how much total funds are needed, and referred to as
business fluctuati.
risk is the
second, to decide the sources or their combinations to source of operating
of economic recession, Nd
raise such funds. The total quantity of funds needed, how particular, the possibility amount of interest"t
fixed
what happens to EBIT,
a
ever, depends upon the investment decisions of the firm. the residu
investors. Consequently,
Given that the firm has good estimates of how much capital paid to the debt also varies in resPrh
funds are needed, the problem then remains one of determin- (which is available to shareholders)
When EBIT falls, a major portion.o he
ing the best mix of different sources to be used in raising the change in EBIT.
required funds. decline is ultimately
deducted from the earni rnings goingt
shareholders. As a result, the greater the use oe
equity
Determining an appropriate financial mix for the firm is not sensitive is the earnings going to
an easy job. At this stage, it is necessary to distinguish between financing, the more

shareholders to a change chan

in EBIT. The present
the financial structure and capital structure. The financial fin" at
the relationship between the debt
tempts to analyze
structure refers to the mix of all funds sources that appear on
in the capital structure and
its effect on the earnings aa
the liability side of the balance sheet. On the other hand, the be anal
the equity shareholders. The relationship
can
to
term capital structure refers to the mix of long-term sources and financial levera
in terms of the operating leverage rage.
of funds. Simply speaking. financial structure is the sum of
capital structure and current liabilities. This relationship has CONCEPT OF LEVERAGE
been shown in Figure 6.1
BALANCE SHEET
The term leverage, in general, reters to a relationship betwen
two interrelated variables. With reterence to a business
Liabilities Assets these variables may be costs, output, sales revenue, EB

Equity Share Capital Earnings Per Share (EPS) etc. In financial analysis, the leter
age reflects the responsiveness or influence of one financi
Preference Share Capital variable over some other financial variable. It helps under
Reserves& Surplus standingthe relationship between any two variables. In the
Long-term Debt leverage analysis, the emphasis is on the measurementofthe
relationship of two variables rather then on measuringthee
Current Liabilities
variables. However,thetwo variables, for which the relation.
Total Total shipisto be established and measured, should beinterrelate
otherwise, the leverage study may not have any useful pur
FIG. 6.1 FINANCIAL STRUCTURE AND pose to serve.
CAPITAL STRUCTURE
The leverage may be defined as the %change in one variadle
Financial structure designing requires attention on following
divided by the %change in some other variable or variables
two questions:
Impliedly,the Fumeratoris thedependent variable,sayX,and
(a) What should be the maturity composition of firms total the denominator is the independent variable, say Y. The
sources of funds ie, what should be the relationship leverage analysis thus, reflects as to how responsiveness s the
between long-term and short-term sources of funds? dependent variable toa change in the independentvariabke
(b) In what proportion the funds be arranged from various Algebraically, the leverage may be defined as
long-term sources?
% Change in Dependent Variable
Capital structure analysis and management deals with the Leverage=-
second question, namely the mix in which long-term (perma- %Change in Independent Variable
nent) sources of funds be raised by the firm so as to maximise
For example, a firm increased its sales
the market price of equity shares of the company. Part IV of promotion expeis
from 5,000 to f 6,000 ie., an increase of 20%. This
the book deals with this question.
the increase in number of unit sold from 200 to 300
resulteu
The process that leads to the final choice of the capital LE,a
increase of 50%. The
structure is referred to as the capital structure planning. A
leverage between the promotiondl
penses and the number of units sold may be defined
firm may use several techniques that allow it to quantify the as
risk-return characteristic of the alternative capital structures. % Change in units sold
Two of such techniques, which are widely used, are the Leverage
% Change in Sales Promotion
Leverage Analysis and the EBIT-EPS Analysis. The former is Expenses
discussed in the present chapter, while the latter is taken up 50
in the next chapter.
-
=2.5
.20
The Earning Before Interest and Taxes (EBIT) for any given
firm is subject to many influences, some particular to a firm This means that %increase 5 times
in number of unit sold i5
and some others common to all the firms in the industry or that of %increase in sales in
promotion expenses. The op of
general economic conditions that affect all thelower
firms. In profit of a firm is a direct consequence of the sales reven
than the firm and in turn the eprofil

practice, the EBIT in any be

period may higher or
operating profit determines u
 135
CH.6: FINANCING DECISION: LEVERAGE ANALYSIS
ahle to the equity shareholders. The functional 7 1,20073,000 = 1
avhetween the sales revenue and the EPS can berelation
estab 74,000 7 10,000
lishedthrough operating rofits (EBIT) and has been shown
in Figure 6.2.
The Operating Leverage (OL) of denotes
1 that the EBIT level
to the increase or
Incteasesordecreases in direct proportion
Sales Revenue
EBIT due to the fact that thereis no
decrease in sales level. This is in nature. Thus,
- VariableCosts - Interest
fixed costs and the tOtal cost is variable
Contribution Profit before tax mpliedly, the profitlevelie.,the EBIT variesih direct propor
fixed
that the firm has a
- Fixed Costs - Tax
tion to the sales level. Now suppose unit.
costs of 1,000 in addition to the
variable costs of 7 7 per
EBIT Profit after tax The present and expected cost and profit
structure of the firm

G. 6.2: RELATIONSHIP BETWEEN SALES AND PROFIT may be expressed as follows:

Present Expected
The left hand side of the above presentation shows that the
Sales @ 10 per unit 710,000 714,000
level of EBIT depends upon the level of sales revenue and, the 9,800
- Variable Costs @7 7 per unit 7,000
oht hand side of the above presentation shows that the level
orofit after tax or EPS depends upon the level of EBIT. The Contribution 3,000 4200
- Fixed Costs 1,000 1,000
relationship betweensales revenue and EBITis definedas
oDerating leverage and the relationship between EBIT and EBIT 2,000 3,200
EPSis defined as financial leverage. The direct relationship
96 Change in EBIT
hetweenthe salesrevenueandtheEPScan also be established
Operating Leverage 6 Change in Sales Revenue
bythecombiningtheoperating leverageand financiallever.
age and is defined as combined leverage. Increase in EBIT + EBIT
Given the level of operating profit ie, EBIT, the financial Increase in Sales * Sales
manager should strive to maximize the EPS and for this

Durpose the understanding of financial leverage is essential.

However, as the level of EBIT depends upon the sales reve
nue, the operating leverage should also be analyzed though
the financial leverage is more important and directly relevant.
Moreover, the operating leverage and financial leverage are
related to each other. In the following 'discussion therefore,
these two leverages have been first defined individually and
then in terms of combined leverage.
OPERATING LEVERAGE
When the sales level increases or decreases, the EBIT also
The operating leverage measures the relationship
changes.
between the sales revenue and the EBIT or in other words, it
measures the effect of change in sales revenue on the level of
EBIT. The operating leverage is calculated by dividing the %
change in EBIT by the % change in sales revenue, or
6 Change in EBIT
Operating Leverage % Change in Sales Revenue
71,200- 2,000 -= 1.5
T4,000T 10,000
The OL of 1.5 means that the % increase in level of EBIT is 1.5
times that of % increase in sales level. In this case, the %
increase in EBIT is 60% (ie., increase of 7 1,200 over the
present level of 2,000), and the h increase in sales is 40% (ie.,
increase of 400 units over the present level of 1,000 units). It
means that for every increase of 1% in sales level, the %
increase in EBIT would be 1.5%. In other words, it means that
for every increase or decrease in sales level, there will be more
than proportionate increase or decrease in the level of EBIT.
This is due to the existence of fixed costs. It is already seen that
when there was no fixed cost, the increase or decrease in EBIT
was direct and proportional to the increase or decrease in
sales level. The OL will always be greater than I for any firm
which has a fixed cost element in its costs structure. In case
there is no fixed cost, the OL is 1.
The above figures of 1 time or 1.5 times are known as the
Degree of Operating Leverage (DOL). Whenever,theb change

