CORPORATE FINANCE

COURSE: MASTERS IN BUSINESS ADMINISTRATION

YEAR: SECOND YEAR FIRST SEMESTER
CODE: HCBA 3207
LECTURER: CPA DR. CALEB MANYAGA
CAMPUS: MOMBASA
TASK: ASSIGNMENT 1

GROUP 3: DIVIDEND POLICY &PRACTICE, FINANCIAL & OPERATING

LEVERAGE AND FIRM VALUE

GROUP MEMBERS

1. ADAN AHMED SOMO HDB311-C005-1449/2021

2. FAITH NDANU KYENGO
3. SHAMSA MUSA ABDULLAHI
4. JOAB OMONDI OCHIENG
5. DAVIS MWASAMBU POLE
6. HESBON FONDO MASHA
7. AWADH BARISSA SHEHE
HDB311-C005-2169/2021
HDB311-C005-0711/2020
HDB311-C005-1724/2021
HDB311-C005-0810/2021
HDB311-C005-2246/2021
HDB311-C005-1722/2021
DIVIDEND POLICY
Introduction
According to (Paramasivan & Subramanian, 2021) financial manager must take careful decisions on
how the profit should be distributed among shareholders. It is very important and crucial part of the
business concern, because these decisions are directly related with the value of the business concern and
shareholder’s wealth. Like financing decision and investment decision, dividend decision is also a major
part of the financial manager. When the business concerns decide dividend policy, they have to consider
certain factors such as retained earnings and the nature of shareholder of the business concern.
However, it is financial management option to look how well the profit of an entity will be distributed to
the owners of the equity. Much time, not everything will be distributed to the owners of the equity but
some value will be maintained for re-investment.

Definition of Dividend
As per (Paramasivan & Subramanian, 2021) Dividend refers to the business concerns net profits
distributed among the shareholders. It may also be termed as the part of the profit of a business concern,
which is distributed among its shareholders.

Types of dividend/form of dividend

Dividends are classified into:
i. Cash dividend
ii. Stock dividend
iii. Bond dividend
iv. Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type,
cash is retained by the business concern. Stock dividend may be bonus issue. This issue is given only to
the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay
cash dividend, the company promises to pay the shareholder at a future specific date with the help of
issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed
under the exceptional circumstance.

DIVIDEND POLICY
Dividend policy determines the division of earnings between payment to shareholders and reinvestment
in the firm. It therefore involves the following four aspects:
1. How to pay?
2. When to pay?
3. Why to pay?
4. How to pay dividends/ mode of paying dividends

1. HOW MUCH TO PAY?

It encompasses the 4 major alternative dividend policies.
a. Constant pay out ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. Dividends will therefore
fluctuate as the earnings change. Dividends are therefore directly dependent on the firms earning ability.
If no profits are made, no dividends are paid. The policy creates uncertainty in ordinary shareholders
especially those who depend on dividend income thus, they may demand a higher required rate of return.
b. Constant amount per share/fixed dividend per share
The dividend per share is fixed in amount irrespective of the earnings level. This creates uncertainty and
is thus preferred by shareholders who have a reliance on dividend income. It protects the firm from
periods of low earnings by fixing dividends per share at a low level. Thus, policy treats all shareholders
like preference shareholders by giving a fixed return. Dividend per share could be increased to a higher
level if earnings appear relatively permanent and sustainable.
c. Constant amount plus extra
Here, a constant dividend per share is paid every year. However, extra dividends are paid in years of
supernormal earnings. This policy gives firms the flexibility to increase dividends when earnings are
high and shareholders are given a chance to participate in the supernormal profits of the firm. The extra
dividends are given in such a way that it is not seen as a commitment to continue the extra in the future.
It is applied by firms whose earnings are highly volatile e.g. the agricultural sector.

d. Residual amount
Under this policy, dividend is paid out of earnings left over after investment decisions have been
financed. Dividends will therefore only be paid if there are no profitable investment opportunities
available. This policy is consistent with shareholder’s wealth maximization.

