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FM 1 Module 7 REVISE
FM 1 Module 7 REVISE
Learning Objectives
INTRODUCTION
In the arena of financing decisions, the capital structure decision assumes
greater significance. As it deals with debt equity composition of the
organization, the resultant risk and return for shareholders is of utmost
concern for finance managers. If the borrowed funds are more than
owners’ funds, it results in increase in shareholders’ earnings. At the same
time, it also increases the risk of the organization. In a situation where the
proportion of the equity funds is more than the proportion of the borrowed
funds, the return as well as risk of the shareholders will be very low. This
underlines the importance of having an optimal capital structure where risk
and return to shareholders be matched. The effect of capital structure
where risk and return to shareholders may judiciously help the finance
managers to decide their short term and long term strategies. The behavior
and application of leverage helps in examining the whole issue in right
perspective.
CONCEPT AND TYPES OF LEVERAGES
The dictionary meaning of the term leverage refers to: “an increased means for
accomplishing some purpose”. It helps us in lifting heavy objects by the
magnification of force when a lever is applied to a function.
James Horne has defined leverage is that portion of a business enterprise’s fixed
cost that represent a risk to the firm.
Types of Leverage
a) Operating Leverage
b) Financial Leverage
c) Total Leverage
Total leverage is concerned with the relationship between the firm’s sales
revenue and EPS.
The first step in finding the operating break-even point is to divide the cost
of goods sold and operating expenses into fixed and variable operating costs.
Fixed costs are a function of time, not sales volume, and are typically
contractual; rent, for example, is a fixed cost. Variable costs vary directly with
sales and are a function of volume, not time; shipping costs, for example, are a
variable cost.
Using the following variables, we can recast the operating portion of the
firm’s income statement given in Table 7.1 into the algebraic representation
shown in Table 7.2.
P = sale price per unit
Q = sales quantity in units
FC = fixed operating cost per period
VC = variable operating cost per unit
Equation:
EBIT = (P x Q) – FC – (VC x Q)
Break-even point in (peso) = Break-even point (units) x Selling price per unit
Contribution margin (CM) – the excess of sales (S) over the variable
costs (VC) of the product. It is the amount of money available to
cover fixed costs (FC) and to generate profits. Symbolically,
CM = S – VC.
Unit CM – the excess of the unit selling price ( p ) over the unit
variable cost ( vc ). Symbolically, unit CM = p – v.
= P15,000/P15
= 1,000 units
= P15,000 .
1 – P15,000/P37,500
= P15,000/ 1 – 0.40
= P 25,000
OR
Break-even point in (peso) = Break-even point (units) x Selling price per unit
= 1,000 units x P25
= P25,000
OR
SOLUTION:
a) Required sales to earn desired profit before tax
= P100,000 + P 20,000 .
P 10
= 12,000 . units
= P100,000 + P 20,000 .
40%
= P300,000 .
b) Required sales to earn desired profit before tax
= P100,000 .
40% – 6%
= P294,118 .
= P100,000 .
P10 – P2
= 12,500 . units
Operating Leverage
Operating leverage, a measure of operating risk, arises from the business
enterprise’s use of fixed operating cost. A simple indication of operating
leverage is the impact of a change in sales on earnings before interest and
taxes (EBIT). The formula is:
To illustrate:
The EFG Business Enterprise manufactures and sells doors to home
builders. The doors are sold for P2,500 each. Variable cost are P1,500 per
door, and fixed operating costs total P5,000,000. Assume further that the
EFG Business Enterprises is currently selling 6,000 doors per year. Its degree
of operating leverage is:
= P6,000,000/P6,000,000 – P5,000,000
= P6,000,000/P1,000,000
= 6 .
*P15,000,000 x 10%
**P9,000,000 x
*** (P1,600,000 – P1,000,000)/P1,600,000
NOTES TO REMEMBER:
1. Sales increases by only 10%, but profit (EBIT) increased 6 times the
increase in sales, or by 60%
2. The increase of 10% in sales is due to change in units (quantity).
3. Since units change by 10%, both the total variable cost and contribution
margin increased by the same percentage (10%).
4. Selling price per unit, variable cost per unit, and total fixed costs are
assumed to be constant.
5. If there is no change in selling price and variable cost per unit,
Contribution Margin per unit, Contribution Margin Ratio, and Variable
Cost Ratio will all remain the same.
6. If contribution margin is more than fixed cost, it is favorable operating
leverage. In case of vice-versa, it is unfavorable financial leverage.
