Operating & Financial Leverage

Operating, Financial And Operating, Financial And Combined LeverageCombined Leverage

By Prof Sameer LakhaniBy Prof Sameer Lakhani

OPERATING, FINANCIAL AND COMBINED LEVERAGE

Operating Leverage

Financial Leverage

Combined Leverage : Total Risk

Solved Problem

Mini Case

Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed returns. As a result, the earnings available to the shareholders/owners are affected as also their risk. There are three types of leverage, namely,

1) Operating – Relationship between sales revenues & EBIT (OP)

2) Financial – Relationship between EBIT & EPS

3) Combined – Relationship between Sales revenue & EPS

Operating LeverageOperating Leverage

Leverage associated with asset acquisition or investment activities is referred to as the operating leverage. It refers to the firm’s ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits (EBIT) and results in more than a proportionate change (±) in EBIT with change in the sales revenue.

Degree of operating leverage (DOL) is computed in two ways:

1) Percentage change in EBIT/Percentage change in sales and

2) (Sales – Variable costs)/EBIT.

Contribution

The operating leverage is favourable when increase in sales volume has a positive magnifying effect on EBIT. It is unfavourable when a decrease in sales volume has a negative magnifying effect on EBIT. Therefore, high DOL is good when sales revenues are rising and bad when they are falling.

The DOL is a measure of the business/operating risk of the firm. Operating risk is the risk of the firm not being able to cover its fixed operating costs. The larger is the magnitude of such costs, the larger is the volume of sales required to recover them. Thus, the DOL depends on fixed operating costs.

Example 1

A firm sells products for Rs 100 per unit, has variable operating costs of Rs 50 per unit and fixed operating costs of Rs 50,000 per year. Show the various levels of EBIT that would result from sale of (i) 1,000 units (ii) 2,000 units and (iii) 3,000 units.

Solution

If sales level of 2,000 units are used as a base for comparison, the operating leverage is illustrated in Table 1

Table 1 EBIT for Various Sales Levels

Case 2

– 50%

Base Case 1

+ 50%

1. Sales in units 1,000 2,000 3,000

2. Sales revenue Rs 1,00,000 Rs 2,00,000 Rs 3,00,000

3. Less: Variable operating cost 50,000 1,00,000 1,50,000

4. Contribution 50,000 1,00,000 1,50,000

5. Less: Fixed operating cost 50,000 50,000 50,000

6. EBIT Zero 50,000 1,00,000

–100% +100%

From the results contained in Table 1, certain generalisations

follow:

1) Case 1: A 50 per cent increase in sales (from 2,000 to 3,000

units) results in a 100 per cent increase in EBIT (from Rs 50,000

to Rs 1,00,000).

2) Case 2: A 50 per cent decrease in sales (from 2,000 to 1,000

units) results in a 100 per cent decrease in EBIT (from Rs

50,000 to zero).

Example 2

A firm sells its products for Rs 50 per unit, has variable operating costs of Rs 30 per unit and fixed operating costs of Rs 5,000 per year. Its current level of sales is 300 units. Determine the degree of operationg leverage. What will happen to EBIT if sales change: (a) rise to 350 units, and (b) decrease to 250 units?

Solution: The EBIT for various sales levels is computed in Table 2.

Table 2: EBIT at Various Sales Levels

Case 2–16.7%

Base Case 1+16.7%

1. Sales in units 250 300 350

2. Sales revenue Rs 12,500 Rs 15,000 Rs 17,500

3. Less: Variable cost 7,500 9,000 10,500

4. Contribution 5,000 6,000 7,000

5. Less: Fixed operating cost

5,000 5,000 5,000

6. EBIT Zero 1,000 2,000

– 100% + 100%

Interpretation

In case 2, 16.7 per cent decrease in sales volume (from 300 units to 250 units)

leads to 100 per cent decline in the EBIT (from Rs 1,000 to zero). On the other

hand, a 16.7 per cent increase in the sales level in case 1 (from 300 units to

350 units) results in 100 per cent increase in EBIT (from Rs 1,000 to Rs 2,000).