2. WHEN TO PAY
Dividends can either be interim or final. Interim dividends are paid in the middle of the financial year
and are paid in cash. Final dividends are paid at the year end and can be and can be in cash and stock
form (bonus issue).

3. WHY PAY
Under this aspect the finance manager will advise the management on the importance of the reasons why
dividend should be paid to the owners of the equity.

4. HOW TO PAY DIVIDENDS/MODE OF PAYING DIVIDENDS

a. Cash or Bonus issue

Ideally, a firm should pay cash dividends, for such a company it must ensure that it that it has enough
liquid funds to make payment. Under conditions of liquidity and financial constraints, a firm can pay
stock dividends (bonus issue) Bonus issue involves an issue of additional shares in addition to or instead
of cash to the existing shareholders prorate to their shareholding in the company. A Stock dividend /
bonus issue involves capitalization of retained earnings therefore does not increase the wealth of the
shareholders. This is because retained earnings are converted into share capital.
Advantages of a bonus issue
i. To indicates that the firm plans to retain a portion of earnings permanently in the business.
ii. To continue dividend distribution s without disbursing cash needed for operation.
iii. To increase the trading of shares in the market.
iv. Tax advantage. Shareholders can sale the new shares to generate cash in the form of capital gains
which are tax exempt unlike cash dividends which attract a 5% withholding tax which is final.
 v. Indication of higher profits in the future of the company. A bonus issue is an inefficient market
survey by important information that the firm expects high profits in future to offset additional
outstanding share so that the earnings per share is not diluted.

b. Stock Splits and reverse split

A stock split is a change in the number of shares outstanding accompanied by an offsetting change in
the par or stated value per share.
The primary purpose of a stock split is to increase the market activity of the stock.
Example
A company has 1000 ordinary shares of sh.20 each and a share split has been announced of 1:4. The
effects on ordinary share capital is a s follows;
New par value = 20/4
=sh.5
Ordinary shares outstanding = 1000×4
= 4000
The ordinary share capital remains the same (4000×5=sh. 20,000)

A reverse split is the opposite of a stock split as it involves consolidation of shares into bigger units
thereby increasing the par value of the shares. It is meant to attract high income clientele.
Example
In the case of 20,000 shares at sh.20 par value, they can be considered into 10,000 shares at par value of
sh.40 par value.

c. Stocks repurchase.
The company can also buy back some of its outstanding shares instead of paying cash dividends. This is
known as stocks repurchase and the share bought back are known as treasury stock. If some outstanding
shares are repurchased, fewer shares would remain outstanding. Assuming a repurchase does not
adversely affect the firm’s earnings, EPS would increase. This would result in an increase in the market
price per share so that a capital gain is substituted for dividends.

Advantages of stock repurchase.

i. Utilization of idle funds
Companies which have accumulated cash balance s in excess of future investments might find a share
re-investment scheme a fair method of returning cash to shareholders. Continuing to carry excess cash
may prompt management to invest unwisely as a means of using excess cash e.g. a firm may invest in a
tendency for more mature firms to continue in investment plans even when the expected return is lower
than the cost of capital.
ii. Enhanced dividends and EPS
Following a stock repurchase, the number of shares issued would decrease therefore in normal
circumstances, both DPS and EPS would increase in future. However, the increase in EPS is a
bookkeeping increase since total earnings remain constant.
iii. Enhanced share price
Companies that undertake a stock repurchase experience an increase in the market price of the share.
iv. Capital structure
A company’s managers may use a share buy-back or repurchase as a means of correcting what they
perceive to be an unbalanced capital structure. If shares are repurchased from cash reserves, equity
would be reduced and gearing increased, assuming debt exists in the capital structural term natively, a
company may raise debt to finance a repurchase. Replacing equity with debt can reduce the overall cost
of capital.

v. Reducing takeover threat

A share repurchase reduces the number of shares in operation and also the number of weak shareholders
i.e. shareholders with no strong loyalty to the company since a repurchase would induce them to sell.
This helps to reduce the threat of as hostile take over as it makes it difficult for a predator company to
gain control. This is also referred to as a poison pill i.e. a company’s value is reduced because of huge
cash outflow or borrowing huge long-term debt to increase gearing.