10per unit. The cost

inEBITresultingfrom given%changeinsales is greaterthan
For example, ABC Ltd. sells 1000 unit @ the % change in sales, the OL
exists and the relationship is
oT production is 7 per unit and the whole of the cost is knownas the DOL. This means that as long as the DOL is
x (R 10-R7)
variable in nature. The profit of the firm is 1,000
its sales level by greater than 1, there is an OL. The OL emergesas result of
3000. Suppose, the firm is able to increase firm
existence offixed elementin the cost structure ot thefirm.
of 1400 units. The profit of the
Uresulting in total sales TheOL may be defined as tirm's position orability to magnity
Would now be 1400 x ( 10-7 7)=74,200. theeffectof changeinsales overthelevelof EBIT. The level
he operating leverage of the firm is. of fixed costs, which is instrumental in bringing this magnify-
ing effect also determines the extent of this effect Higher the
6 Change in EBIT
leveloffixed costs in relation to variable cost, greater would
perating Leverage Change in Sales Revenue be the DOL. The DOL may, at any particular salesvolume,
also
Increase in EBIT+EBIT becalculated as a ratio of contribution to the EBIT Le,
Increase in Sales + Sales
 136 DECISION
PARTII:
FINANCING

3 Higherthe fixed cost, greater would be the Or.n

effect of
Land la
change
Operating Leverage = Contribution Oty. (S.P-V.C.) would be the
magnitying
change in EBIT.
sales n
EBIT Oty.(S.P.- V.C.) - F.C.
means
that the firm is operati
DOL
This formulation of the OL 4A positive the level and both thee
however, static in nature and
is
calculates the effect on EBIT for a change in given level of
than
higher
in
break-even

the same direction

EBTT
sales will vary
sales. If the level of sales changes, the DOL for the new level
means that the firm is operating
of sales may be different. For example, the DOL for a sales Anegative DOL EBIT
break-even level; and the
level of 1000 units and 1400 units is as follows : lower than the will he
1400 Units
negative.
Sales/Level 1000 Units
Uperating Levera.
of
Importance and Significance
Sales @ 10 per unit 10,000 14,000 ot fixed coste4
introduction
the
- Variable Costs @ 7 per unit 7,000 9,800 already mentioned,
cost structure of a firm tendsto
magnitythe operatina
Contribution 3,000 4,200 at higher level of operations. This is due to the increme
- Fixed Costs 1,000 1,000
additional unit provide. Dependin
contribution each
EBIT 2,000 3,200
fixed and variable costs in the st co
the proportion of tru
3,000 4,200 can result in a sizable
incremental contribution
ture, the
DOL= 2,000 3,200 recovere
Once all fixed costs are
= 1.50 = 1.31 in the operating profits.
the contributions, protits grow proportionately faster
the growth in volume. Untortunately the same effect hoi
This means that if the firm is presently operating at a level of
for declining volumes also, which result in decline in roft
sales of 100 units, the change from this level has a DOL of 1.5
and acceleration of losses disproportionate to the rate
times. However, if the firm is operating at the sales level
of
1400 units, then the change from this level will have DOL of volume reduction.
1.31 times. Similarly, the firm will have different DOL at Analysis of operating leverage of a firm is very useful to t
different levels of operations. financial manager. It tells the impact of change in sales onthe
level of operating profits of the firm. A firm having highe
DOLcan beused to find outthe changein EBIT as a result of
DOL can experience a magnitied ettect on EBIT for evena
changeinsaleslevel. For example in the abovecase, the firm
is presently operating at a sales of T10,000 and has DOL of 1.5. small change in sales level. Higher DOL can dramatical
Now, if next year, the sales are expected to increase by 40% to increase the operating profit. Nevertheless, the EBIT ma
14,000, then the EBIT would increase by 40% X 1.5 disappear and even give place to operating loss if there sa
= 60%. This can be verified in the above table when the EBIT decline in sales.
has increased by 60% from R2,000 to R3,200. The relationship
Therefore, a firm should always try to avoid operating undar
between sales, DOL and EBIT can be presented as follows:
high DOL. A high DOL condition is a high risk situation ad
6 Change in EBIT = % Change in Sales X DOL even a small decrease in sales can excessively affect the ims
efforts to record profits. On the other hand, a firm shouldy
The behaviour and direction of OL depends upon the state of
to operate at a level sufficiently higher than the break-eva
sales level vis-a-vis the break-even level. If thefirmis operat- levelso that the chances of loss due to fluctuations in salesar
ing at a sales level ahove the hreak-even lerel the DOL minimized.
decreases with everyincreasein saleslevel. Thereasonbeing
that thefixed costs becomerelatively smallerascomparedto FINANCIAL LEVERAGE
thetotal sales revenue, However, if the firm is operating at
break-even level (where the contribution is just equal to the The Financial
Leverage (FL) measures the relationship be
fixed costs and the EBIT is zero) then the DOL for this firm ween the EBIT and the
EPS and it reflects the eftect
cannot be defined. Say, the firm is operating at 333 units of change in EBIT on the level of EPS. The FL
sales, the DOL for the firm is
measures
responsiveness of the EPS to a change in EBIT and is de
as the %
Contribution T1,000
change in EPS divided by the % change in
DOL = = Undefined Symbolically,
EBIT 0
6 Change in EPS
Thus, on the basis of the above analysis, the OL may be Financial Leverage =
% Change in EBIT
interpreted as follows
1. The OL is the %change in EBIT as a result of 1% change Increase in EPSEPS
in sales. Increase in EBIT EBIT
2. OL arises as a result of fixed costin the coststructure. If It may be noted
that the EBIT is a the
lein
thereis nofixed cost,there wil benoOLand the%change OLand was determined by the sales dependent varnaeo
the FL, the level. Howevern
in EBIT will be same as % change in sales. EBIT is an independentvariable and n
determining the level of EPS. That is why the EBLL
calleda

linking point in the leverage

study.
 137
CH.6 FINANCING DECISION LEVERAGE ANALYSIS
different
ntinue with the example of OL, the firm is 2,000 to 7 3,200 the EPS for
To having level increases from
C an EBIT level of 7 2,000. This profit is available
pre ment of interest cost and for earnings for levels of EBIT is:
tne the shareholders. Suppose, the tax rate distributions
1400 Units
1000 Units
Sales Level
mis 30% and there is no debt financing. Theapplicable
to 73,200
a total funds EBIT 7 2,000
nloved by the firm are, say, ? 7,000 represented by 700 7 200 7 200
-Interest
cty shares of ? 10 each. Now, the EPS of the firm may bee 7 1,800 73,000
Profit before Tax
determined as follows: 7 540 9
-Tax @ 30%
7 1,260 72,100
(EBIT Interest) X (1 - t) Profit after Tax
EPS =

500 500
Number of Shares Number of Share
EPS 7 2.52 Z4.20
(2,000-0) X (1-.3)
= R2 In this case, the % increase in EBIT is 60% (ie., from
7 2,000 to
700 from 7 2.52 to
7 3,200). But the increase in EPS is 66.6% (ie.,
than the %
So.the firm is having an EPS ofR 2, Now, assume that the total 4.20). Thus, the % increase in EPSis higher
of fixed interest
funds requirements of R 7,000 is partly financed by the issue increase in EBIT. This is due to the existence
the fixed
of 10% debentures to the extent of T 1,000 and balanced is charge ie., interest on 10% debentures. But how
financed by the issue of 600 equity shares of 710 each. In this
interest charge affects the level of EPS. In the above example,
the firm has employed funds of 7 7,000 T 5,000 from equity
case, the EPS is
is
capital and 7 2,000 from debts) and the EBIT
(2,000 2,000. Thus, the firm is earning 28.57% 2,000 on the capital
EPS=
-