The two illustrations (Tables 1 and 2) clearly show that when a firm has fixed

operating costs, an increase in sales volume results in a more than

proportionate increase in EBIT. Similarly, a decrease in the level of sales has

an exactly opposite effect. This is operating leverage; the former being

favourable leverage, while the latter is unfavourable. Leverage, thus, works in

both directions.

Alternative definition of Operating LeverageWhen proportionate change in EBIT as a result of a given change in sales is more than the proportionate change in sales, operating leverage exists. The greater the DOL, the higher is the operating leverage. Symbolically,

2)level) base (at EBIT

level) base (at onContributi Total

FV)Q(S

V)Q(S

ΔQ

Q

F-V)-Q(S

V)-Q(S ΔDOL

costs. fixed Total F

unit per cost VariableV

unit per price Selling S

units inquantity Sales Q

Where

V)-Q(S ΔEBIT ΔF,V)Q(SEBITQΔQ

EBIT ΔEBIT DOL ely,Alternativ

1)1sales in change Percentage

EBIT in change PercentageDOL

(

(

Since the DOL exceeds 1 in both the illustrations, operating leverage exists. However, the degree of operating leverage is higher (3 times) in the case of the firm in Example 2 as compared to the firm in Example 1, the respective quotients being 6 and 2. The quotients mean that for every 1 per cent change in sales, there will be 6 per cent (Examples 2) and 2 per cent (Example 1) change in EBIT in the direction the sales change.

250,000 Rs

1,00,000 Rs

2) (Case 250%

100%1), (Case 2

50%

100%DOL

get, we1 Example to 2 and 1 Equations Applying

61,000 Rs

6,000 Rs

2) (Case 616.7%-

100%- 1), (Case6

16.7%

100%DOL

2, Example in Similarly,

Operating leverage exists only when there are fixed operating costs. If there are no fixed operating costs, there will be no operating leverage. Consider Example 3.

Example 3

Particulars Base Level New Level

1. Units sold 1,000 1,100

2. Sales price per unit Rs 10 Rs 10

3. Variable cost per unit 6 6

4. Fixed operating cost Nil Nil

Solution The relevant computations are given in Table 3.

TABLE 3 EBIT for Various Sales Volume

Particulars Base Level New Level

1. Sales revenues Rs 10,000 Rs 11,000

2. Less: Variable costs 6,000 6,600

3. Less: Fixed costs — —

4. EBIT 4,000 4,400

Applying Equation 1, DOL = 1. Since the quotient is 1, there is no operating leverage.

Financial LeverageFinancial Leverage

Financial leverage is related to the financing activities of a firm. It results from the presence of fixed financial charges (such as interest on debt and dividend on preference shares). Since such financial expenses do not vary with the operating profits, financial leverage is concerned with the effect of changes in EBIT on the earnings available to equity-holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share (EPS).

Example 4

The financial manager of the Hypothetical Ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs 10,000. The firm has 5 per cent bonds aggregating Rs 40,000, while the 10 per cent preference shares amount to Rs 20,000. What would be the earnings per share (EPS)? Assuming the EBIT being (i) Rs 6,000, and (ii) Rs 14,000, how would the EPS be affected? The firm can be assumed to be in the 35 per cent tax bracket. The number of outstanding ordinary shares is 1,000.

Solution

TABLE 4 EPS for Various EBIT Levels

Case 2 Base Case 1

–40% +40%

EBIT Less: Interest on bondsEarnings before taxes (EBT) Less: Taxes (35%)Earning after taxes (EAT) Less: Preference dividendEarnings available for ordinary shareholdersEarnings per share (EPS)

Rs 6,0002,0004,0001,4002,6002,000

6000.6

Rs 10,0002,0008,0002,8005,2002,0003,200

3.2

Rs 14,0002,000

12,0004,2007,8002,0005,800

5.8

– 81.25% +81.25%

The interpretation of Table 4 is as follows:

Case 1:

A 40 per cent increase in EBIT (from Rs 10,000 to Rs 14,000) results in 81.25 per cent increase in EPS (from Rs 3.2 to Rs 5.8).