Disadvantages of a stock repurchase

i. High price
A company may find it difficult to repurchase at the current value or the price paid maybe too high to
the detriment of the remaining shareholders.
ii. Market signaling
Despite director’s efforts at trying to convince markets otherwise, a share repurchase may be taken as a
signal that the company lacks suitable investment opportunities. This may be interpreted as a sign of
management failure.
 iii. Loss of investment income
The interest that could have been earned from investment of excess cash is lost.
DIVIDEND THEORIES
1. Dividend Irrelevance Theory – As per MM prepositions
This was proposed by Modigliani and Miller. This theory asserts that a firms divided policy has no
effect on its market value and cost of capital. They argued that the firm value is primarily determined by
i. Ability to generate earnings from investments.
ii. Level of business and financial risk.
According to MM dividend policy is a passive residue determined by the firms needs for investment
funds. It does not matter how earnings are divided between dividend and retention, therefore, divided
policy does not exist. When investment decisions are made dividend decision is a mere detail without
any effect on the value of the firm.
Assumptions of MM Prepositions
i. There exists a perfect market:
 There are no transactional costs
 There are no taxes
 Same information to all participants in the market
 There are no restrictions to trading
 Securities can be divisible
 Investors are price takers
 There is no floatation cost
ii. Investments are given and constant
iii. Financing of investment out of retained earnings, equity or debt has no effect on the cost of
capital. This means that the capital structure decision is irrelevant.

Criticism:

Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance in the
real world situation. Thus, it is being criticized on the following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This cannot be true if the costs of
floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm pays

dividends or not. But, because of the transactions costs and inconvenience associated with the sale of
shares to realise capital gains, shareholders prefer dividends to capital gains.

4. Even under the condition of certainty it is not correct to assume that the discount rate (k) should be
same whether firm uses the external or internal financing.

If investors have desire to diversify their port folios, the discount rate for external and internal financing
will be different.

5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is considered,

dividend policy continues to be irrelevant. But according to number of writers, dividends are relevant
under conditions of uncertainty.

2. Dividend Relevancy Theories or Models

I. Walter’s model
Professor James E. Walter argues that the choice of dividend policies almost always affects the value of

the enterprise. His model shows clearly the importance of the relationship between the firm’s internal

rate of return (r) and its cost of capital (k) in determining the dividend policy that will maximise the
wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not issued;

2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;

3. All earnings are either distributed as dividend or reinvested internally immediately.

4. Beginning earnings and dividends never change. The values of the earnings pershare (E), and the

divided per share (D) may be changed in the model to determine results, but any given values of E and D
are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:

P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is the sum of the present value

of two sources of income:

i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism:

Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can lead to
conclusions which are net true in general, though true for Walter’s model.

The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The

model assumes that the investment opportunities of the firm are financed by retained earnings only and

no external financing debt or equity is used for the purpose when such a situation exists either the firm’s

investment or its dividend policy or both will be sub-optimum. The wealth of the owners will maximise
only when this optimum investment in made.

2. Walter’s model is based on the assumption that r is constant. In fact decreases as more investment

occurs. This reflects the assumption that the most profitable investments are made first and then the
poorer investments are made.

The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimise the
wealth of the owners
 II. Bird in hand theory
Shareholders are risk averse and prefer certainty. Dividends payments are more certain than capital
gains, which rely on demand and supply forces to determine share prices. Therefore, one bird in hand
(certain dividends) is better than two birds in the bush (uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value since shareholders will require
to use lower discounting rate. MM argued against the above proposition. They argued that the required
rate of return is independent of dividend policy. They maintained that an investor can realize capital
gains generated by reinvestment of retained earnings, if they sell shares.
Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant
forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.