100) x (l=3)z 222

600 employed of 7 7,000), on the funds employed. However on the
debt financing of T 2,000, the interest is payable @ 10% only
So,the EPS of the firm has increased from7 2 toF 2.22. Let the Thus, in terms of cost-benefits, the cost of debt financing is
10% debentures be increased by another 1,000 (however, 10% whereas, the benefit is 28.57%. The surplus generated by
total funds requirement pegged atR 7,000 only). The remain- employing debt financing of 7 2,000 is in fact available to the
ingfunds of 5,000 are arranged by the issue of 500 equity shareholders and as a result the total earnings available to the
shares of 7 10 each. In this case, the EPS is shareholders has enhanced. Moreover, the fixed interest charge
is tax deductible and provides a tax-shield. This tax shield
EPS (2,000-200)X
(5)-7 2.52 provided by the interest charge further increases the earnings
available to the shareholders. This has resulted in proportion-
500
ately higher increase in EPS.
So, the EPS of the firm has again increased toR 2.52. It may be
Thus, the FL which is defined as a % increase in EPs divided
noted that the EPS has shown a gradual increase when the by the % increase in EBIT, emerges as aresult of fixed financial
debt proportion is increased. But the EBIT level was taken
charge against the operating profits of the firm. The fixed
constant at 2,000. But what happens if the EBIT level also
changes. Suppose, the sales level of the firm increase from financial charge appears in case the funds requirements of
the firm are partly financed by the debt inancing which is
1000 units to 1400 units resulting in increase of EBIT from
generally a cheaper souree of finance. By using this relatively
2,000 to 7 3,200. The effect of this change on the EPSS cheaper source of finance ie., the debt financing, the firmn is
(assuming that there is no debt financing) can he expressed as able to magnify the effect of change in EBIT on the level of
follows: EPS.
Sales Level 1000 Units 1400 Units So, the FL may be defined as a increase in EPS that is
EBIT 2,000 73,200 associated with a given increase in the level of EBIT. The
- Interest increase in EPS of the firm may be more than proportionate
for increase in the level of EBIT. In other words, the effect of
-Tax@ 30% 600 7 960
increase or decrease in EBIT is magnified on the level of EPS.
Profit after Tax 1,400 2,240
The existence of fixed financing charge is instrumental to
Number of Share 700 700 bring this magnifying etfect and also determines the extent of
EPS T2 T3.20 this effect. Higher the level of fixed tinancial
charge greater
would be the FL. The FL may also be defined as:
ne EBIT has increased by 60% (i.e., from 2,000 to
,200). The EPS has also increased by 60%) (ie., from Financial Leverage=
EBIT EBIT EBIT
tOR 3.20). Thus, when the fixed interest charge in the form EBIT - Financial Charge EBIT - Int.
PBT
nterest on debt financing is not there, both the EBIT and
S FL in of Preference Share
are
increasing by the same percentages. case
Capital:
Now Suppose, the firm has debt financing also and the firm In case, the firm has issues
preference share capital, then it has
afixed financial liability in terms of
raisedT 2,000 by the issue of 10% debentures in order to preference dividend also.
The financial leverage in such cases can be found as
tTinance the total requirements ofR 7,000. In case the EBIT
follows:
 PART II: FINANCING DECISION

Financial Leverage EBIT EBIT increases by 60% from 2,000 to z 3200

increases by 66.6% (ie., 60% X 1.11) from 7 2,52he
PBT -PD+(1 -1) 2.52 to 4.2
As the The firm will have different DFL at different level
preference
dividend in India is
dividend tax, the above the firm is operating, in the above case, at the Fp of hp
subject to the EBIT
formula can be modified tocorporale lev
rate the
of PD corporate dividend tax also.
in the
incopo-
In suchcases,the amount DFL is undefined.
financial charge ,.
200 (i.e., EBIT just equal to the fixed financial.

equation would be preference

rate dividend dividend + corpo-
tax on that. EBIT 200
For = Undefined
example, a firm has an EBIT of T
liability is 30,000. It has issued 2,00,000. The interest
DFLPRIT Interest 0
10%
R3,00,000 and 10,000 equity shares preference shares of This is also known asfinanctal break-even level ie
tax rate
applicable to the of T100 each. The average of EBIT is just sufficient to cover the fixed finance
firm is 40% and
tax is 20%. The total corporate dividend only and there is no earnings available to the sharehe
liabilityof the firm in
respect of
ence dividend would be prefer
30,000 + 6,000 = 7 36,000 and the hence no EPS as such. The concept ot tinancial break
financial leverage is been discussed in the next chapter. Further, the above
tion of the FL has shown that the EPS increases u a
Financial Leverage = 2,00,000 increase in debt financing. Does it mean that the E
increase invariably with every increase in debt
1,70,000-36,000 (1 - 4) financin.
= 1.818
continue with the above example, suppose, the total .
employed by the firm are? 25,000 financed bythe fund
Suppose, the EBIT of the firm increases by 20% to 1500 equity shares ofR 10 each and7 10,000 by the isce
(ie 2,40,000 debentures. What is the EPS and how it changes if tha 10
2,00,000+40,000).
of EBIT and new EBIT
The EPS of the firm at
existing level
would be as follows financing is increased to 7 15,000? The position
expressed asfollows: may te
EBIT
Existing New
Debt (10%)
T2,00,000 10,000 15,0
- Interest 2,40,000 EBIT
30,000 2,000 2.0
Profit before Tax 30,000 - Interest
1,70,000 F1,000 1500
2,10,000 Profit before Tax
-Tax@40% 68,000 84,000 - Tax @ 30%
T 1,000
7500
Profit After Tax T 300
Pref. Dividend
1,02,000 1,26,000 Profit after Tax
30,000
700 350
30,000 Number of Share
-

Corp. Div. Tax @20%

6,000
1500 100
Net profit for Equity 6,000 EPS 47
66,000 90,000
No. of Equity shares In this case, the EPS has
10,000 10,000 decreased fromT47 toR.35
EPS 10% debt whenthe
6.60 9.00 financing is increased from 7 10,000 to
T15,000. Why? Perusal of the above
The EPS has increased
by 2.40 and the % increase in EPS is answer. In this case, the firm is
example wil provide te
2.40+6.60 36.36%. The FL of
the firm is 1.818 and the EBIT T2,000 on the total capital
earning a return of 8h (4

increases in 20%, so the EPS should employed of 25,000) and is payig

7
36.36%. Thus, the results are
increase by 20X 1.818 10% interest to the debt
investors. This excess amount
verified. to debt investors
(over and above the earnings on their
payatk
Like the OL, this formulation of FLis also static
in nature and
results in lowering of the EPS as tun
the shareholders will havel0
ascertained the effect on the EPS for a change in a bear this burden. This
particular level of EBIT. So, for different levels of EBITgiven of the firm is less than happens, whenever the rate reu
of
the the %
interest on debt financing
Degree of Financial Leverage (DFL) would be different. For situation may be called
example, the DFL for the EBIT level of T 2,000 and 3,200 is: A
unfavourable FL.
finance manager can
easily find out whether the firm n
Sales Level prospectsfor FL or not. Debt
1000 Units 1400 Units when the firm has financing is suggested
EBIT 2,000 3,200 prospects for FL. For this purpos
financial manager should
- Interest
200 200 compare the cost of debt tinau
With the average Return on Investment (RO) by
the
Profit before Tax 1,800 3,000 Three situations
may emerge as a consequence ot
DFL= 2,000 3,200 parison as follows: u
1,800 3,000 () ROIis equal to the Cost
of Debt: In this case, firm
= 1.1 = 1.06 just earning what is the
It is neither being paid to the suppliers
sensible nor advisable to
This means that at the EBITlevelofR2,000,the DFLis 1.11 ie, this situation and the firm borrow tne generale

for every 1% change in EBIT from the present level of may not be able tO 8
any surplus by debt financing.
2,000, the % increase in EPS would be 1.11%. So, when the
 CH. 6: FINANCING DECISION: LEVERAGE 139
ANALYSIS
(ti) RO
less than Cost of Debt: In this
case, the if the EBIT turns out to be low. The firm obtains a higher
in fact
employs borrowed fundsfirm
ses if it
fact incur losses
or
will
only.
risk If EBIT
for debt ancing. This situation as opts
already noted is also expected returns at the expense of greaterincrease in costs or
known as Unfavourable FL. because of a decrease in sales o r
declines,
both, then a chance of financial insolvency is inevitable. So,
as
more than Cost of Debt: In
this case, the firm is with the investment decision, again a firm is faced with the
(in t o earn a return on funds
debt financing.employed
ab at ever present risk-return trade-off. The leverage has the costs
of a rate higher
than the cost The firm in this as well as the benefits.
nloy the debt
financing. As more and more borrowedmay case

ds are employed by the firm, the benefits Operating Leverage and Financial Leverage: Both the OL and
accruing to
the shareholder wil also ncrease. This situation FL emerge for more or less the same reason. The OL appears
known as Favourable FL or Trading on Equity. is also it the firm has fixed operating costs (ie., the fixed costs)
whereas the FL appears when the firm has a fixed financial
Ont basis
of the abOve discussion and
analysis, the FL can charge (in the form of interest payment on debt financing).
beinterpreted follows:
as

