FINANCIAL

MANAGEMENT
Presented by :
Rajan
Rakesh.s.g
Shreyas.bm
Sameer
Sriparna
 TOPICS:

a)LEVERAGE
 Meaning and measurement of
FINANCIAL LEVERAGE
OPERATING LEVERAGE
COMBINED LEVERAGE

 FINANCIAL LEVERAGE & EPS

b) CAPITAL STRUCTURE
 LEVERAGES

“Employment of an asset of funds for which a firm pays

a fixed cost or fixed return to magnify the return to its
owner”
--- JAMES HORN

Types of leverage:

 Operating leverage
 Financial leverage
 Combined leverage
 OPERATING LEVERAGE
It is defined as “The use of fixed cost to magnify the change in operating
profit with the relative change in revenue or sales”

In other words it may be defined as “The ability of the firm to use fixed
operating cost to magnify the changes in sales on its operating profits”

Operating leverage is determined by sales, revenue, variable cost & fixed cost.

It is denoted by :
O.L = contribution
earnings before interest & tax

Degree of O.L
= percentage change in EBIT
percentage change in sales
 O.L can be illustrated with following eg :
FIRM
Particulars YEAR 07 YEAR 08

Sales 5,000 6,000

(-) Variable cost 3,000 3,600
(60% on sales)

Contribution 2,000 2,400

(-) Fixed cost 1,000 1,000

OPERATING
PROFIT / EBIT 1,000 1,400

O.L 2 1.71
Degree of operating leverage :
= percentage change in EBIT
percentage change in sales

= (1,400 – 1,000) *100

1,000

(6,000 – 5,000) *100

5,000
= 40
20
= 2
 FINANCIAL LEVERAGE

It refers to the use of securities carrying a fixed cost in the capitalization of a

company to produce more gain to the equity share holders by magnifying the
earnings per share.

In other words it is the use of fixed charges of funds such as debt &
preference capital along with owners equity in the capital structure is
described as financial leverage .
Financial leverage is also known as TRADING ON EQUITY .
It is denoted by :
F.L = earnings before interest & tax
earnings before tax

Degree of F.L
= percentage change in EPS
percentage change in EBIT
Firm invest Rs10,00,000 with return of 15% ,and raises the entire amt through
1,00,000 equity shares of Rs 10 each. Find out financial leverage of the firm. Tax –
40%
and also find out if the profits are increased by 30%.

Particulars case 1 case 2 (30% )

EBIT (10 lakhs * 15%) 1,50,000 1,95,000
(-)Debenture - -

EBT 1,50,000 1,95,000

(- Tax (40%) 60,000 78,000

Earnings after tax 90,000 1,17,000

(/) no of equity shares 1,00,000 1,00,000
earnings per shares 0.9 1.17

FINANCIAL LEVERAGE 1 1
Degree of Financial leverage :
= percentage change in EPS
percentage change in EBIT

= (1.17 – 0.9) *100

0.9

(1,95,000 – 1,50,000) *100

1,50,000

= 30
30

= 1
 Effect on share holders returns is calculated on 2 factors :
 Earnings per share = Profit after tax
no of outstanding shares

 Return on equity = Profit after tax

net worth on equity capital
Measurement of Financial leverage :

 The ratio of debt to total capital

L= Debt or Debt
Debt + Equity Total capital
 The ratio of debt to equity
L = Debt
Equity
 The ratio of net operating income to interest charges
L = EBIT
Interest
Replacement
Expansion CAPITAL BUDGETING DECISSION
Modernization
Diversification Internal funds

Need to raise fund Debt

External equity
Capital structure decision

Existing capital Desired debt Retention policy

structure equity

Effect on EPS Effect on risk

Effect on cost of capital

 COMBINED LEVERAGE
It is a combination of operating leverage & financial leverage . It may be defined
as
a use of assets having fixed cost as well as securities having fixed charges to
magnify the operating profits as well as the earnings per share with the relevance.

It is denoted by :

C.L = operating leverage * financial leverage

OR contribution
EBT

Degree of combined leverage

= percentage change in EPS

percentage change in sales
 CAPITAL STRUCTURE
“Capital structure of a company refers to its CAPITALIZATION .It includes
all long term sources .i.e. loans, reserves , shares & bonds “

Capitalization refers to the determination of amount of capital to be raised &

the relative proposition of the various types of securities to be issued & the
administration of the capital.

capitalization includes only long term sources of funds while the term capital
includes both long term & short term sources of funds.
 There are 2 set of factors which influence capital structure , namely :
 Internal factor
 External factor

Internal factor :
1. Financial leverage
2. Risk
3. Growth & stability
4. Retaining control
5. Cost of capital
6. Cash flow
7. Flexible
8. Purpose of finance
9. Assets structure
 External factor :
1. Size of business
2. Nature of industry
3. Investors
4. Cost of flotation/ issue
5. Legal requirements
6. Periods of finance
7. Level of interest rate
8. Level of business activity
9. Availability of funds
10. Taxation policy
11. Level of stock prices

Features of appropriate capital structure:

12. Profitability
13. Solvency
14. Flexibility
15. Capacity
16. control