According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is equal to the
present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend policy, (b),
internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of the value of
the share (P0).

III. Information signaling effect theory

In an inefficient market, management can use dividend policy to signal important information to the
market which is only known to them.
Example – If the management pays high dividends, it signals high expected profits in future to maintain
the high dividend level. This would increase the share price/value and vice versa. MM attacked this
position and suggested that the change in share price following the change in dividend amount is due to
informational content of dividend policy rather than dividend policy itself. Therefore, dividends are
irrelevant if information can be given to the market to all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the higher the
value of the firm.
The theory is based on the following four assumptions:
i. The sending of signals by the management should be cost effective.
ii. The signals should be correlated to observable events (common trend in the market).
iii. No company can imitate its competitors in sending the signals.
iv. The managers can only send true signals even if they are bad signals. Sending untrue signals is
financially disastrous to the survival of the firm.

IV. Tax differential theory

Tax rate on dividends is higher than tax rate on capital gains. Therefore, a firm that pays high dividends
have lower value since shareholders pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the value of the firm and vice
versa.
Note
In Kenya, dividends attract a withholding tax of 5%, which is final, and capital gains are tax exempt.
 V. Clientele effect theory
It states that different groups of shareholders (clientele) have different preferences for dividends
depending on their level of income from other sources. Low income earners prefer high dividends to
meet their daily consumption while high income earners prefer low dividends to avoid payment of more
tax. Therefore, when a firm sets a dividend policy, there will be shifting of investors into and out of the
firm until an equilibrium is achieved. Low, income shareholders will shift to firms paying high
dividends and high income shareholders to firms paying low dividends.
At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has. Dividend
decision at equilibrium is irrelevant since they cannot cause any shifting of investors

VI. Agency theory

The agency problem between shareholders and managers can be resolved by paying high dividends. If
retention is low, managers are required to raise additional equity capital to finance investment. Each
fresh equity issue will expose the managers financing decision to providers of capital e.g bankers,
investors, suppliers etc. Managers will thus engage in activities that are consistent with maximization of
shareholder’s wealth by making full disclosure of their activities.
This is because they know the firm will be exposed to external parties through external borrowing.
Consequently, Agency costs will be reduced since the firm becomes self-regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is because dividend policy
can be used to reduce agency problem by reducing agency costs. The theory implies that firms adopting
high dividend payout ratio will have a higher value due to reduced agency costs.

DIVIDEND POLICIES IN PRACTICE

The various types of dividend policies practices are discussed as follows:
1. Regular Dividend Policy
In this type of dividend policy, the investors get dividend at usual rate. Here the investors are generally
retired persons or weaker section of the society who want to get regular income. This type of dividend
payment can be maintained only if the company has regular earning. Payment of dividend at the usual
rate is termed as regular dividend.
Advantages of regular dividend policy
i. It establishes a profitable record of the company.
ii. It creates confidence amongst the shareholders.
 iii. It aids in long term financing and renders financing easier.
iv. It stabilizes the market value of shares.
v. The ordinary shareholders view dividends as a source of funds to meet their day-to-day living
expenses.