%
The fixed cost magnifies the effect of variability of the sales on
a The FL is a change in EPS as result of 1% the level of EBIT, and thus the OL increases the variability of
EBIT.
change in
the EBIT. On the other hand, fixed financial charge magnifies
(b The FL emerges as a result of fixed financial cost (in the the effect of variability of the EBIT on the level of EPS and
form of interest and thusFLincreases the variability of the EPS. So, there is a close
preference dividend). If there is
fixed financial liability, there will be no FL. In such a
no
similarity between OL and FL in that both present an oppor
case, tunity to gain from the fixed nature of certain costs in relation
thechange in EPS will be same as % change in EBIT. to incremental profits.
(Higher the fixed tinancial cost, greater would be FL and On the basis of the analysis of the OL, a finance
larger would be the effect of change in EBIT manager can
on the determine the reasonable level of fixed cost. The FL on the
change in EPS.
other hand, helps in determining the level of fixed financial
( Apositive FLmeans that the firm is operating at a level of charge or in particular, in determining the extent of debt
EBIT which is higher than the financial break-even level financing. As the debt financingis relatively a cheaper source,
and both the EBIT and the EPS will the FLmay suggest for more and more use of debt
vary in the same financing.
direction as the EBIT changes. But with every increase in debt
financing, the financial risk
(e) A negative FL means that the firm is ie, the risk of bankruptcy also increases. Therefore,
operating at a level the FL may suggest for higher debt
though
lowerthan the financial break-even level and the EPS will financing in order to
be negative. increase the EPS, yet a finance
manager must strive to
achieve a trade off between the cost and benefit of debt
Importance and Significance of Financial Leverage: Analysis financing.
of FL isprobably the most important tool in the hands of a The OL and the FLare
financial manager who is
engaged in framing the capital related to each other. The FL takes over
structure of the firm. Any firm can where the OL leaves off. The OL and the FL, taken
easily adopt an all-equity in fact multiply and together,
capital structure and thus can avoid the financial risk. But, magnify the effect of change in sales level
on the EPS. The OL
then, why not to avail the benefits of cheaper debt may be rightly called the
first order or first stageleverage whereas the leverage
financing? of the
With ftinancialleverage, the advantage arises from the possibili- the leverage of the second order or second
FLmay called
be
Ly that funds borrowed at a fixed interest rate can be used for stage leverage.
nvestment
ne
opportunities earning a rate of return higher than COMBINED LEVERAGE
interest paid. The difference of course, accrues to the
cquity shareholders. Given the ability to make investments So far the OL and FL have been
analyzed separately. The OL
at consistently provide return above the fixed financial explains the business risk complexion of the firm whereas the
geit will be advantageous for the firm to 'trade on equity'. FL deals with the financial risk of the
firm. But a firm has to
s means borrowings as much as
prudent debt-manage look into the overall risk or total risk of the
firm, which is
Caidenits, and thereby magnifying the returns to the business risk plus the financial risk.
ty shareholders. The opposite effect will of course, apply Therefore, a financial
manager should consider both the OL and the FL
the
company fail to earn higher returns. simulta-
neously.
The
riskemployment of debt The OL causes a
to the firm financing, nodoubt, brings financial
and erefore, a financial manager must be
magnified effect of the change in sales level
on the EBIT level and if
the FL is also considered
cerned with the effects of borrowings. He is required to neously, then the change in EBIT will, in turn, have asimulta-
intf between risk and return. As the degree of leverage fied effect on the EPs. Thus, a firm magni-
ases, the probability (likelihood) of higher returns to FL will have wide fluctuations inhavingboth the OL and the
the EPS for even
eholders also increases, but it also increases the likeli- change in the sales level. This effect of change in sales a smal
hood of lower the EPS is known as combined level on
returns. With increased leverage, the expected
return is higher, but a price is to be paid for this advantages
leverage.
he firm The Combined
Leverage (CL) is not a distinct type of
must ex expose itself to the possibility of lower returns
analysis, rather it is a product of the OL and the FL.leverage
The CL
 140 PART II1: FINANCING DECISION

10% from
may be defined as the % change in EPS for a given % change The sales level has increased by
has increased by I6 67
in the sales level and may be calculated as follows: 11,000, whereas the EPS
increase in EPS is I.66 time
2.52 to 7 2.94. The %
This coefticient 1.66 is the Dr
CL = OL X FL increase in sales level.
Contribution the same already calculated.
and
Contribution EBIT
to how the OL and FL interract
EBIT PBT PBT Thus, theCLexplains as
a magnified change in t
6 Change in EPS changein sales levelproduces follows:
e F%
%Change in EBIT The CL may be interpreted
as
or, CL =
%Change in Sales 6 Change in EBIT in EPS resulting from
om a1%
a lMchange
() The CL is the hchange
%Change in EPS in sales level.
-

(i) A positive CL means that the leverage is being ompu

4Changein Sales
than the break-even level a e
for a sales level higher
To continue with an above example, the DOL and the DFL at in the same direction
the EPS and sales will vary
the sales level of 1000 units are 1.5 and 1.11. The Degree of m e a n s that the leverage
is being cale.
Combined Leverage (DCL) is : (iin A negative CL financial break-even . lculated
sales level lower than the
for a leve
DCL = DOL X DFL
and the EPS will be negative.
in ditferernt combinat.
= 1.5 X 1.11 = 1.66 The OL and the FL can be employed
CL. For example, the o
and may produce still the
same

This that for every 1% increase in sales level, the EPS &2,2 & 3,4& 1.5,1 &6 etc.allgivea
means

will increase by 1.66%. It may be verified by taking the sales

FLcombinations of 3 aDCL
of 6.
levelof O0 units and increasing it by say, 10% as follows: Conclusion: The OL means that a part of the cost of the f
Expected volume. As a
Present is fixed over a broad range of consequenCe
F1100 boosted or depressed more than prone
Units sold 1000 operating profits are
volume. Similarly, FL occurs wh
Sales@ 10 per unit 10,000 11,000 tionately for a change in
contains obligation with fixed fina
-Variable Cost @7 per unit 7,000 7,700 a firm's capital structure
cial charges. The effect of this condition is similar to that
Contribution 3,000 3,300 OL. The EPS may be boosted or depressed more than propor
- Fixed Costs 1,000 1,000
as the volume changes. Both OL and
operating
EBIT 2,000 2,300 tionately
200 may be present in a firm and the respective impact on the
- Interest 200
profits will tend to be mutually reintorcing. The concepts o
Profit before Tax 1,800 2,100 OL, FL and CL are useful tools in the hands of financil
Tax @ 30 540 630 managers. Their significance lies in the fact that the concent
Profit after Tax 1,260 1470 of leverage helps () in specitying and measuring the effecto
Number of Equity shares 500 500 change in sales volume on the earningS available to the
EPS 2.52 2.94 shareholders and (i) in establishing the relationship between
the OL and the FL.

