Financial Leverage

Financial leverage is primarily concerned with the financial activities which involve raising
of funds from the sources for which a firm has to bear fixed charges such as interest
expenses, loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.)
and preference share capital.

Degree of Financing Leverage:

Financing leverage is a measure of changes in operating profit or EBIT on the levels of
earning per share.
It is computed as:
Financial leverage = Percentage change in EPS / Percentage change in EBIT

The financial leverage at any level of EBIT is called its degree. It is computed as ratio of
EBIT to the profit before tax (EBT).
Degree of Financial leverage (DFL) = EBIT / EBT
The value of degree of financial leverage must be greater than 1. If the value of degree of
financial leverage is 1, then there will be no financial leverage.
 Operating Leverage

Operating leverage refers to the use of fixed operating

costs such as depreciation, insurance of assets, repairs
and maintenance, property taxes etc. in the operations of
a firm. But it does not include interest on debt capital.
Higher the proportion of fixed operating cost as
compared to variable cost, higher is the operating
leverage.
Operating Leverage=Revenue- Variable Cost(Contribution)/Revenue-

Variable Cost- Fixed Cost(Operating Income or EBIT)

Operating Leverage=Contribution)/EBIT
Combined Leverage = Operating leverage x Financial leverage
EBIT-EPS Analysis
• The EBIT-EPS analysis is carried out to assess the impact of different
financial proposals on the value (EPS) of the company. Since the basic
aim of financial management is to maximise the wealth of shareholders,
the EBIT-EPS analysis is crucial in maximising the wealth of the company.

• The financial proposal having the highest EPS is considered for the
execution.
• The different financial proposals may be the use of, only equity,
combination of equity and debt, combination of equity and preferential
capital, or any combination of equity, debt and preferential capital.
• EBIT-EPS analysis shows the impact of financial leverage on the EPS of
the company under different financial proposals.
The example given below explains the concept of EBIT-EPS analysis:
Tulip Limited is planning to set up an industrial plant costing Rs. 40,00,000. It is expected the plant will yield an EBIT of Rs.
8,00,000 per annum.
The company has following financial proposals to meet the cost of the plant:
(i) To finance the project by issuing 4,00,000 equity shares of Rs. 10 each,
(ii) To finance the project by issuing 3,00,000 equity shares of Rs. 10 each and 1,00,000 10% preferential shares of Rs. 10 each,
(iii) To finance the project by issuing 3,00,000 equity shares of Rs. 10 each and raising Rs. 10,00,000 by way of debt at 10%, or
(iv) To finance the project by issuing 2,00,000 equity shares of Rs. 10 each, 1,00,000 10% preferential shares of Rs. 10 each and
raising Rs. 10,00,000 by way of debt at 10%.
If the company is in the 40% tax bracket, which financial proposal is best?
Solutions:
Indifference Point
The indifference point refers to that level of EBIT at which EPS
are the same regardless of leverage in alternative financial
plans. At this level, all financial plans are equally desirable and
the management is indifferent between alternative financial
plans as far as the EPS is concerned.
In other words, it is that
level of EBIT at which it is immaterial for the financial manager
as to which capital structure or capital mix he adopts for the
company. At this point, the use of debt capital or a change in
this proportion in the total capital will not affect the return to
equity shareholders or earning per share.