2. Stable Dividend Policy

The term 'stability of dividends' means consistency in the stream of dividend payments. In more precise
terms, it means payment of certain minimum amount of dividend regularly. A stable dividend policy
may be established in any of the following forms:
a. Constant payout ratio
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings. The DPS would therefore,
fluctuate as the earnings per share changes. Dividends are directly dependent on the firm’s earnings
ability and if no profits are made no dividend is paid.
This policy creates uncertainty to ordinary shareholders especially who rely on dividend income
and they might demand a higher required rate of return.
b. Constant amount per share (fixed D.P.S.)
The DPS is fixed in amount irrespective of the earnings level. This creates certainty and is therefore,
preferred by shareholders who have a high reliance on dividend income. It protects the firm from periods
of low earnings by fixing DPS at a low level.
This policy treats all shareholders like preferred shareholders by giving a fixed return. The DPS
could be increased to a higher level if earnings appear relatively permanent and sustainable.
c. Constant DPS plus Extra/Surplus
Under this policy a constant DPS is paid every year. However extra dividends are paid in years of
supernormal earnings.
It gives the firm flexibility to increase dividends when earnings are high and the shareholders are given a
chance to participate in super normal earnings. The extra dividend is given in such a way that it is not
perceived as a commitment by the firm to continue the extra dividend in the future. It is applied by the
firms whose earnings are highly volatile e.g agricultural sector.
d. Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment decisions have been
financed. Dividend will only be paid if there are no profitable investment opportunities
available. The policy is consistent with shareholder’s wealth maximization.
Advantages of Stable Dividend Policy
i. It is sign of continued normal operations of the company.
ii. It stabilizes the market value of shares
iii. It creates confidence among the investors, improves credit standing and makes financing
iv. easier.
v. It provides a source of livelihood to those investors who view dividends as a source of fund
to meet day-to-day expenses.
vi. It meets the requirements of institutional investors who prefer companies with stable divide.

3. Irregular Dividend Policy

In this policy the firm doesn’t pay fixed dividend regularly and it changes from year to year according to
changes in earnings level. This is followed by the companies which have unstable earning. Some
companies follow irregular dividend payments on account of the following:
i. Uncertainty of earnings
ii. Unsuccessful business operations
iii. Lack of liquid resources

4. No Dividend Policy
A company can follow a policy of paying no dividends presently because of its unfavorable working
capital position or on account of requirements of funds for future expansion and growth.

Example
The management of Viwanda Limited is in the process of evaluating the company’s dividend policy.
The following information is provided.
i. Company paid Kshs. 1.2M as dividend in the last financial year.
ii. The profit after tax for the last financial year was Kshs. 3.6M.
iii. The company has not issued any preference shares.
iv. The earnings growth rate has been consistent at 10% p.a for the past 10 years.
v. The expected profit after tax for the current financial year is Kshs. 4.8M
vi. The company anticipates investment opportunities worth Kshs. 1.4M in the current financial
year.
vii. The capital structure of the company consists of 60% equity and 40% debts.
Required
Determine the Optimal total dividend for the current financial year if the company wishes to adopt each
of the following independent policies.
a) Pure residual dividend policy
b) Constant pay-out ratio dividend policy
c) Stable predictable dividend policy, the growth rate being equivalent to the earnings growth rate
d) Low regular dividend plus extra policy. The regular dividend would be based on the long run
growth rate of earnings while the extra dividend could be based on the residual income.

Solutions

i. Pure residual dividend policy

Shs “M”
Earnings for the year 4.8
Less: Investment (1.4)
Dividend 3.4

ii. Constant pay-out ratio policy

Pay-out ratio = Dividend * 100

Earnings
Shs. 1.2M *100
Shs. 3.6M = 33 1/3%
Dividend to be paid = 33 1/3% * Shs. 4.8M =Shs. 1.6M

iii. Stable predictable dividend policy

= Shs. 1.2M (1+0.1)1 = Shs. 1.32M

Regular plus extra policy
Regular: Shs. 1.2M (1+0.1) 1 = Shs. 1.32M
Residual Income Shs.”M”
Expected Income 4.8
Less: Investment opportunity (1.4)
Regular dividend (1.32)
Extra dividend 2.08

Therefore, Total dividend = Regular dividend + Extra dividend

Shs.(1.32M + 2.08M) = Shs. 3.4

FACTORS INFLUENCING DIVIDEND POLICIES

1. Legal rules:
i. Net profit rule- This states that the dividends may be paid from company profits, either past or
present.
ii. Capital impairment rule- This prohibits payment of dividends from capital i.e. from the sale of
assets. This would be liquidating the firm.
iii. Insolvency rule- This prohibits payment of dividends when a company is insolvent. An
insolvent company is one where assets are less than liabilities. In such a case all earnings and
assets belong to debt holders and no dividends are paid.
2. Profitability and liquidity.
A company’s capacity to pay dividends will be determined primarily by its ability to generate adequate
and stable profits and cash flows. If the company has liquidity problems, it may be unable to pay cash
dividends and resort to paying stock dividends.