PoINTS To REMEMBER
6 Change in EBIT Contribution
The total funds needed by a firm depends upon the Operating leverage = Or =
investment decisions of the firm. However, the next step 6 Change in Sales EBIT
is to determine the best mix of different sources of funds.
O L appears as a result of fixed cost. If there is no tixed
The process that leads to the choice of capital mix is often
cost, there will be no OL
referred to as the capital structure planning
There are different techniques of analysing the risk- The Financial leverage measures the responsiveneso
return characteristics of differentalternativecapital struc- the EPS for a given change in EBIT and is definedas
tures. The Leverage Analysis and EBIT-EPS Analysis are %Change in EPS EBIT
Financial leverage =-
two such techniques. or
PBT
% Change in EBIT
In Leverage Analysis, the relationship between two inter
related variables is established. In financial management, I n case of Preference Share Capital,
there are two types of leverages calculated. These are EBIT
FL=
Operating leverage and Financial leverage. A Combined PBT- PD/(1-1)
leverage may also be calculated. The financial leverage appears as a finat
result of fixed
The Operating leverage establishes the relationship bet cial charge ie. interest and preference dividena.
ween sales and EBIT. It measures the effect of chance in
sales revenue on the level of EBIT and is defined as:
 141
CH. 6: FINANCING DECISION: LEVERAGE ANALYSIS
the risk
nbined lever
rage y also be ascertained to measures used to analyse
The concept of leverage c a n be used to
hange in EPS for a % change in the Sales and FL and CL c a n be
may level of the firm. The OL,
the of the irm.
b ed e f i n e d a s
measure
financial and total risk
business,
96 Change in EPS Contribution
Combined l e v e r a g e = - , or , or = OLXFL
96 Change in Sales PBT

GRADED ILLUSTRATIONSS

Ilustration 6.1
llustration 6.2
eulate the degree of operating leverage (DOL), degree of variable of 77,00,000 and
cost
Ca
lleverage (DFL) and the degree of combinedleverage Afirm has sales of T 10,00,000,
and debt of 7 5,00,000 at 10% rate
of
f i n a n c i a l l tixed costs of 7 2,00,000
financial and combined
DCL) for the following firms and interpret the results. interest. What a r e the operating,
before
? If the firm wants to double its earnings
Firm A| Firm B leverages be
Firm C in sales would
interest and tax (EBIT), how much of a rise
1.Output (Units) 60,000 15,000 1,00,000 needed on a percentage basis?
costs () 7,000 14,000 1,500
2. Fixed
cost per unit () 0.20 .50 0.02 Solution :
3. Variable STATEMENT OF EXISTING PROFIT
on b o r r o w e d funds 4,000 8,000
4.Interest
unit ) 0.60 5.00 0.10
5. Selling price per 710,00,000
Sales
-Variable Cost 7,00,000

Contribution 3,00,000
Solution:
2,00,000
-Fixed Cost
Firm A Firm B Firm C
EBIT 1,00,000
Output (Units) 60,000 15,000 1,00,000 50,000
Selling Price per unit ) 0.60 5.00 0.10
-Interest @ 10% on 5,00,0000
Variable Cost per unit 0.20 1.50 Profit before tax (PBT) 50,000
0.02
Contribution per unit R) 0.40 3.50 0.08
7 24,000
Contribution 3,00,000
Total Contribution 52,500 8,000 Operating Leverage =3
14,000 EBIT 1,00,000
-Fixed Costs 7,000 1,500
EBIT 17,000 38,500 6,500 EBIT 1,00,000
Financial Leverage= 2
- Interest
4,000 8,000 PBT 50,000
Profit before Tax (P.B.T) 13,000 30,500 6,500 Combined Leverage =3 X2=6

STATEMENT OF SALEs NEEDED TO DOUBLE THE EBIT

Degree of Operating Leverage
Operating leverage is 3 times ie, 33 % increase in sales
Contribution 24,000 52,500 8,000 volume causes a 100% increase in operating protit or EBIT.
EBIT 17,000 38,000 6,500 Thus, at the sales of T13,33,333, operating profit or EBIT will
1.23
= 1.41 = 1.36
become 2,00,000 ie., double the existing one.
Verification
Degree of Financial Leveragee
EBIT 17,000 38,500 6,500 Sales 13,33,333
6,500
-Variable Cost (70%) 9,33,333
PBT 13,000 30,500
= 1.31 = 1.26 = 1.00 Contribution 4,00,000D
-Fixed Costs 2,00,000
Degree of Combined Leverage EBIT 2,00,000
Contribution 24,000 52,500 8,000

PBT 13,000 30,500 6,500 llustration 6.3

= 1.85 = 1.72 = 1.23 Following information are related to four firms of the same
industry:
Interprpretation: Higho
operatingleverage combined with high Firm Change in Sales
financia leverage reprpresents risky situation. Low operatingg A 27%
Change in EBIT
25%
Change in EPS
30%
leverag combined with low financial leverage will constitute B 25% 32% 24%
anideal:situation. Therefore, firm Cis less risky because it has C 23% 36% 21%
low lix low D 21% 40% 23%
bine cost and no interest and consequently com-
bined leverage. Calculate (i) Degree of OL & (i) Degree of CL for all firms.
 142 PART II: FINANCING DECISION
leverage at the
Solution: infer from the degree of operating their differe
units and
Firm Operating Leverage Combined Leverage volumes of 2,500 units and 3,000 ence f
any?
in EBIT 6 Change in EPS
OL Change CL Solutton:
6 Change in Sales 6 Change in Sales OF OPERATING LEVERAGE
STATEMENT

2500 Units 3000 Unta

A OL-70.926 CL ==1.111 Particulars
35,000
27 Sales @14 per unit 42.00
,500
Variable st
12,500
27 000
B L-=1.280 CL= =0.960 Contribution
10,000
15.000
Fixed cost (2000x ( 14-9) 10,09
EBIT 2,500
21 =_Contribution 12,500 15.00
C OL = =1.565 CL 0,913 Operating Leverage
EBIT 2,500 5,000
23

40
D
D OL ==1.905 CL 1.095 At the sales volume of 3000 units, the operating profit
21
7 5,000 which is double the operating profit of R 2,500 (sales
volume of 2,500 units) because of the fact that the operatino
leverage is 5 times at the sales volume of 2,500 units. Hence
lustration 6.4 increase of 20% in sales volume, the operating profit has
XCorporation has estimated that for a new productits break increased by 100% ie., 5 times of 20%. At the level of 3000units
even point is 2,000 units if the item is sold for T 14 per unit; the the operating leverage is 3 times. If there is change in sals
cost accounting department has currently identified variable from the level of 3,000 units, the % increase in EBIT would be
cost of 9 per unit. Calculate the degree of operating leverage three times that of % increase in sales volume.
for sales volume of 2,500 units and 3,000 units. What do you

llustration 6.5
The balance sheet of Well Established Company is as follows:

Liabilities Amount Assets Amount

Equity Share Capital T60,000 Fixed assets 1,30,000
Retained Earnings 20,000 Current Assets 50,000
10% Long-term Debt 80,000
Current Liabilities 40,000
2,00,0000 2,00,000

The company's Total Assets turnover ratio is 3, its Fixed Tax at 30% 75,000
operating costs areT 1,00,000 and its Variable operating cost PAT
ratio is 40%. The income tax rate is 30%. Calculate for the 1,76,400
Company the different types of leverages given that the face Number of shares 6,000
value of the share is 10. EPS 2940

Solution Degree of Operating Leverage = Contribution/EBIT

Sales 3,60,000
Total Assets Turnover Ratio = = 1.38
Total Assets 2,60,000
Sales Degree of Financial Leverage =
EBIT/PBT
3
2,00,000 2,60,000 = 1.03
Sales 2,52,000
6,00,000
Variable Operating Cost (40%) Degree of Combined Leverage= 1.38 X 1.03 = 142
2,40,000
Contribution 3,60,000 Note :n this question, the
Fixed Operating Cost
-
operating leverage, finan
1,00,000 leverage and the combined
leverage are to be calculated a
EBIT which the detailed income statement is
-Interest (10% of 2,60,000 the sales level, as a required. Thererl
PBT 80,000) 8,000 Assets Turnover Ratio.
firststep, is calculated with the help of

2,52,000
 CH.6: 143
FINANCING DECISION LEVERAGE ANALYS
llustration6.6 Financial Leverage = EBrT/Profit before Tax=-
? 300 lacs/7 200
lacs

Theffollowing ormation is available in respect of two firms, 1.5

PLid. andQLtd.: before tax = OL X FL
Contribution/Profit
Combined Leverage =

3.5
(Figures in Lacs) c a s e of Q Ltd.
and hence
The operating leverage is higher in However,
PLid. Q Ltd. of operating o r business risk.
it has higher degree have s a m e degree of financial leverage.
Sales 500 1000 both the companies
risk. The combined
-Variable Cost 200 300 Hence, both the firms have s a m e financial
than P Ltd. Therefore, o n
Contribution
300 700 leverage of Q Ltd. is 3.5 and is higher
a s compared
Fixed Cost 150 the whole P Ltd. s e e m s to be having lower risk
400
to Q Ltd.
EBIT 150 300
-Interest 50 100
Profit before Tax 100
llustration 6.7
200 of lawn
The Karnal Recreation Ltd. manufactures a full line
are required to calculate different leverages for both the finished unit is 7 2,500
ar furniture. The average selling price of a
You the
irms and also comment on their relative risk position. and variable cost is 7 1,500 per unit. Fixed cost for
company is 7 50,00,000 per year.
Solution in units for the company?
different leverages (P Ltd.): ()What is break-even point
Calculation of
Operating Leverage = Contribution/EBIT = 300 lacs/ 150 lacs
(i) degree of operating leverage at the follow-
Find the
ing production and sales levels: 4,000 units; 5,000
Financial Leverage = EBIT/Profit before Tax=T 150 lacs/ 100 lacs
units; 6,000 units; 8,000 units.

