MBA Sem II FM

Leverage

1. Meaning
 When we use lever properly, a force applied at a point is transformed or magnified
into another large force or motion, at some other point (e.g.: crowbar).
 Leverage, generally is referred to as ‘effectiveness’ or ‘power’.
 In the business context, leverage means use of fixed costs in an attempt to increase
profitability.
 To put differently, leverage denotes the ability of a firm to use fixed costs to magnify
return to the shareholders.

Fig. 1: First-class Lever

2. Types of Leverage
Leverage is classified into two broad categories, namely operating leverage and financial
leverage. Both operating and financial leverages affect the level and variability of the
company’s profit after tax and hence the risk and return.
a) Operating Leverage
 The use of fixed operating cost (e.g.: depreciation of plant and machinery, rent,
staff salaries, insurance etc.) by the firm is referred to as Operating Leverage.
 In other words, operating leverage arises due to the use of fixed operating cost.
 Operating leverage is defined as the firm’s ability to use fixed operating cost to
magnify the effect of changes in sales on its operating profit, i.e., EBIT.
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 Likewise lever, the presence of fixed operating cost causes percentage change in
sales to produce magnified or more percentage change in operating profit (i.e.,
EBIT).
 It is associated with capital budgeting (i.e., Asset mix) of the firm.
 Operating leverage indicates the degree of operating/business risk.
 It is measured by Degree of Operating Leverage (DOL) – A quantitative metric
that captures the sensitivity of firm’s profit to a change in the firm’s sales.
% Change ∈EBIT
 Mathematically, DOL =
% Change ∈Sales
Contribution
 Alternatively, DOL =
EBIT
 The higher the DOL, the greater is the operating risk. But at the same time, it also
increases the possibility of higher operating profit.
b) Financial Leverage
 The use of fixed financial cost (e.g.: cost of debt and preference share) by the firm
is referred to as Financial Leverage. It is also called as ‘Gearing’.
 In other words, financial leverage arises due to the use of fixed financial charges.
 Financial leverage is defined as the firm’s ability to use fixed financial cost to
magnify the effect of changes in EBIT on the earnings available to equity
holders.
 Likewise lever, the presence of fixed financial cost causes percentage change in
EBIT to produce magnified or more percentage change in Shareholders’ return
(i.e., EPS).
 It is associated with capital structure (i.e., Debt-Equity mix) of the firm.
 Financial leverage indicates the degree of financial risk.
 It is measured by Degree of Financial Leverage (DFL) – A quantitative metric
that captures the sensitivity of firm’s EPS to a change in the firm’s EBIT.
% Change ∈EPS
 Mathematically, DFL =
% Change ∈EBIT
EBIT
 Alternatively, DFL =
EBT
 The higher the DFL, the greater is the financial risk. But at the same time, it also
increases the possibility of higher return to shareholders.
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c) Combined Leverage
 The use of both fixed financial cost and fixed operating cost (e.g.: cost of debt
and preference share) by the firm is referred to as Combined Leverage.
 Total leverage is defined as the firm’s ability to use fixed cost, both financial and
operating to magnify the effect of changes in sales volume on the earnings
available to equity holders (i.e., EPS).
 It indicates the total risk of the firm.
 It is measured by Degree of Combined Leverage (DCL) – A quantitative metric
that captures the sensitivity of firm’s EPS to a change in the firm’s sales.
% Change ∈EPS
 Mathematically, DCL =
% Change ∈Sales
Contribution
 Alternatively, DCL =
EBT
 The higher the DCL, the greater is the total risk. But at the same time, it also
increases the possibility of higher return to shareholders.

3. Combined Effect of Operating and Financial Leverage

Situatio Operating Leverage Financial Leverage Effect/Conclusion
n
1 High High Very Risky
2 High Low Sales still unsatisfactory in
relation to the fixed costs to be
absorbed. Long-term
borrowings not a strain on
earnings.
3 Low High Ideal situation for profit
maximization
4 Low Low Management over cautious

4. Trading on Equity
 The use of fixed return bearing securities like preference shares, debentures, bonds,
and term loans in an attempt to increase the earnings available to equity
shareholders is termed as ‘Trading on Equity’.
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 In other words, it refers to the practice of employing more of fixed-bearing
securities in expectation of producing a higher return to shareholders.
 The debts are a cheaper source of funds as compared to equity funds. The providers
of debt have a prior claim on income and assets of the firm over equity holders. The
return payable on debt is less than the return available to equity shareholders.
 Moreover, the tax deductibility of interest payable leads to magnification of return
on equity capital.