3. Investment opportunity.
Lack of appropriate investment opportunities i.e. those with positive returns may encourage a firm to
increase its dividend distribution. If a firm has many investments opportunities, it will pay low dividends
and have high retention.
4. Tax position of shareholder
Dividend payment is influenced by the tax regime of a country e.g. in Kenya cash dividends are taxed at
source, while capital gains are tax exempt. The effect of tax differential is to discourage shareholders
from wanting high dividends.
5. Capital structure.
A company’s management may wish to achieve or restore an optimal capital structure. E.g. If they
consider gearing to be too high they may pay low dividends and allow reserves to accumulate until a
more optimal capital structure is achieved or restored.
6. Industrial practice
Companies will be resistant to deviate from accepted dividend or payment norms in the industry.
7. Growth stage.
Dividend policy is likely to be influenced by the firm’s growth stage, e.g. a young rapidly growing firm
is likely to have high demand for developing funds therefore may pay low dividends or differ dividend
payment till the company reaches maturity. It will therefore retain high amounts.

8. Ownership structure.
A dividend policy may be driven by the ownership structure in affirm e.g. in small firms where the
owners and managers are the same, dividend payout is usually low. However, in large quoted public
companies, dividends are significant since the owners are not the managers. The value and preferences
of a small group of owner managers would exert more direct influence on the dividend policy.
9. Access to capital markets.
Large well established firms have access to capital markets hence can get funds easily. They therefore
pay high dividends unlike small firms which pay low dividends due to the limited borrowing capacity.
10. Shareholders expectation.
Shareholder s that have become accustomed to receiving stable and increasing dividends will expect a
similar pattern to continue in to the future. Any sudden reduction or reversal of such a policy is likely to
dissatisfy shareholders and the results in falling share prices.
11. Contractual obligations on debt covenants.
This limits the flexibility and amount of dividends to pay e.g. the cash flow based covenants.
LEVERAGE
Introduction
According to (Paramasivan & Subramanian, 2021) financial decision is one of the integral and important
parts of financial management in any kind of business concern. A sound financial decision must
consider the board coverage of the financial mix (Capital Structure), total amount of capital
(capitalization) and cost of capital (Ko). Capital structure is one of the significant things for the
management, since it influences the debt equity mix of the business concern, which affects the
shareholder’s return and risk. Hence, deciding the debt-equity mix plays a major role in the part of th
value of the company and market value of the shares. The debt equity mix of the company can be
examined with the help of leverage.

Definition of Leverage
(Paramasivan & Subramanian, 2021) defined leverage as, “the employment of an asset or fund for which
the firm pays a fixed cost or fixed return.

Types of Leverage
Leverage can be classified into three major headings according to the nature of the finance mix of the
company.
The company may use finance leverage or operating leverage to increase the EBIT and EPS.

1. Operating Leverage
This is the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes.
It consists of two important costs, fixed cost and variable cost. A company is said to have a high degree
of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost.
Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating
leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:

𝐶
OL = 𝑂𝑃

Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits

Degree of Operating Leverage

The degree of operating leverage is defined as percentage change in the profits resulting from a
percentage change in the sales. It can be calculated with the help of the following formula:

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡𝑠

DOL = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠

Example
From the following selected operating data, determine the degree of operating leverage. Which company
has the greater amount of business risk? Why?

Variable expenses as a percentage of sales are 50% for company A and 25% for company B.

