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Unit 8
Unit 8
CHAPTER 8
LEVERAGE ANALYSIS
Learning Objectives
After reading this unit, you will be able to:
Explain the meaning of different leverages
Calculate various leverages
State the effect of these leverages
Structure
8.1 Introduction
8.2 Meaning of Leverage
8.3 Types of Leverage
8.4 Effect of Leverage
8.5 Summary
8.1 Introduction
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FINANCIAL MANAGEMENT
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Interpretation:
1. When sales ↑ or ↓ by 100% E.B.I.T. ↑ or ↓ by 133.3%
2. When EBIT ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 120%
3. When sales ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 160%
Illustration 3:
Operating leverage is 2 and financial leverage is 1.5. Interest paid by company
is Rs. 2 lakh and fixed cost is Rs. 3 lakh. Prepare income statement of
company if tax rate is 40% and P/V ratio for company is 30%.
Solution:
F.L.= E.B.I.T.
E.B.T.
= E.B.I.T. __
E.B.I.T. – Interest
1.5 = E.B.I.T.__
E.B.I.T. – 2
E.B.I.T. = 3 = 6
0.5
O.L. = __C__
E.B.I.T.
C = O.L. x EBIT
= 2 x 6
= 12
Now C = P/V
S
Hence C = S
P/V
_12_ = 40
30%
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Income Statement Rs. in Lakh.
Sales 40
P/V 30%
= Contribution 12
(-) Fixed Cost 6
= E.B.I.T. 6
(-) Interest 2
= E.B.T. 4
(-) Tax ( 40%) 1.60
= E.A.T. 2.40
Illustration: 4
Net Sales = 10 Crore.
EBIT = 20% of sales
Tax rate = 40%
Equity capital Rs. 2 crore
Preference capital (10%) Rs. 3 crore
Debentures (12%) Rs. 5 crore
Calculate: (a) E.P.S. (b) Percentage change in EPS. If E.B.I.T. increases
by 10% (c) Calculate financial leverage.
Solution:
a) E.P.S. = (E.B.I.T. – Interest) ( 1 – t) – Dp
N
t = Tax rate = 40%
Dp = Preference dividend = 10% of Rs. 3 Crs. = Rs. 0.3 Crs.
Interest = 12% of Rs. 5 Crs. = Rs. 0.6 Cr.
N = No. of equity shares in Crs. = 0.2 Cr.
EBIT = 20% of 10 = 2 Crore
Hence,
a) (E.P.S.)1 = [ 2 – 0.6 ] ( 1-0.4) - 0.3
0.2
= (1.4) (0.6) - 0.3
0.2
= 0.84 - 0.30
0.2
= 0.54
0.2
= Rs. 2.70
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Solution:
[Rs. in lakh]
Particulars P Ltd Q Ltd.
Operating leverage Contribution 300 = 2 700 = 2.33
EBIT 150 300
Financial leverage EBIT 150 = 1.5 300 = 1.5
EBT 100 200
Combined leverage Contribution 300 = 3 700 = 3.5
EBT 100 200
Comment:
Ÿ The operating leverage is higher for Q Ltd. and therefore it is subject to
greater degree of business risk than P Ltd. The EBIT will tend to vary more
with sales in Q Ltd.
Ÿ The financial leverage of both the companies stand at 1.5 times. It conveys
that interest burden is proportionately same and also financial risk is similar
both the companies.
Ÿ The combined leverage of Q Ltd. is higher and its overall risk is more as
compared to P Ltd.
Illustration 6:
A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost
of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs.
55,00,000.
i) What is the firm's ROI?
ii) Does it have favorable financial leverage ?
iii) If the firm belongs to an industry whose asset turnover is 3, does it have a
high or low asset leverage?
iv) What are the operating, financial and combined leverages of the firm?
v) If the sales drop to Rs. 50,00,000. What will be the new EBIT ?
vi) At what level the EBT of the firm will be equal to zero?
Solution:
Calculation of EBIT and EBT Rs.
Sales 75,00,000
Less: Variable cost 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest on debt (@ 9% on Rs. 45 lakh.) 4,05,000
EBT 22,95,000
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= EBIT x 100
Equity + Debt.
= 27,00,000 x 100__
55,00,000 + 45,00,000
= 27%
ii) The return on investment of Firm is 27% where as the firm is only paying 9%
rate of interest on its debt and hence the firm is enjoying favorable financial
leverage.
iii) Asset Turnover = Net Sales
Total Assets
Or = Net sales_
Total Investment
= 75,00,000
1,00,00,000
= 0.75
As compared to the industry's normal asset turnover of 3 times, the firm's asset
turnover ratio is only 0.75 and the investment level of the firm is highly
abnormal.
iv) Calculation of operating, financial and combined leverages
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v) New EBIT when sales drop to Rs. 50,00,000 Rs.
