LEVERAGE

Presented by:
Name-Pinaky sethy
Branch-CSE
Semester-7th
Guided by:
Prof.Joytiranjan Sahoo
CONTENTS

• Definition
• Classification
• Objective
• Effects
• Degrees of Leverages
• Levered Company
• Sales level
• Significant/Benefits of Leverages
• Limitations of Leverages
• Conclusion
Definition of 'leverage’

1. The use of various financial instruments or borrowed

capital,such as margin, to increase the potential return Of an
investment.
2. The amount of debt use to finance a firm’s assets.A firm with
significantly more debt than equity is considered to be highly
leveraged.
Objectives

Objective of Operating leverage

• To enhance the profitability (EBIT) through enhancing sales and
optimizating the fixed cost.
Objective of financial Leverage
• To enhance the profitability (EPS) of shareholders through positive
financial Leverage.
Objective of combined Leverage
• To optimize the use of both the Leverages together.
Operating Leverage

• Operating Leverage is the ratio of a company‘s fixed costs to its

variable costs.
• A firm with relatively high fixed operating costs will experience
more variable operating income if sales change.
Effects of Operating leverage

• More operating Leverage leads to more business risk,for then a

small sales decline causes a big Profit decline.
 Degree of Operation leverage
(DOL)
• Operating Leverage-By using fixed Operarting costs,a small change
in sales revenue is magnified in to a larger change in Operarting
income.
• This 'multiplier effect’ is called degree of Operating Leverage.
• DOL from sales level(s)
• DOLs=%change in EBIT/%change in sales
• =Change in EBIT/EBIT
• Change in sales/sales
DOLs from sales level(s)

• DOLS=Sales- variable costs/EBIT

Q(p-v)/Q(p-v)-F

F=total anticipated fixed costs

P=sales price per unit
V=variable cost per unit
 What does this tell us ?

• IF DOL = 2,Then a 1% increase in sales will result in a 2% increase in

Operarting income (EBIT)

EBIT Stock-holders
Sales EPS
Financial Leverage

• The use of fixed cost sources of financing rather than variable

cost sources.
 Degree of financial Leverage

1. Financial Leverage:By using fixed cost financing,a small change in Operarting

income is magnified in to a larger change in earning per share.
2. This ‘multiplier effect’ is called the degree of financial Leverage.
3. DFL=%change in EPS/%change in EBIT
1. Change in EPS/EPS
2. change in EBIT/EBIT
1. If we have the data ,we can use this formula
DFL=EBIT/EBIT-I
What does this tell us?

• If DFL=3,then a 1% increase in Operarting income will result in a

3% increase in earnings per share.
 COMBINED LEVERAGE

• Combined Leverage: by using Operarting Leverage and financial Leverage, a samll change
in sales is mignified in to a larger change in earnings per share.
• This “multiplier effect” is called the degree of combined Leverage.
• DCL=DOL×DFL
=%change in EPS/%change in shale
• If we have the data,we can use this formula
DCL= Sales – variable costs/EBIT-I

=Q(p-v)/Q(p-v)-F-I
What does this tell us?

• If DCL=4,then a 1% is increase in sales will result in a 4% increase

in earnings per share.

Sales EBIT EPS Stock-

holders
Levered Company

Sales(100,000Units)---------- 1,400,000
Variable costs ------------------ 800000
Fixed costs ---------------------- 250,000
Interest Paid -------------------- 125,000
Tax rate --------------------------- 34%
Common shares outstanding--- 1000,00
Degree of Operating leverage From sales
level (s)

• DOLs= Sales- variable cost/ EBIT

= 14,000,00- 8,00000/3,50,000
= 1.71
• Degree of financial Leverage
DFL= EBIT/EBIT- I
= 3,50,000/2,25,000
= 1.556
• Degree of combined Leverage
DCL= Sales- variable costs/EBIT-I
=14,00000-8,00000/ 2,25,000
= 2.661
Significance/Benefits of Leverages

• Significance of Operarting Leverage

• Operating Leverage guides the finance manager for fixed investment decision and creating
a proper mixed between fixed and variable cost in the total cost of business operation.It
leads sales and profits optimization.
• Significance of financial Leverage
• Financial Leverage guides the finance manager to optimize debt equity mix in the capital
structure with a view to optimize the capital structure and fulfil the objective of owner’
wealth maximization.
• Significance of combined Leverage
• Combined Leverage views the Leverage in totality of financial and operating Leverage so
that the overall business profits and ultimate wealth maximization objective can be
fulfilled.
Limitations of Leverages

• Limitations of Operating leverage

• If sales are not proper then the break-even point may not be realized .This
situation is also harmful for the business.
• Limitation of financial Leverage
• Financial Leverage sometimes can be unfavorable causing a loss and
financial risk to the business.
• Limitation of combined Leverage
• Combined Leverage monitors and balances both the Leverages sometimes
both of these or anyone of these can be unfavorable causing the
disturbances in the combined Leverage.
 Conclusion

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THANK YOU