Problems on Leverage:
1. The following are the operating results of Dark Web Ltd.:
Sales (in units) 50,000 Interest per annum ₹ 60,000
Selling Price per unit ₹ 24 No. of equity shares 20,000
Tax Rate 30% Fixed Cost per annum ₹ 1,60,000
Variable cost per unit ₹ 16
Compute:
(a) Operating Leverage (b) Financial Leverage © Combined Leverage (d) EPS

2. F4 Ltd. had the following Balance Sheet for the year ended 31st March 2022:
Particulars Note Amount (₹)
No.
I. Equity and Liabilities
(1) Shareholder’s Fund:
(i) Share Capital (Equity shares of ₹ 10 each) 20,00,000
(ii) Reserve and Surplus 4,00,000
(2) Non- current Liabilities:
(i) Long-term Borrowings (15% Debentures) 40,00,000
(3) Current Liabilities 16,00,000
Total 80,00,000
II. Assets
(1) Non-current Assets:
(i) Fixed Assets
a) Tangible 50,00,000
(2) Current Assets 30,00,000
Total 80,00,000

Additional Information:

Fixed cost per annum ₹ 16,00,000 Total Asset Turnover 3

(excluding interest)
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Variable Operating Cost 80% Income tax 30%
Ratio

Compute:
(a) Operating Leverage (b) Financial Leverage © Combined Leverage (d) EPS

3. The following information is related to Big Brother Company Ltd. for the year ended
31st March 2022:
Equity share capital (of ₹ ₹ 50,00,000
10 each)
12% Bond of ₹ 1000 each ₹ 18,50,000 Profit-volume ratio 30%
Sales ₹ 42,00,000 Income tax applicable 30%
Fixed Cost (excluding ₹ 3,48,000
interest)
You are required to calculate:
(a) Operating Leverage (b) Combined Leverage (c) EPS

4. The data relating to two companies are as given below:

Apple Samsung
Equity Capital ₹ 6,00,000 ₹3,50,000
12% Debentures ₹4,00,000 ₹ 6,50,000
Output (units) per annum 60,000 15,000
Selling Price / unit ₹ 30 ₹ 250
Fixed Cost per annum ₹ 7,00,000 ₹ 14, 00,000
Variable Cost per unit ₹ 10 ₹ 75
You are required to calculate the Operating leverage, Financial leverage and Combined
leverage of two Companies.

5. The Operating Profit (EBIT) of Laddu Manufacturing Co. Ltd. is Rs. 4,00,000. The
capital structure consists of the following:
8% Debentures ₹ 10,00,000
10% Preference Share Capital ₹ 2,00,000
Equity Share Capital @ Rs. 100 each ₹ 8,00,000
The company is in the 50% tax bracket.

(i) Determine the firm’s EPS.

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(ii) Determine the financial leverage with the current level of EBIT.
(iii) Determine the % change in EPS corresponding with 30% increase in EBIT.
(iv) Assuming DOL 2; determine the DCL.

6. The financial data of ABC Company is given below:

Variable Expenses as a % of Sales 60%

Interest paid ₹ 10,00,000
Operating leverage 3:1
Financial leverage 2:1
Tax rate 30%

Prepare the Income Statement of the Company.

7. A firm has sales of ₹ 40,00,000, variable cost - ₹ 28,00,000, Fixed costs - ₹ 8,00,000
inclusive of interest of ₹ 2,00,000.
i) Calculate its operating, financial and combined leverages.
ii) If the firm decides to double its EBIT, how much of a rise in sales would be needed on
a percentage basis?

8. A firm has sales of ₹ 75,00,000; variable cost of ₹ 42,00,000 and fixed cost of ₹
6,00,000 (excluding interest). It has a debt of ₹ 45,00,000 at 9% and equity of ₹ 55,
00,000. Tax rate being 30%.
i) What is the firm’s ROI?
ii) Does it have favourable financial leverage?
iii) If the firm belongs to an industry whose asset turnover is 3, does it have high or
low asset leverage?
iv) What are the operating, financial and combined leverages of the firm?
v) If the sales drop to ₹ 50,00,000, what will be the new EBIT?
vi) At what level the EBIT of the firm will be equal to Zero?
vii) At what level the EBT of the firm will be equal to Zero?

9. Installed capacity 600 units

Capacity in Operation 400 units
Selling price per unit ₹ 15
Variable cost per unit ₹ 10
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Fixed Cost: Situation - A ₹ 500
Situation - B ₹ 1,000
Situation - C ₹ 1,500

Financial Plan -X Financial Plan -Y Financial Plan -Z

(1: 1) (3:1) (1:3)
Equity ₹ 2,500 ₹3,750 ₹ 1,250
10 % Debt ₹ 2,500 ₹ 1,250 ₹ 3,750
Compute Leverages and discuss implications.

EBIT-EPS ANALYSIS:
 It is the most widely used technique employed in corporate finance to design an
appropriate capital structure which ensures the highest EPS under firm’s expected
range of EBIT.
 This analysis helps to examine the effect of financial leverage on the behavior of EPS
under alternative financial plans and with varying levels of EBIT.

10. The financial manager of a company has formulated the following Financial Plans to
finance ₹ 10,00,000 which is required for a new project:
Plan -I Plan- II Plan- III
(₹) (₹) (₹)
Equity Share Capital (of ₹ 10 8,00,000 6,00,000 8,00,000
each)
10% preference Share Capital - 1,50,000 2,00,000
8% Debt 2,00,000 2,50,000 -
Total 10,00,000 10,00,000 10,00,000
Tax rate is 50%.
(i) Calculate the indifference point for Plan I & II and II & III.
(ii) Verify your result by calculating the EPS.
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