New Sales (After 33.33% drop) 50,00,000
Less: Variable cost (Rs. 42 lakh 33.33%) 28,00,000
Contribution 22,00,000
Less: Fixed Cost 6,00,000
New EBIT 16,00,000
vi) Sales level at which EBT of the firm will be equal to zero. Since the
combined leverage is 1.44, sales have to drop by 100 / 1.44 i.e. 69.44%
New sales = 75,00,000 x (1 – 0.6944)
= Rs. 22,92,000 (approx)
Solution:
A Ltd. data
a) Calculation of EBIT
Financial leverage (given) = 2
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EBIT ___ = 2
EBIT - Interest
EBIT = 2
EBIT - 12
2 EBIT - 24 = EBIT
Contribution = 3
EBIT
Contribution = 3
24
Contribution = Rs. 72 lakh
Contribution = 3
Contribution – FC
___72 = 3
72 - FC
(3 x 72) - 3 FC = 72
3 FC = 216 - 72
FC = 144/3
d) Calculation of sales
Contribution = 40%
Sales
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Sales = 72 x 100 / 40
Similarly, following the above procedure, the basic data of B Ltd. can also be
ascertained.
Particulars A Ltd. B Ltd.
Operating leverage (Contribution / EBIT) 3 4
Financial leverage ( EBIT / EBT) 2 3
Combined leverage (Contribution / EBT) 6 12
P.V. Ratio (Contribution / Sales) 40% 50%
Comments:
Ÿ Contribution / Sales ratio is more in case of B Ltd.
Ÿ Operating leverage of B Ltd. is more than that of A Ltd. indicating a
larger proportion of fixed costs in the former. The ratio of fixed costs to
sales is 37.5% for B Ltd. against 26.67% for A Ltd.
Ÿ Finance leverage for B Ltd. is 3 against 2 for A Ltd. This indicates a
higher percentage of debt in the capital structure of B Ltd. although in
absolute terms the interest amount is less. Interest accounts for 81/3%
of sales realization is B Ltd. as against 62/3% only for A Ltd.
Ÿ Although contribution / sales is more for B Ltd., both operating leverage
and financial leverage are higher for the company. As a result
profitability (EAT/sales) is only 2.5% as against 4% for A Ltd.
Illustration 8:
The balance sheet of Alpha Numeric Company is given below:
Liabilities Rs. Assets Rs.
Equity capital (Rs. 10 per share) 90,000 Net fixed assets 2,25,000
10% Long-term debt 1,20,000 Current Assets 75,000
Retained earnings 30,000 Current liabilities 60,000
3,00,000 3,00,000
The Company's total assets turnover ratio is 3, its fixed operating costs is
Rs. 1,50,000 and its variable operating cost ratio is 50%. The income – tax
rate is 50%.
You are required to
(i) Calculate the different type of leverages for the company.
(ii) Determine the likely level of EBIT if EPS is:
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__Sales__ = 3
3,00,000
Sales = 3 x 3,00,000
= Rs. 9,00,000
i) Calculation of Leverage
Income statement for the year ended Rs.
Sales 9,00,000
Less: Variable cost (50% of sales) 4,50,000
Contribution 4,50,000
Less: Fixed operating cost 1,50,000
EBIT 3,00,000
Less: Interest (Rs. 1,20,000 x 10 / 100) 12,000
EBT 2,88,000
Less: Tax (@ 50%) 1,44,000
EAT 1,44,000
a) Operating leverage = Contribution
EBIT
= 4,50,000 = 1.50
3,00,000
= 3,00,000 = 1.04
2,88,000
c) Combined leverage = Operating leverage x Financial
leverage
= 1.50 x 1.04 =1.56
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EPS = (EBIT - I ) ( 1 – t )
N
Illustration 9:
You are a finance manager in Big Pen Ltd. The degree of operating
leverage of your company is 5.0. The degree of financial of your company is
3.0. Your Managing Director has found that the degree of operating
leverage and the degree of financial leverage of your nearest competitor
Small Pen Ltd. are 6.0 and 4.0 respectively. In his opinion, the Small pen
Ltd. is better than of Big Pen Ltd. because of higher value of degree of
leverages. Do you agree with the opinion of your Managing Director? Give
reasons.
Solution:
Particulars Big Pen Ltd. Small Pen Ltd.
1) Operating leverage = Contribution 5 6
EBIT
Ÿ The operating leverage of Big Pen Ltd. is 5 and of small Pen Ltd. is 6.
It means change in the level of sales will have more impact on EBIT of
small Pen Ltd. than that of Big Pen Ltd. The volume of fixed cost may
be higher in case of small Pen Ltd. than that of Big Pen Ltd. The
business risk of small Pen Ltd. is also more as compared to Big. Pen
Ltd.
Ÿ The financial leverage of Big Pen Ltd. is 3 and of small Pen Ltd. is 4. It
means that the interest burden of small Pen Ltd. is higher than Big
Pen Ltd. Financial risk of small Pen Ltd. is higher as compared to Big
Pen Ltd.
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Illustration 10:
From the following information available for four companies, calculate –
(a) EBIT
(b) EPS
(c) Operating leverage
(d) Financial leverage
Particulars P Q R S
Solution:
Company P Q R S
8.5 Summary
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