1.5 (ii) Does the degree of operating leverage increase o r

decreaseas the production and sales levels rise above
Combined Leverage = Contribution/Profit before tax = OL X FL
the break-even point? What conclusion would you
3
draw from such increase or decrease?
Calculation of different leverages (Q Ltd.):
Operating Leverage = Contribution/EBIT = 700 lacs/R 300 lacs (iv) By what percentage the EBIT will increase if the
= 2.33 company's sales should increase by 10% from the
production and sales level of 8,000 units?
[B.Com. (H), D.U., 2010]

Solution:
Calculation of Operating Leverages:

Production (No. of Units) 4,000 5,000 6,000 8,000 8,800

Selling Price () 2,500 2,500 2,500 2,500 2,500
Sales () 100,00,000 125,00,000 150,00,000 200,00,000 220,00,000
- Variable Cost @ 1,500 60,00,000 75,00,0000 90,00,0000 120,00,000 132,00,000
Contribution 40,00,000 50,00,000 60,00,000 80,00,0000 88,00,000D
- Fixed Cost
50,00,0000 50,00,000 50,00,000 50,00,000 50,00.0000
EBIT -10,00,0000 10,00,000 30,00,000 38,00,000
6.000 2.667 2.316
OL (ContributionFC)
Break-even level (Units)= FC/(SP-VC) llustration6.8
50,00,000/(2500- 1500) The capital structure of Radhika Ltd. consists of ordinary
share capital of 10,00,000 (shares of 7 100 each) and
5,000 710,00,000 of 10% debentures. The selling price is? 10perunit;
the OOL
den the
sales level rises above the break-even level,
reases. This means that when the sales increases beyond
variable costs amount to ? 6 per unit and fixed expenses
amount to ? 2,00,000. The income tax rate is assumed to be
(EBIT)
iseak-even level, the increase in operating profits
1s
lesser and lesser. 30%. The sales level is expected to increase from 1,00,000 units
to 1,20,000 units.
the 10% from 8000 level, the EBIT
sales increases by
Wo can be veritied in (a) You are required to calculate:
th ncrease by 10X2.667 26.67%. Thisfrom 7 30,00,000 to
2 e.TheEBIT increases by 7 8,00,000 () The percentage increase in earnings per share;
38,00,000 ie., 26.67%.
(i) Thedegree of financial leverage at 1,00,000 units and
1,20,000 units.
 144
PART I1: FINANCING DECISION
(iin The degree of
Operating
and 1,20,000 units. leverage at 1,00,000 units Particulars
1,00,000 unlts
1,20 000 unt
(6) Conmment -Tax at 30%
30,000
on the behaviour of 70,000
leverages in
relation to increaseOperating Financial and Profit after tax
1,26 00
1,00,000 units to 1,20,000 units. in
production trom 70,000
() EPS (10,000 shares)
10,000 1,26,5M0
BCom. (H.), D.U, 2011] 7,00 1000%
Solution: %increase in EPS 12.60
(a) 2,00,000
Comparative Statement of EPS, Financial &
(i) Degree of Financial Leverage
1,00,000 2,1,30,M
80000
Leverages Operating 2

Particulars 4,00,000 156

1,00,000 units 1,20,000 units
(iin Degree of Operating Leverage
2,00,000 430000
Sales at T 10 per unit 2.80 06
-

Variable costs at 6 per unit 10,00,00o 712,00,000 1.71

Contribution 6,00,000 7,20,000 (b) As a result of increase in sales trom 1,00,000
- Fixed Expenses 4,00,000 4,80,000 1,20,000 units (20% increase), both the financial leu
EBIT 2,00,000 2,00,000 and operating leverage have decreased. This signifu
-Interest on Debentures 2,00,000 2,80,000
1,00,000 1,00,000 the business risk and financial risk of the businea
Profit before tax are
1,00,000 1,80,000 reduced

lustration 6.9
The data relating to two
companies are as given below:

Company A
Capital Company B
12% Debentures T6,00,000 3,50,000
T 4,00,000
Output (units) per annum 6,50,000
60,000 15,000
Selling price/unit 30
Fixed Costs per annum 250
T 7,00,000
Variable Cost per unit T14,00,000
10 75
You required
are to calculate the Operating leverage, Financial leverage and Combined leverage of two Companies.
Solution
COMPUTATION OF OPERATING LEVERAGE, FINANCIAL
LEVERAGE AND COMBINED LEVERAGE

Company A CompanyB
Output (units per annum)
60,000 15,000
Selling price per unit
T 30
Sales revenue 7 250
T 18,00,000 T37,50,000
Less Variable costs @ 10 and 75
6,00,000 11,25,000
Contributíon
12,00,000 26,25,000
Less: Fixed costs
7,00,000 14,00,000
EBIT
5,00,000 12,25,000
Less: Interest @ 12% on Debentures
48,000 78,000
PBT
4,52,000 11,47,000

DOL = Cont.
EBIT 12,00,000/7 5,00,000) R26,25,000/ 12,25,000)
2.4 2.14

DFL = EBIT
PBT 5,00,000/7 4,52,000) R12,25,000/7 11,47,000)
1.07
1.11
DCL = DOLXDFL (2.4 X 1.11) = 2.66 (2.14 X 1.07) =2.29|
 145
CH.6:FINANCING DECISION: LEVERAGE ANALYSIS
llustration6.10
Calculatlon of Financial Leverage :