Solution
Statement of Profit
Comment
Operating leverage for B Company is higher than that of A Company; B Company has a higher degree
of operating risk. The tendency of operating profit may vary portionately with sales, is higher for B
Company as compared to A Company.
Uses of Operating Leverage
i. Operating leverage is one of the techniques to measure the impact of changes in sales which lead
for change in the profits of the company. If any change in the sales, it will lead to corresponding
changes in profit.
ii. Operating leverage helps to identify the position of fixed cost and variable cost.
iii. Operating leverage measures the relationship between the sales and revenue of the company
during a particular period.
iv. Operating leverage helps to understand the level of fixed cost which is invested in the operating
expenses of business activities.
v. Operating leverage describes the over all position of the fixed operating cost.

2. Financial Leverage
Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects
of changes in EBIT on the earnings per share. It involves the use of funds obtained at a fixed cost in the
hope of increasing the return to the shareholders.
The use of long-term fixed interest bearing debt and preference share capital along with share capital is
called financial leverage or trading on equity.
Financial leverage may be favorable or unfavorable depends upon the use of fixed cost funds. Favorable
financial leverage occurs when the company earns more on the assets purchased with the funds, then the
fixed cost of their use. Hence, it is also called as positive financial leverage.
Unfavorable financial leverage occurs when the company does not earn as much as the funds cost.
Hence, it is also called as negative financial leverage.
Financial leverage can be calculated with the help of the following formula:
𝑂𝑃
FL = 𝑃𝐵𝑇

Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Degree of Financial Leverage
Degree of financial leverage may be defined as the percentage change in taxable profit as a result of
percentage change in earnings before interest and tax (EBIT).
This can be calculated by the following formula
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑎𝑥𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒
DFL= 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

Example
A Company has the following capital structure.

The present EBIT is Rs. 50,000.

Calculate the financial leverage assuring that the company is in 50% tax bracket.
Solution

Uses of Financial Leverage

i. Financial leverage helps to examine the relationship between EBIT and EPS.
ii. Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
iii. Financial leverage locates the correct profitable financial decision regarding capital structure of
the company.
iv. Financial leverage is one of the important devices which is used to measure the fixed cost
proportion with the total capital of the company. If the firm acquires fixed cost funds at a higher
cost, then the earnings from those assets, the earning per share and return on equity capital will
decrease.
 DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

OPERATING LEVERAGE FINANCIAL LEVERAGE

1. Operating leverage is associated with investment
activities of the company.
2. Operating leverage consists of fixed operating
expenses of the company.
3. It represents the ability to use fixed operating
cost.
4. Operating leverage can be calculated by
OL = C/OP
5. A percentage change in the profits resulting from
a percentage change in the sales is called as degree
of operating leverage.
6. Trading on equity is not possible while the
company is operating leverage.
7. Operating leverage depends upon fixed cost and
variable cost.
8. Tax rate and interest rate will not affect the
operating leverage.
1. Financial leverage is associated with financing
activities of the company.
2. Financial leverage consists of operating profit of
the company.
3. It represents the relationship between EBIT and
EPS.
4. Financial leverage can be calculated by
FL = OP/PBT
5. A percentage change in taxable profit is the result
of percentage change in EBIT.
6. Trading on equity is possible only when the
company uses financial leverage
7. Financial leverage depends upon the operating
profits.
8. Financial leverage will change due to tax rate
and interest rate.

3. Combined Leverage
When the company uses both financial and operating leverage to magnification of any change in sales
into a larger relative changes in earning per share. Combined leverage is also called as composite
leverage or total leverage.
Combined leverage expresses the relationship between the revenue in the account of sales and the
taxable income.
Combined leverage can be calculated with the help of the following formulas:

CL = OL × FL
𝐶 𝑂𝑃 𝐶
CL = 𝑂𝑃 × = 𝑃𝐵𝑇
𝑃𝐵𝑇

Where,
CL = Combined Leverage
OL = Operating Leverage
 FL = Financial Leverage
C = Contribution
OP = Operating Profit (EBIT)
PBT= Profit Before Tax

Degree of Combined Leverage

The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This
is also equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage
(DFL) at a particular level of sales.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
Degree of contributed coverage = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠

