4.

LEVERAGE
• It is the use of fixed cost in order to increase the
profitability of the company, the fixed costs will
come in the form of interest charges & preference
dividends.
• If a company risk debt in its capital structure then
the company will enjoy from the interest tax
shield benefits and consequently the cash flows
of the geared firm will be higher than the cash
flow of the ungeared firm.

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 Types of Leverage
• 1) Operating leverage
• 2) Financial leverage
• 3) Total/combined leverage
• Operating Leverage
It refers to the amount of fixed operating expenses to
the company, companies with higher fixed cost may
suffer during the period when there is a reduction in
sales. However such companies will gain when there
is an increase in sales, the operating leverage is
measured using the degree of operating leverage

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• Degree of operating leverage is calculated
using any of the following methods which
depends on the information available:
• DOL = % in EBIT
• % in sales
• DOL = Q( sp- vc)
• Q( sp – vc ) – fc

• DOL = Q
• Q – Bep (units) Bep = Fc / sp - vc

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• Example,
• Calculate the degree of operating leverage of
a company with the following characteristics,
the quantity in units is 800 units, the selling
price per unit is ksh. 15 and the variable cost is
Ksh 10. The fixed cost is 1000.
• DOL = Q (sp – vc )
• Q (sp – vc) – fc
• 800( 15 – 10) = 1.33
• 800 ( 15 – 10 ) - 1000

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• DOL = Q
• Q – BEP ( units)

• BEP = FC / Contribution per unit ( sp –vc )

• BEP = 1000 = 200

• 15 – 10
• DOL = 800 = 8/6 = 1.33
800 – 200

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• Sales = 800 * 15 = 12,000
• Less: VC 800 * 10 (8000)
• Contribution 4,000
• Less fixed cost ( 1000)
• EBIT 3,000

• DOL = % in EBIT
• % in sales

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• Lets say change in units is 1,000
• Sales = 1000 * 15 = 15,000
• Less: VC 1000 * 10 (10000)
• Contribution 5,000
• Less fixed cost ( 1000)
• EBIT 4,000

• DOL = DOL = % in EBIT

• % in sales

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• % in EBIT = 4000 – 3000 = 1/3
• 3000
• % in sales = 15,000 – 12,000 = ¼
• 12,000
• DOL = 1/3 * 4/1 = 1.33
• The degree of operating leverage shows how
sensitive the companies earnings before interest
& taxes are to the changes in sales e.g for a
company with a degree of operating leverage of
1.33 times, it means that changes in sales is
accompanied with 1.33 times changes in EBIT.
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• If a company has a degree of operating
leverage of 2 times it will mean that its
changes in sales will be accompanied by 2
times changes in EBIT.

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 Financial Leverage
• It is the use of financing costs to influence the
earnings per share of a company. A company
that uses financial leverage will have less equity
in its capital structure hence an increase in
earnings per share.
• The financial leverage is measured by the
degree of financial leverage. The degree of
financial leverage is a numerical measure of the
sensitivity of the company’s earnings per share
to changes in EBIT, DFL is calculated through the
following methods:
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• DFL = % in EPS
• % in EBIT

• DFL = Q (sp – vc ) – FC
• Q (sp – vc) – fc – interest – preference
dividend / 1-tax
• The higher the degree of financial leverage,
the higher the sensitivity.

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 COMBINED LEVERAGE
• It is the use of both the financial and operating
leverage. It is measured by the degree of total or
degree of combined leverage.
• It shows sensitivity of the companies earnings
per share to changes in sales and measures the
effects of both fixed costs and interest expenses.
• i) DTL = % in EBIT * % in EPS
• % in sales % in EBIT

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DTL = Q (sp – vc ) * Q (sp – vc ) – FC
• Q (sp – vc) – fc Q (sp – vc) – FC -interest
– preference div/ 1-t
•
• Example
• The following information relates to
operations of capital structure of Xyz ltd, its al
capacity is 1200 units , actual production 800
units, SP per unit is ksh. 15, VC per unit is ksh
10. Fixed cost is based on three situations:

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• Situation A: Ksh. 1,000
• Situation B : Ksh. 2, 000
• Situation C : Ksh 3,000
• Capital structure,
• Financial plans
1 2 3
Equity (Ksh) 5,000 1,500 2,500
Debt ( Ksh) 5,000 2,500 7,500

• The cost of debt for all the plan is 12%.

Required:
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• A) Determine operating leverage under
situation A, B & C respectively.
• B) Determine financial leverage under
financial plans 1,2 &3 respectively.
• C) Determine the highest and the lowest value
of combined leverage.

• Soln.
• A B C
• A) DOL 1.33 times 2 times 4 times

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• B) DFL A B C
Plan 1 1.25 1.43 2.5

Plan 2 1.11 1.18 1.43

Plan 3 1.43 1.82 10

• DTL/ DCL = 1.33 * 1.11 = 1.48 (lowest)

• 4* 10 = 40 ( highest)
• DFL = Q (sp – vc ) – FC
• Q (sp – vc) – fc – interest – preference
dividend / 1-tax
• Interest = 12% * debt in every plan
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 b) The following information is available for XYZ company for the year
ended 31 December 2013:
- Sales for the year 3,000,000

- Variable cost 500,000

- Fixed cost for the year 1,000,000

- Number of units sold during the

year 1,000

- Ordinary share capital 200,000

- 5% Preference share capital 300,000

- 5% debenture capital 1,000,000

Corporate tax rate is provided at 30% of the net profit.

Operating profit for the year was reported at Sh. 5 Million

Required:

(5
(i) Determine the operating leverage for the company Marks)

(5
(ii) Determine the financial leverage for the company Marks)

(5
(iii) Determine the combined leverage for the company Marks)

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