following formation is available for ABC & Co. Plan I Plan

Plan I
The

11,20,000 Stuatlon A
EBIT
3,000 3,000
Profit betore Tax EBIT 73,000
3,20,000 600 300 900
-Interest @ 12%
Fixed costs
7,00,000 Profit before Tax 2,400 2,700 2,100
1.11 1.43
Calcul
sc h change in EPS if the sales are expected to increase Financial Leverage 1.25
(EBIT/Profit before Tax)
by
5%.
Situation B
Solution EBIT 7 2,000 72,000 2,000
the %change in EPS as a result of %
find out the 600 300 900
-Interest@ 12%
rder to change 1,700 1,100
e s the combined leverage should be calculated as fol- Profit before Tax 1,400
in sa
143 1.18 1.82
Financial Leverage
lows =
Contribution/EBIT (EBIT/Profit before Tax)
Operating Leverage Situation C
= 11,20,000+ 7,00,000/11,20,000 71,000
EBIT T1,000 7 1,000
1.625 900
600 300
Leverage
=
EBIT/Profit before Tax -Interest @12%
Einancial Profit before Tax 400 700 100
=R 1,20,000/3,20,000 10.0
Financial Leverage 2.5 1.43
3.5
(EBIT/Profit before Tax)
Combined Leverage= Contribution/ Profit before Tax= OL X FL
Calculation of Combined Leverage: The combined leverage
1.625 x 3.5
=
5.69 and
The combined leverage of 5.69 implies that for 1% change in may be calculated by multiplying the operating leverage
financial for different combination of Situation A, B
sales level, the %change inEPS would be 5.69%. So, if the sales leverage
&C and the Financial Plans I, II & II as follows:
are expected to increase by 5%, then the % increase in EPS
would be 5 X 5.69 = 28.45%.
Situation C
Situation A Situation B
Plan I 1.66 2.86 10
llustration 6.11 Plan I 1.47 2.36 5.72
Plan I 1.90 3.64 40
XYZ & Co. has three financial plans before it, Plan I, Plan I
and Plan I Calculate operating and financial leverage for the The calculation of combined leverage shows the extent of the
firm on the basis of the following information and also find total risk and is helpful to understand the variability of EPS as
out the highest and lowest value of combined leverage: a consequence of change in sales levels. In this case, the
Production 800 Units highest combined leverages is there when Financial Plan IIlis
Selling Price per unit 15 implemented in situation C; and lowest value of combined
Variable cost per unit 10 leverage is attained when Financial Plan II is implemented in
Fixed cost: Situation A 1,000 situation A.
Situation B 2,000
Situation C 3,000 lustration 6.12
The share capital of a company is R 10,00,000 with shares of
Capital Structure Plan I Plan II Plan II face value of 7 10. The company has debt capital of
Equity Capital 7 5,000 7,500 T 2,500
6,00,000 at 10% rate of interest. The sales of the firm are
12% Debt 5,000 2,500 7,500 3,00,000 units per annum at a selling price ofR5per unit and
the variable cost is 3 per unit. The fixed cost amounts to
Solution:
2,00,000. The company pays tax at 35%. If the sales increase
Calculation of Operating Leverage: by 10%, calculate:
Situation C () Percentage Increase in EPS;
Situation A Situation B
Number of unit sold 800 800 800 (i) Degree of Operating Leverage at the two levels; and
Sales @ 15 12,000 12,000 12,000
(in Degree of Financial Leverage at the two levels.
Variable cost@ 10 8,000 8,000 8,000
Contribution 4,000 4,000 4,000 Solution:
Fixed cost 1,000 2,000 3,000
EBIT 3,000 2,000 1,000 Exlsting Expected
Operating Leverage 1.33 2.00 4.00 Sales (in units) 3,00,000 3,30,000
Contribution/EBIT) Sales @5/- 15,00,000 16,50,000
Variable Cost at 3/-
9,00,000 9.90,000
Contribution 6,00,000 6,60,000
Fixed cost 2,00,000 2,00,000
 146
PARTII: FINANCING DECISION
7 40,500
So, Contribution
Existing Expected 40,500 - 27,000= 7 13,500
Operating
Less
Profit BIT) 4,00,000 4,60,000
Fixed Cost
PV Ratio =
40%, and Contribution = 7 40 00
Interest on debt
Profit Before Tax
at 10%
60,000 60,000 Sales=
Contribution + PV Ratio
So, 40,500 +40=7 1,01,250
Less Tax 35% 3,40,000 4,00,000
Net Profit after taxx 1,19,000 1,40,000 Variable Cost
= 1,01,250 X .60 =
7 60,750
2,21,000 2,60,000 can be calculated as follows:
EPS of the Company
Increase In EPS:
Sales
-Variable Cost
10123
Existing EPS = Net Profit 2,21,000 60,75
No. of Shares - 7 2.21 Contribution 40 300
1,10,000 - Fixed Cost
13,300
EBIT 27 000
Expected EPS = 260,000 2.60 - Interest
1,00,000 8,000
PBT
-Tax @ 30%
19000
Percentage increase in EPS 5,700
=
1=17.65% 13.300
No. of Equity Shares
Operating Leverage 10,.000
EPS (13,300+10,000) 133
Existing OL =Contribution 6,00,000 lustration6.14
EBIT 4,00,000 *1.5
The following data is available for XYZ Ltd.:

Expected OL =00 =143 Sales 72,00,000

4,60,000 -Variable cost @ 30%
60,0
Financial Leverage: Contribution 1,40,00
EBIT 4,00,000 Fixed cost 1,00,0
Existing FL PBT 3,40,000
=1.176 EBIT 40,000
-Interest 5,000
Expected FL=460,000
4,00,0001.150 Profit before tax 35,000
Find out:
lustration 6.13 ( Using the concept of financial leverage, by what per
centage will the taxable income increase if EBIT in
Following information is available in respect of Som Dut creases by 6%.
Bearings Ltd.:
(i) Using the concept of operating leverage, by what per
Profit Volume (PV) Ratio 40% centage will EBIT increase if there is 109% increase in sales
Operating Leverage 1.5000 and
Financial Leverage 1.421
Interest Liability
(ii) Using the concept of leverage, by what percentage wIl
T8,000 the taxable income increase if the sales increase by 6n
Tax rate 30% Also verify the results in view of the above
No. of Equity Shares 10,000 figures
Solution
Prepare the income statement and find out EPS. ( Degree of Financial leverage:
Solution: FL EBIT/Profit before Tax= 40,000/35,000
EBIT EBIT EBIT = 1.15
FL =

PBT EBIT-Interest EBIT 8000

If EBIT increases
by 6%, the taxable income will increasc
1.421 EBIT 1.15 X6= 6.9% and it
may be verified as followS
EBIT 8000
EBIT (after 6% increase) 742,400
EBIT=E 27,000 5,000
So -Interest
27,000 8,000 = 19,000
PBT= Profit before Tax 37,-400
OL =
Contribution Contribution Increase in taxable income is 2,400 ie., 6.9% of R 55,0
,000.
EBIT 7 27,000
(i) Degree of Operating
1.5 Contribution OL
leverage:
T 27,000
=
Contribution/EBIT =
1,40,000/40,000
= 3.50
 147
CH.6: FINANCING DECISION: LEVERAGE ANALYSISs

Tf sale increases by 10%, the EBIT will increase by 3.50 X 10 20,00,000

EBIT
=35% and it may be verified as follows: -Interest at 12% on 75,00,000 9,00,000
Sales (after 10% increase) 2,20,000 PBT 11,00,000
-Variable Expenses @ 30% 66,000
Contribution
1,54,000 Financial Leverage EBIT 20,00,000= 182
PBT 11,00,000
-Fixed cost 1,00,000
EBIT 54,000 lustration6.16
Increase in EBIT is R 14,000 ie, 35% of 40,000. The following are details of Bankers Ltd. for the year ending
31.03.2015.
(it) Degree of Combined leverage :
CL Contribution/Profit before Tax =
1,40,000/ Operating Leverage
35,000 4 Financial Leverage
Interest charge per annum 720 Lakhs
If sales increases by 6%, the profit before tax will increase by
Corporate Tax Rate 50%
4X6 24% and it may be verified as follows:
Variable Cost as percentage of sales 60%
Sales (after 69% increase) 2,12,000 Prepare Income Statement of the Company.
-Variable Expenses @ 30% 63,600 B.Com(H) D.U, 2013]
Contribution 1,48,400 Solution:
-Fixed cost 1,00,000
Calculatlon of EBIT:
EBIT 48,400
Financial Leverage 2 (Given)
-Interest 5,000
Interest 20,00,0000
Profit before Tax 43,400 EBII EBIT
Now, FL
Increase in Profit before tax is 7 8,400 ie, 24% of 35,000. PBT EBIT-Int.
EBIT
lustration 6.15 EBIT 20,00,000
EBIT 740,00,000
(Find out Operating Leverage from the following data: Calculation of Contribution:
Sales T 50,000 Operating Leverage 3 (Given)
Variable Costs 60% EBIT 40,00,000
Contribution
Fixed Costs 12,000 OL
EBIT
(i) Find out the Financial Leverage from the following data: So, Contribution R120,00,000
= Contribution-EBIT
Net Worth 25,00,000 Now, Fixed cost
3:1 120,00,000-40,00,000
Debt/Equity = R80,00,000
Interest rate 12%
Calculation of Sales:
Operating Profit 20,00,000 60%
6 Variable Cost
Solution: So, Contribution 40%
T 50,000 Contribution 7120,00,000
( Sales
So, Sales F1,20,00,000 40) 300,00,000
-Variable cost at 60% 30,000 Now, the Income Statement can be prepared as follows:
Contribution 20,000 Sales 300,00,000
-Fixed Cost 12,000 Less: Variable Cost (6096) 180,00,000