Case 2:

A 40 per cent decrease in EBIT (from Rs 10,000 to Rs 6,000) leads to 81.25 per cent decrease in EPS (from Rs 3.2 to Re 0.6).

Example 5

A company has Rs 1,00,000, 10% debentures and 5,000 equity shares outstanding. It is in the 35 per cent tax-bracket. Assuming three levels of EBIT (i) Rs 50,000, (ii) Rs 30,000, and (iii) Rs 70,000, calculate the change in EPS (base level of EBIT = Rs 50,000).

Solution

TABLE 5 EPS at Various EBIT Levels

Case 2 Base Case 1

–40% +40%

EBIT Less: interestEarnings before taxes Less: TaxesEarning after taxesEarnings per share (EPS)

Rs 30,00010,00020,000

7,00013,000

2.6

Rs 50,00010,00040,00014,00026,000

5.2

Rs 70,00010,00060,00021,00039,000

7.8

– 50% +50%

Thus, a 40 per cent increase in EBIT in case 2 from the base level of EBIT has led to 50 per cent increase in EPS. And a decrease of 40 per cent in EBIT has decreased the EPS by 50 per cent.

The preceding examples show that the presence of fixed-interest sources funds leads to a more than proportionate change in EPS as a result of change in EBIT level. Whenever a firm has fixed cost in its capital structure, financial Leverage is present.

The greater the amount of fixed-interest sources of funds (and, therefore, the larger is the fixed-financial cost), the higher is the financial leverage.

In Example 4, the amount of fixed financial cost is higher than in Example 5 owing to the preference dividend. As a result of this difference, the propionate change in EPS was much higher (+ / - 81.25%) in example 4 compared to (+ / - 50%) in example 5, although the changes in EBIT in both cases are the same (+ / - 40 %).

Alternative Definition of Financial Leverage

The procedure outlined above is merely indicative of the presence or absence of financial leverage. Financial leverage can be more precisely expressed in terms of the degree of financial leverage (DFL). The DFL can be calculated by Eq. (3)

)4(

t1/DIEBIT

EBIT

t1/DIFVSQ

FVSQ

VSΔQ

FVSQ

t1/DIFVSQ

VSΔQDFL

t1/DIFVSQ

VSΔQ

t1by rdenominato and numerator Dividing

Dt1IFVSQ

t1VSΔQ

EPS

ΔEPS

/Nt1VSΔQΔEPS

ts,areconstanD and F,ISince,N

Dt1IFVSQN

Dt1IEBITEPS

EBITΔEBIT

EPSΔEPSDFL ely,Alternativ

(3)1EBIT in change Percentage

EPS in change PercentageDFL

pP

P

p

P

p

P

p

As a rule, when a percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. In other words, financial leverage occurs when the quotient in Equation 3 is more than one.

In both the examples, the relevant quotient is larger than one. Therefore, financial leverage exists. But the degree of financial leverage is higher in Example 4 (2.03) than in Example 5 (1.25). The higher the quotient of percentage change in EPS due to percentage change in EBIT, the greater is the degree of financial leverage. The quotient of 2.03 implies that 1 per cent change in EBIT will cause 2.03 per cent change in EPS in the same direction (± increase/decrease) in which the EBIT changes. With 1.25 quotient the proportionate change in EPS as a result of 1 per cent change in EBIT will be comparatively less, that is, 1.25 per cent in either direction.

