CHAPTE

FINANCIAL AND OPERATING LEVERAGE

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 Capital Structure
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 Capital Structure of a company refers to the

composition of its capitalisation and it includes all
long term capital sources viz., loans, reserves,
shares and bonds.
 Capital structure or capitalisation of an undertaking
refers to the way in which long term obligations are
distributed between different classes of owners and
creditors.
 Sources of funds
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 Capital Structure Defined
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 The term capital structure is used to represent the

proportionate relationship between debt and equity.

 The various means of financing represent the financial

structure of an enterprise. The left-hand side of the
balance sheet (liabilities plus equity) represents the
financial structure of a company.

 Traditionally,
short-term borrowings are excluded from
the list of methods of financing the firm’s capital
expenditure.
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 Conceptual Clarity
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 Capitalisation- Equity share capital, preference

share capital, Debentures, Term Loans.
 Capital Structure- Equity share capital,
preference share capital, Debentures, Term Loans,
Retained earnings.
 Financial Structure- Equity share capital,
Preference share capital, Debentures, Term Loans,
Current Liabilities.
 Optimum Capital Structure
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 Optimum Capital Structure is that capital

structure where at that level of debt and equity
proportion the market value per share is
maximum and the cost of capital is
minimum.
 EPS and ROE Calculations
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 For calculating ROE either the book value or the market value
equity may be used.
 Interest Tax Shield
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 The interest charges are tax deductible and,

therefore, provide tax shield, which increases the
earnings of the shareholders.
 Case-1
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 The present capital structure of a company has share capital of

Rs 1,00,000 face value of Rs 10 each. It required additional
capital of Rs 50,000 to finance its expansion program. For this
the firm has 3 alternative financial plans.
 A) issue 5000 Equity Shares of Rs 10 each.
 B) issue 500 Preference shares of Rs 100 each @10% dividend.
 C)issue 10% debentures amounting to Rs 50,000
 Company’s Earnings before interest and tax after additional
investment is Rs 40,000 pa. Tax 50%
 Calculate EPS and suggest best alternative.
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LEVERAGE
 Leverage
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 Leverage has been defined as “the action of lever,

and mechanical advantage gained by it.”
 A lever is a rigid piece that transmits and modifies
the force or motion when forces are applied at two
points and turns around the third.
 Leverage is the tendency of profits to change at a
faster rate than sales.
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 In Business, the term leverage is the means which a

business can increase the profits.
 The force will be applied on the debt and benefit of
this is reflected in the form of higher returns to equity
shareholders.
 This is termed as “Trading on Equity”.
 The term gearing explains the relationship between
equity capital and fixed bearing securites.
 It helps in finalising issues of Capitalisation.
 Types of Leverages
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 FinancialLeverage
 Operating Leverage
 Combined Leverage
 Master Table to Calculate
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Leverages
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 Meaning of Financial
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Leverage
 The use of the fixed-charges sources of funds, such as debt and
preference capital along with the owners’ equity in the capital
structure, is described as financial leverage or gearing or trading
on equity.
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 Degree of Financial Leverage
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 The degree of financial leverage (DFL) is defined

as the percentage change in EPS due to a given
percentage change in EBIT:
Financial leverage=EBIT/EBT
 Effect of Leverage on ROE and
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EPS

Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i
 Operating Leverage
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 Operating leverage affects a firm’s

operating profit (EBIT).
 Operating % Change in EBIT
DOL 
Leverage=Contribution/EBIT % Change in Sales
 The degree of operating leverage  EBIT/EBIT
(DOL) is defined as the percentage DOL 
 Sales/Sales
change in the earnings before interest
and taxes relative to a given
percentage change in sales.
 Combining Financial and Operating
Leverages
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 Operating leverage affects a firm’s operating profit

(EBIT), while financial leverage affects profit after
tax or the earnings per share.

 The degrees of operating and financial leverages

is combined to see the effect of total leverage on
EPS associated with a given change in sales.
 Combining Financial and Operating
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Leverages
 The degree of combined leverage (DCL) is given
by the following equation:
% Change in EBIT % Change in EPS % Change in EPS
  
% Change in Sales % Change in EBIT % Change in Sales

 Combined Leverage=Contribution/EBT
 Combined leverage= FL* OL