7. Leverage is achieved by increasing fixed cost while lowering variable cost.
Another illustration:
The following data were available for your analysis:
Selling price per unit ………………………..P 20
Variable cost per unit ………………………. 12
Actual sales …………………………………..200 units
Installed capacity ………………………….300 units
Financial Leverage
Financial leverage is a measure of financial risk that arises from the
presence of debt and/or preference share capital in the business enterprise’s
capital structure. One way to measure financial leverage is to determine how
earning per share (EPS) are affected by a change in EBIT. When financial
leverage is used, changes in EBIT translate into larger changes in EPS. If EBIT
falls, a financially leveraged business enterprise will experience negative
changes in EPS that are larger than the relative decline in EBIT. Again,
leverage is a two-edged sword.
Generally, financial leverage as the potential use of fixed financial costs
to magnify the effects of changes in earnings before interest and taxes on the
firm’s earnings per share. The two fixed financial costs that may be found on
the firm’s income statement are (1) interest on debt and (2) preferred stock
dividends. These charges must be paid regardless of the amount of EBIT
available to pay them.
Basically, financial leverage affects earnings after interest and taxes. The
degree of financial leverage is the percentage change in earnings available to
ordinary shareholders and can be computed as follows:
(DFL) = EBIT .
EBIT – Interest
= ( 6,000 x P2,500) – (6,000 x P1,500) – P5,000,000 .
[( 6,000 x P2,500) – (6,000 x P1,500) – P5,000,000] – P2,430
= P10,000 .
P10,000 – P2,430
= 1.32
Illustration.
ABC Ltd. has the following capital structure :
If EBIT is (a) P100,000 (b) P80,000 and (c) P120,000, calculate financial
leverage under three situations. Assume 50% tax rate.
Solution:
Items A B C
Earning before interest and taxes (EBIT) ……………….. P100,000 P 80,000 P120,000
Less: Interest on Debentures (P200,000 x 10%) …….. 20,000 20,000 20,000
Earning before Taxes (EBT) ……………………………………. P 80,000 P 60,000 P100,000
Less: Income tax (EBT x 50%) ………………………………… 40,000 30,000 50,000
Earning after tax (EAT) ………………………………………….. P 40,000 P 30,000 P 50,000
Less: Preference dividend (P200,000 x 10%) …………. 20,000 20,000 20,000
Earnings for Equity shareholders (EES)…………………… P 20,000 P 10,000 P 30,000
Number of shares …………………………………………………. 10,000 10,000 10,000
Earning per share (EPS) EES/No. of shares …………….. P2 P1 P3
Total Leverage
We also can assess the combined effect of operating and financial
leverage on the firm’s risk by using a framework similar to that used to develop
the individual concepts of leverage. This combined effect, or total leverage, can
be defined as the potential use of fixed costs, both operating and financial, to
magnify the effect of changes in sales on the firm’s earnings per share. Total
leverage can therefore be viewed as the total impact of the fixed costs in the
firm’s operating and financial structure.
This interrelationship can be quantified by computing for the degree of
total leverage (DTL) as follows:
GSU Company
Income Statement
For the Year Ended December 31, 2021
Capital Structure
Capital structure is the combination of capitals from different sources of
finance. The capital of a company consists of equity share holders’ fund,
preference share capital and long term external debts. The source and quantum
of capital is decided keeping in mind following factors:
Control – capital structure should be designed in such a manner that
existing shareholders continue to hold majority share.
Risk – capital structure should be designed to such a manner that financial
risk of the company does not increases beyond tolerable limit.
Cost – overall cost of capital remains minimum.
Practically it is difficult to achieve all of the above three goals together hence
a finance manager has to make a balance among these three objectives.
However, the objective of a company is to maximize the value of the company
and it is prime objective while deciding the optimal capital structure. Capital
structure decision refers to deciding the forms of financing (which sources to be
tapped); their actual requirements (amount to be funded) and their relative
proportions (mix) in total capitalization.
Thus, capital structure is one of the most complex areas of financial decision
making because of its interrelationship with other financial decision variables.
Poor capital structure decisions can result in a high cost of capital, thereby
lowering the NPVs of projects and making more of them unacceptable. Effective
capital structure decisions can lower the cost of capital, resulting in higher NPVs
and more acceptable projects—and thereby increasing the value of the firm.
Requirement 2:
Company A . Company B .
Amount . % of sales Amount % of sales
Sales ………………………. P110,000 100% P110,000 100%
Variable costs ………… 66,000 60% 33,000 30%
Contribution margin .. P 44,000 40% P 77,000 70%
Fixed costs ………………. 30,000 60,000
Net income ……………… P 14,000 P 17,000
MC 7-2
= 2 .
b) DFL = EBIT .
EBIT - Interest
= P150,000 .
P150,000 – P60,000
= 1.67 .
= P150,000 .
( P50 – P20)
= 5,000 skates .
Seatwork Exercises
6) The amount of money available to cover fixed costs (FC) and to generate
profits:
a) contribution margin c) fixed contribution margin
b) unit contribution margin d) none of the above
End of Module 7