1.2510,000 Rs50,000 Rs

50,000 Rs

1.25 40%

50% 2 Case 1.25,

40%

50% 1 Case :5 e(ii)Exampl

2.030.3512,000/ RsRs2,00010,000 Rs

10,000Rs

2.03 40%-

81.25 2 Case 2.03,

40%

81.25% 1 Case :4 Example (i)For

5, and 4 Examples in 2 Case and 1 Case to 3 Equations Applying

Degree of financial leverage (DFL): Applying Eq. (3)

(i) Case 1 = (+40% / + 40%) = 1

(ii) Case 2 = (-40% / -40%) = 1

Thus, the quotient is 1. Its implication is that 1 per cent change in EBIT will result in 1 per cent change in EPS, that is, proportionate. There is, therefore, no magnification in the EPS.

There will be, however, no financial leverage, if there is no fixed-charged financing. (Table 6).

TABLE 6 EPS at Various EBIT Levels

Case 2 Base Case 1

– 40% +40%

EBIT Rs 30,000 Rs 50,000 Rs 70,000

Less: Taxes (0.35) 10,500 17,500 24,500

Earnings available for equity-holders

19,500 32,500 45,500

Number of shares 10,000 10,000 10,000

EPS 1.95 3.25 4.55

– 40% +40%

Financial leverage involves the use of funds obtained at a

fixed cost in the hope of increasing the return to the equity-

holders. When a firm earns more on the assets purchased

with the funds than the fixed cost of their use, the financial

leverage is favourable. Unfavourable leverage occurs when

the firm does not earn as much as the funds cost.

High fixed financial costs increase the financial leverage

and, thus, financial risk. The financial risk refers to the risk

of the firm not being able to cover its fixed financial costs.

In case of default, the firm can be technically forced into

liquidation. The larger is the amount of fixed financial costs,

the larger is EBIT required to recover them. Thus, the DFL

depends on fixed financial costs.

EBIT-EPS Analysis

It is a method to study the effect of leverage essentially involves the comparison of alternative methods of financing under various assumptions of EBIT.To devise an appropriate capital structure, the amount of EBIT under various financing plans should be related to EPS. The EBIT-EPS analysis is a widely-used method of examining the effect of financial leverage/use of debt. A financial alternative that ensures the largest EPS is preferred, given the level of EBIT.

Example 6

Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to Rs 10,00,000. The firm now wishes to raise additional Rs 10,00,000 for expansion. The firm has four alternative financial plans:

(A) It can raise the entire amount in the form of equity capital.

(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.

(C) It can raise the entire amount as 6% debentures.

(D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital.

Further assume that the existing EBIT are Rs 1,20,000, the tax rate is 35 per cent, outstanding ordinary shares 10,000 and the market price per share is Rs 100 under all the four alternatives.

Which financing plan should the firm select?

Solution

TABLE 7 EPS Under Various Financial Plans

Particulars Financing plans

A B C D

EBIT Less: InterestEarnings before taxesTaxesEarnings after taxes Less: Preference dividendEarnings available to ordinary shareholdersNumber of sharesEarnings per share (EPS)

Rs 1,20,000—

1,20,00042,00078,000

—

78,00020,000

3.9

Rs 1,20,00025,00095,00033,25061,750

—

61,75015,000

4.1

Rs 1,20,00060,00060,00021,00039,000

—

39,00010,000

3.9

Rs 1,20,000—

1,20,00042,00078,00025,000

53,00015,000

3.5

The calculations in Table 7 reveal that given a level of EBIT of Rs 1,20,000, the financing alternative B, which involves 50 per cent ordinary shares and 50 per cent debt, is the most favourable with respect to EPS. Another disclosure of the table is that although the proportion of ordinary shares in the total capitalisation under the financing plan D is also 50 per cent, that is, equal to plan B, EPS is considerably different (lowest). The difference in the plans B and D is due to the fact that interest on debt is tax-deductible while the dividend on preference shares is not. With 35 per cent income tax, the explicit cost of preference shares would be higher than the cost of debt.