Operating profit T 8,000 Contribution 120,00,000

Less: Fixed Cost 80,00,000
Contribution
Operating Leverage= Operating Profit 20,000=
8,000
2.50 EBIT 40,00,000
Less: Interest 20,00,000
(i) Net Worth T 25,00,000 Profit Before Tax 20,00,000
3:1 -Tax50% 10,00,000
Debt/Equity
Hence Debt 75,00,000 Profit After Tax 10,00,000
-

OBJECTIVE TYPE QUESTIONS

State whether each of the following statements is True (7) or (i) Financial leverage depends uponthe operatingleverage.
False (F). (it) Dividend on Pref.shares is a factor of operatingleverage.
(9 Operating leverage analyses the relationship between (iv) Operating leveragemay be defined as Contribution+
sales level and EPS. EPS.
 149

CH. 6: FINANCING DECISION: LEVERAGE ANALYsIs

t h S a l e s D e c r e a s e s

(b FL will increase
(b) () OL will decrease
(a)and
Both and (b) (d) FL will decrease
of ( ) means
iNone is correct? firm has a DOL of 2.8, it increase by 1%
Which of
ofthe
following 21. If a increase by 2.8%,the
EBIT will
by 1%
OL + } ( a ) fSales
increase
FL the EPS will
C L =

increase by 2.8%,
(a) OL
-
FL (b) IF EBIT will rise by 2.8%
CL=
1%, EBIT
(b) =OL X FL (c)IfSales rise by
above
c)OL
OL + FL (d) None of the of higher:
the
=
use
related to
OL cost of duction is zero, which one of the 22. Higher OL is
&Ethefixec
f o l l o w i n g I S c o r r e c t ?
() Debt

OL is
zero (b) Equity
() zero
(c) Fixed Cost
FL is
(b) zero
(d) Variable Cost
CL is of:
( the use
None of
the above 23. Higher FL is related
( no debt, which one is correct? () Higher Equity
has
1
fafirm (b) Higher Debt
OL is
one

(a) (c)LowerDebt
FL is
one

(b) None of the above

OL is
zero (d 7. (a), 8. (b),
(d), 3. ,4. (a), 5. (a), 6.
(c) (c),
( F L i s zero [Answers: 1. (a), 2. 15. (b), 16. (c), 17.
10. (c), 11. (b), 12. (b), 13. (b), 14. (b),
new share capital to redeem deben- 9. (c), 23. (b)]
20. (d), 21. (c), 22. (c),
issues
0facompany (c), 18. (d), 19. (b),
tures, t h e n :

will increase
() OL
AssIGNMENTS

leverage? Examine its significance in

7. What is combined
notes o n
. Write short financial planning of a firm.
Fixed Financial Costs. and financial lever
(a) 8. Which combination of the operating
situation.
() Combined Leverage. () risky situation and (i) ideal
ages constitutes
2 What do you by leverage? Why is increasing lever
mean
9. Is it that a firm with high
true degree of OL should have
indicative of increasing risk? [BCom(H) DU, 2014]
age high degree of FL ? Examine.
3. Differentiate between the business
risk and financing is different
measured by the leverage? 10. The purpose of measuring operatingleverage
risk of a firm. How a r e they from that of financial leverage. Explain
BCom(H), D.U, 2005, 2006, 2008, 2012] BCom.(H) D.U, 2009]
and financial
Distinguish between operating cleverage
be measured? 11. What does combined leverage
measure? What shouldbe
leverage. How the two leverage a n
of combined leverage in each
B.Com(H), D.U. 2007] the changes in the degree
Examine the of following situations:
Explain the concept of financial leverage.
Does the finan-
impact of financial leverage on the EPS. (a)The fixed cost increases.
C1al leverage always increases the EPS$?
(b) The sale price decreases.
the degree
Why must the finance manager keep in mind When FL
[BCom(H), D.U, 2010]
in
OTFL evaluating various financial plans?
becomes favourable? [BCom(H.), D.U. 2004, 2013]

PROBLEMS
P6.1 ne following figures relate to two companies: PLTD. QLTD.
(In lacs) Contribution 450 700
Fixed costs 225 400
PLTD. Q LTD. EBIT 225 300
Sales 750 1,000
-Interest 75
Variable Cost 300 100
300 Profit before Tax
150 200
 DECISION
150
PARTII:
FINANCING
50 acs
Sales 10 1acs
You are required to: -Variable cost

( Calculate the Operating, Financial and Combined

leverages for the two companies; and
-Fixed cost
20 acs
(in Comment on the relative risk position of them.
EBIT
Slacs
[Answer:OL = 2 and 2.33; FL = 1.5 and 1.5.]
-Interest

Profit before tax

15 lacs
6lacs
-Tax at 40%
P6.2 A firm has sales of 20,00,000, Variable costs of 9lacs
costs of T 4,00,000 inclusive
ot Profit after tax
T14,00,000 and Fixed -Preference dividend
I lac
interest of 1,00,000. shareholder 8 lacs
Combined
(9 Calculate its Operating, Financial and Profit for equity
equity
shares issued
leverages. has 4 lacs
The company
the degree
of () ODere
how much Find out
(i) If the firm decides to double its EBIT, shareholders.
and (i) Comh
of a rise in sales would be needed on a percentage Financial Leverage,
leverage, (i) be the EPS
if the ale
basis? leverage.
What would level
[Answer : Operating leverage is 2. So, 50% increase in increases by 10%.
sales is required for 100% increase in EBIT.] different leverages
are 2, 1.5 and

3
[Answer: The
unit. The new EPS
would be 30% higher at26
P6.3 XYZ Ltd. has an average selling price of R 10 per
Its variable unit costs are 7, and fixed costs
amount its products at 2 per unit. The
6.5 ABC Ltd. is selling has been estimated
by equity funds.
to 1,70,000. It finances all its assetsLtd. variable cost of
manutacturing at
is identical to the present sales level of
It pays 30% tax on its income. ABC 35% while the
fixed cost at

XYZ Ltd. except in respect of the pattern of financing. c o m e s to?

1,00,000. The firm has ssued
1,00,000 units
and 50% by the Operatine
The latter finances its assets 50% by equity of ? 26,000. Find out
14% debentures
debt, the interest on which amounts to 20,000.
Deter-
leverage for the firm.
combined Financial and Combined
mine the degree of operating, financial and
[Answer: OL 4.33, FL=1.14 and CL=4931
=

leverages at 7,00,000 sales for both the firms, and

interpret the results. The ABC Co. has the
following Balance Sheet and
P6.6
Income statement:
firms
[Answer:Combined leverage of the two are

5.25 and 10.5.]

for
P6.4 The following is the income statement of XYZ Ltd.
the year 2000:

BALANCE SHEET

Amount
Amount Assets
Liabilities Fixed assets 1000,000
Equity capital (R 10 per share) 8,00,000
Retained earnings 3,50,000 Current assets 9,00,000
10% Debt 6,00,000
Current liabilities 1,50,000
19,00,000 19,00,000

INCOME STATEMENT [Answer:() 1.23,1.38 and 1.70; (i) EPS under newsitua
3,40,000 tions would be 7 1.88, and 1.16 respectively
Sales
-Operating Expenses (including Dep.) 1,20,000 P6.7 Afirm sells its product at 7 10per unit. Its
ratio is 709% while fixed cost are
variablecos
10,000. Present sals
EBIT 2,20,000
60,000 are 10,000 units. You are required to calculate :
-Interest
Profit before Tax 1,60,000 (0 Degree of Operating Leverage.
-Tax @ 30% 48,000 (i) New EBIT if sales increased by 40%.
Profit after Tax 1,12,000 (ii) New EBIT if sales falls by 25%.
Determine the OL, FL and CL at the current sales level ts
( (iv) By what % should sales fall before the firm saa
given that all operating expenses (excluding depreciation incurring loss. BCom. (H), D.U,
2013
of 7 52,000) are variable, and
Answer: OL is 1.5; New EBIT = 32,000; New EBIT
EB
at the same level but (a) sales
(i) If total assets remaining what
7 12,500; EBIT should fall
by 100%].
increasing by 20% and (b) sales decreasing by 20%,
will be the EPS?