Example
Kumar company has sales of Rs. 25,00,000. Variable cost of Rs. 12,50,000 and fixed
cost of Rs. 50,000 and debt of Rs. 12,50,000 at 8% rate of interest. Calculate combined leverage.
Solution
Statement of Profit

Calculation of Combined leverage

CL = OL × FL: 2 × 1.25 = 2.5
FIRM VALUE
Introduction
As per (Borad, 2018) firm value is an economic notion that shows a company's worth. It is the worth of a
company at a specific point in time. In theory, it is the sum required to purchase or take over a company
entity.
A firm's worth can be determined using either book value or market value, just like an asset. However, it
usually refers to a company's market worth. EV is a more thorough alternative to market capitalization
that can be determined using a variety of methods.
The value of a firm is basically the sum of claims of its creditors and shareholders. Therefore, one of the
simplest ways to measure it is by adding the market value of its debt, equity, and minority interest. Cash
and cash equivalents would then be deducted to arrive at the net value
Formula for Calculating a Firm’s Value
EV = market value of common equity + market value of preferred equity + market value of debt +
minority interest – cash and investments
One of the reasons why the concept of EV has gained more importance than market capitalization is
because the former is more inclusive. Besides equity, it includes the value of debt as well as cash reserves
which have an important role to play in a corporation’s valuation. A buyer would have to pay off a firm’s
debt when taking over the firm. And the same could be net off from the cash and cash equivalents available
with the firm.
Another sound approach for computing the value of a firm is to determine the present value of its future
operating free cash flows. The idea is to draw a comparison between two similar firms. By similar firms,
we mean similar in size, same industry, etc. The firm whose present value of future operating cash flows
is better than the other is more likely to attract a higher valuation from the investors. Operating Free Cash
Flow (OFCF) is calculated by adjusting the tax rate, adding back depreciation, and deducting the amount
of capital expenditure, working capital, and changes in other assets from earnings before interest and taxes.

Formula for Computing Operating Free Cash Flow (OFCF)

OFCF = EBIT (1-T) + Depreciation – CAPEX – working capital – any other assets
Where,
EBIT = earnings before interest and taxes,
T = tax rate
CAPEX = capital expenditure
Book Value of a Firm
As the name implies, the firm’s book value is its value as reflected in its ‘books’ or financial statements.
It is the difference between the assets and liabilities of a firm as per its balance sheet. It is the shareholder’s
equity in the balance sheet. This is the true worth of a business when its liabilities are net off from its
assets.

Example
If company ABC has total assets worth sh500 million. And its total liabilities amounting to sh450 million,
the firm’s book value would be sh50 million (by deducting the value of liabilities from that of assets).
This means that if a company XYZ is to purchase company ABC, then it will have to shell sh 50 million
out of its pocket, the actual book value of buying company ABC

Market Value of a Firm

The market value of a company, also known as market capitalizations, is its value as reflected in the stock
exchange. It is calculated by multiplying a company’s outstanding share by its current market price.

Example
If the company ABC has 10 million shares outstanding and the market price of each share is sh50millions.
The market value of the company would be sh500 million, assuming there are only common shares issued
in the markets
Market value and the book value of the firm are two different concepts. There is quite a possibility of a
huge difference between the book and the market value of a company at a given point in time.

Factors affecting firm value

i. Firm size
ii. Capital structure
iii. Profitability
iv. Sale
v. Liquidity
References
Borad, S. B. (2018, 06 20). Value of a Firm. Retrieved from Investment Decisions:
https://efinancemanagement.com/investment-decisions/value-of-a-firm
Paramasivan, C., & Subramanian, T. (2021). Leverage & Dividend Decision. In C. Paramasivan, & T.
Subramanian, Financial Management (pp. 84-117). New Delhi: New Age International.

References
Paramasivan, C., & Subramanian, T. (2021). Leverage & Dividend Decision. In C. Paramasivan, & T.
Subramanian, Financial Management (pp. 84-117). New Delhi: New Age International.

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