Table also indicates that the annual before tax cost of the various

financing plans are:

Financing plan B Rs 25000

Financing plan C Rs 60000

Financing plan D (Rs 25000/1-0.35) Rs 38642

Financing plan A involves no cost as there is no fixed financial charge.

Financing plan involves an equal amount of EBIT necessary to cover

fixed financial charges.

EPS would be Zero for plan B,C&D for the EBIT levels of Rs 25000, Rs

60000,Rs 38642.This level of EBIT may be termed as financial break

even (BEP)level of EBIT because it represents the level of EBIT

necessary for the firm to break even on its fixed financial charge. In

other words it is the level of EBIT at which the firm can satisfy all fixed

financial charges i.e. Interest & preference dividends. EBIT less than

this level will result in negative EPS.

Financial Break-even Point (BEP)

Financial break-even point (BEP) represents a point at which before-tax earnings are equal to the firm’s fixed financial obligations. Symbolically, it is computed as follows:

I + { Dp /(1 – t) } (5)

In other words, at financial BEP, EPS is zero.

Equation 5 gives before-tax earnings necessary to cover the firm’s fixed financial obligations.

As fixed financial charges are added, the break-even point for zero EPS is increased by the amount of the additional fixed cost. Beyond the financial break-even point, increase in EPS is more than the proportionate increase in EBIT. This is illustrated in Table 8, which presents the EBIT-EPS relationship for the data in Example 6 under the various EBIT assumptions given in the box:

1) Rs 80,000 (4 per cent return on total assets)2) 1,00,000 (5 per cent return on total assets)3) 1,30,000 (6.5 per cent return on total assets)4) 1,60,000 (8 per cent return on total assets)5) 2,00,000 (10 per cent return on total assets)

TABLE 8 EBIT-EPS Analysis under Various EBIT Assumptions for the Four Financing Plans of Example 6

(i) EBIT = Rs 80,000 (4 per cent return on investments)

Particulars Financing Plans

A B C D

EBIT

Less: Interest

EBT

Less: Taxes

EAT

Less: Preference dividend

EAT for equity-holders

EPS

80,000 80,000 80,000 80,000

— 25,000 60,000 —

80,000 55,000 20,000 80,000

28,000 19,250 7,000 28,000

52,000 35,750 13,000 52,000

— — — 25,000

52,000 35,750 13,000 27,000

2.6 2.38 1.3 1.8

(ii) EBIT = Rs 1,00,000 (5 per cent return)

EBIT 1,00,000 1,00,000 1,00,000 1,00,000

Less: Interest — 25,000 60,000 —

EBT 1,00,000 75,000 40,000 1,00,000

Less: Taxes 35,000 26,250 14,000 35,000

EAT 65,000 48,750 26,000 65,000

Less: Preference dividend — — — 25,000

EAT for equity-holders 65,000 48,750 26,000 40,000

EPS 3.25 3.25 2.6 2.67

(iii) EBIT = Rs 1,30,000 (6.5 per cent return)

EBIT 1,30,000 1,30,000 1,30,000 1,30,000

Less: Interest — 25,000 60,000 —

EBT 1,30,000 1,05,000 70,000 1,30,000

Less: Taxes 45,500 36,750 24,500 45,500

EAT 84,500 68,250 45,500 84,500


EAT for equity-holders 84,500 68,250 45,500 59,500

EPS 4.22 4.55 4.55 3.97

(iv) EBIT = Rs 1,60,000 (8 per cent return)

EBIT 1,60,000 1,60,000 1,60,000 1,60,000

Less: Interest — 25,000 60,000 —

EBT 1,60,000 1,35,000 1,00,000 1,60,000

Less: Taxes 56,000 47,250 35,000 56,000

EAT 1,04,000 87,750 65,000 1,04,000


EAT for equity-holders 1,04,000 87,750 65,000 79,000

EPS 5.2 5.8 6.5 5.3

Contd.

(v) EBIT = Rs 2,00,000 (10 per cent return)

EBIT 2,00,000 2,00,000 2,00,000 2,00,000

Less: Interest — 25,000 60,000 —

EBT 2,00,000 1,75,000 1,40,000 2,00,000

Less: Taxes 70,000 61,250 49,000 70,000

EAT 1,30,000 1,13,750 91,000 1,30,000


EAT for equity-holders 1,30,000 1,13,750 91,000 1,05,000

EPS 6.5 7.6 9.1 7

It can be seen from Table 8 that when the EBIT level exceeds the financial break-even level (Rs 25,000, Rs 60,000 and Rs 38,462 for financing alternatives, B, C and D respectively) EPS increases. The percentage increase in EPS is the greatest when EBIT is nearest the break-even point. Thus, in Plan C, an increase of 25 per cent in EBIT (from Rs 80,000 to Rs 1,00,000) results in a 100 per cent increase in EPS (from Re 1.3 to Rs 2.6), whereas the percentage increase in EPS is only 40 per cent (from Rs 6.5 to Rs 9.1) as a result of the change in EBIT at higher levels from Rs 1,60,000 to Rs 2,00,000 (i.e. 25 per cent increase).

Contd.

We can also see from tables 7 & 8 that the EPS for different financing

plans at a given level of EBIT is equal. At EBIT levels above or below

the given level the EPS is higher or lower.

Thus for alternative A & C at the EBIT level of Rs 1,20,000(table 7) the

EPS is the same, that is Rs 3.9. If EBIT is below this level alternative A

(ordinary shares) will provide higher EPS, above this level the debt

alternative (C) is better from the viewpoint of EPS.

Between preference share (D) and Ordinary shares (A) the EPS is equal

Rs 5.2 at Rs 1,60,000 EBIT level. Above this level alternative D will give

better EPS while below it alternative A would provide higher EPS.

EPS in alternative A & B are the same at EBIT level of Rs

1,00,000.Above this B plan would lead to higher EPS at levels lower

than this financing plan A would provide higher EPS

Debt alternative (B) gives higher EPS for all levels of EBIT as compared

to preference share alternative (D)

Indifference Point: The EBIT level at which EPS is the same for two

alternative financial plans is referred to as the indifference point/level.

The indifference point may be defined as the level of EBIT beyond

which the benefits of financial leverage begin to operate with respect to

EPS.

In operational terms if the expected level is to exceed the indifference

level of EBIT ,the use fixed charge source of finance i.e. debt would be

advantageous from the view point of EPS that is financial leverage will

be favorable and lead to an increase in the EPS.The capital structure

should include debt.

If the expected level of EBIT is less than the indifference point the

advantage of EPS would be available from the use of equity capital.

The indifference point between two methods of financing can be obtained mathematically (algebraic approach) as well as graphically.

Algebraic Approach

Mathematically, the indifference point can be obtained by using the following symbols:

X = earnings before interest and taxes (EBIT) at the indifference point

N1 = number of equity shares outstanding if only equity shares are issued

N2 = number of equity shares outstanding if both debentures and equity shares are issued

N3 = number of equity shares outstanding if both preference and equity shares are issued

N4 = number of equity shares outstanding if both preference shares and debentures are issued

I = the amount of interest on debentures

DP = the amount of dividend on preference shares

t = corporate income tax rate

Dt = tax on preference dividend

For a New Company

The indifference point can be determined by using the following equations:

(8)

N

Dt1IX

N

t1X:Debentures and shares Preference versus sharesy (iii)Equit

(7A)N

Dt1Dt1X

N

t1X

:dividend Preference ontax withshares Preference versus sharesEquity (ii)(b)

(7)N

Dt1X

N

t1X:shares Preference versus sharesEquity (ii)(a)

(6)N

t1IX

N

t1X:Debentures versus shares(i)Equity

4

p

1

3

p

1

3

p

1

21

For an Existing Company

If the debentures are already outstanding, let us assume I1 = interest paid on existing debt, and I2 = interest payable on additional debt, then the indifference point would be determined by Equation 9.

)9(

N

t1IIX

N

t1IX

2

21

1

1

Example 7

The financial manager of a company has formulated various financial plans

to finance Rs 30,00,000 required to implement various capital budgeting

projects:

1) Either equity capital of Rs 30,00,000 or Rs 15,00,000 10% debentures

and Rs 15,00,000 equity;

2) Either equity capital of Rs 30,00,000 or 13% preference shares of Rs

10,00,000 and Rs 20,00,000 equity;

3) Either equity capital of Rs 30,00,000 or 13% preference capital of Rs

10,00,000, (subject to dividend tax of 10 per cent), Rs 10,00,000 10%

debentures and Rs 10,00,000 equity; and

4) Either equity share capital of Rs 20,00,000 and 10% debentures of Rs

10,00,000 or 13% preference capital of Rs 10,00,000, 10% debentures of

Rs 8,00,000 and Rs 12,00,000 equity.

You are required to determine the indifference point for each financial plan,

assuming 35 per cent corporate tax rate and the face value of equity shares

as Rs 100.

Solution

Confirmation Table

Particulars Equity financing Equity + debt financing

EBIT Rs 3,00,000 Rs 3,00,000

Less: Interest — 1,50,000

Earning before taxes 3,00,000 1,50,000

Less: Taxes 1,05,000 52,500

Earnings for equity-holders 1,95,000 97,500

Number of equity shares 30,000 15,000

EPS 6.5 6.5

3,00,000 Rs /0.651,95,000 Rs X

1,95,000 Rs - 0.65X -Or

1,95,000 Rs - 1.3X 0.65XOr

15,000

97,500Rs0.65X

30,000

0.65XOr

15,000

0.3511,50,000 RsX

30,000

0.351XOr

N

t1IX

N

t1X (i)

21

Confirmation Table

Particulars Equity financing Equity + Preference financing

EBIT Rs 6,00,000 Rs 6,00,000

Less: Taxes 2,10,000 2,10,000

Earning after taxes 3,90,000 3,90,000

Less: Dividends on preference shares

— 1,30,000

Earnings for equity-holders 3,90,000 2,60,000


EPS 13 13

6,00,000 RsX20,000

1,30,000Rs0.65X30,0000.65XOr

20,0001,30,000 Rs0.351

30,0000.351X

Or

3N

pDt1X

1N

t1X (ii)

Confirmation Table

Particulars Equity financing

Equity + Preference + Debentures financing

EBIT Rs 4,80,000 Rs 4,80,000

Less: Interest — 1,00,000

Earnings after interest 4,80,000 3,80,000

Less: Taxes 1,68,000 1,33,000


Less: Dividends including dividend tax

on preference shares — 1,43,000

Earnings available for equity holders 3,12,000 1,04,000


EPS 18.4 18.4

000,80,4

000,10

000,43,1000,6565.0

000,30

65.0

000,10

1.0135.01000,00,1

000,30

35.01

1)(

41

RsX

RsRsXXOr

1,30,000 RsRsXXOr

N

DtDt1IX

N

t1X iii p

Confirmation Table

Particulars Equity financing

Equity + Debt + Preference financing

EBIT Rs 5,50,000 Rs 5,50,000

Less: Interest 1,00,000 80,000

Earnings before taxes 4,50,000 4,70,000

Less: Taxes 1,57,500 1,64,500


Less: Dividends on preference shares

— 1,30,000

Earnings for equity-holders 2,92,500 1,75,500


EPS 14.625 14.625

000,50,5RsX

000,12

000,30,135.01000,80X

000,20

35.01000,00,1RsXOr

N

Dt1IX

N

t11X )iv(

4

p

2

Graphic ApproachGraphic Approach

The indifference point can also be determined graphically. In order to graph the financial plan, two sets of EBIT-EPS coordinates are required for each financial plan. The point at which the two lines intersect is the IP.

In order to graph the financial plan, two sets of EBIT-EPS coordinates are required. The EPS values associated with EBIT values of Rs 2,00,000 and Rs 6,00,000 are calculated and plotted on the graph paper under each financial plan in case of Figure 1. It may noted that 100 per cent equity financing plan starts from origin (O) because EPS would be zero if EBIT is zero.

However, EBIT required to have the value of the EPS as zero is Rs 1,50,000, that is, the interest charges payable on 10% debentures of Rs 15,00,000. Therefore, the starting point of 50 per cent equity financing plan is away from the point of the origin (i.e. it starts from Rs 1.5 lakh). The point at which the two lines intersect is the indifference point (IP). When we draw a perpendicular to the X-axis from the point of intersection, we have EBIT required for the IP. A line drawn from the point of intersection and joined with the Y-axis determines the EPS at the indifference point of EBIT.

An important point to be remembered in relation to the drawing of 33 per cent preference share financial plan (Fig. 2), is that EPS would not be zero if the firm’s EBIT is Rs 1,30,000, because dividend payable on preference share is not tax-deductible. The firm must earn so much more than Rs 1,30,000 that it is left with Rs 1,30,000 after paying taxes. This amount can be calculated dividing Rs 1,30,000 by (1 – t). The required amount is Rs 2,00,000 [Rs 1,30,000) ÷ (1 – 0.35)]. Thus, the starting point of preference share financial plan would be Rs 2 lakh.

0 1 2 3 4 5 6 7

6.5

13

19.5

EBIT (Rs in lakhs)

Figure 1: EBIT-EPS Analysis

Debt Advantage

Debt + EquityAlternative

Equity Alternative

Indifference PointEquity Advantage

EP

S (

Rs

)

The indifference points of Figs. 1 and 2 correspond to what we have determined through the algebraic approach. But the utility of the EBIT-EPS chart lies in its being more informative regarding the EBIT-EPS relationship. It gives a bird’s eye view of EPS at various levels of EBIT. The EPS value at the estimated level of EBIT can be promptly ascertained. Moreover, it more easily explains why an equity financing plan is better than other plans requiring debenture and/or preference shares for the EBIT level below the IP. For instance, Fig. 2 indicates that for all EBIT levels below Rs 6 lakh, the EPS under equity alternative is greater than 33 per cent preference share financing plan and for all EBIT levels above Rs 6 lakh, the EPS is greater under 33 per cent financing plan than 100 per cent equity financing. The IP can be compared with the most likely level of EBIT. If the likely level of EBIT is more than the IP, the use of fixed cost financing plan may be recommended, otherwise equity plan would be more suitable. To sum up, the greater the likely level of EBIT than the indifference point, the stronger is the case for using levered financial plans to maximise the EPS. Conversely, the lower the likely level of EBIT in relation to the indifference point, the more useful the unlevered financial plan would be from the view point of EPS. In other words, financial leverage will be favourable and shareholders will get higher EPS if the return on total investment is more than the fixed cost (interest and preference dividend). If the return is less than the fixed financial charge, the EPS will decline with the use of debt and the leverage will be unfavourable. The financial leverage will have no effect on EPS in case the return on investment is exactly equal to the fixed financial costs.

0 1

6.5

13

19.5

EBIT (Rs in lakhs)

Figure 2: EBIT-EPS Analysis

Equity + PreferenceAdvantage

Equity + PreferenceAlternative

Equity Alternative

Indifference PointEquity Advantage

EP

S (

Rs

)

2 3 4 5 6 7 8 9 10 11 12 13

26

32.5

The indifference point may be computed in another way using market value as the basis. Since the operational objective of financial management is the maximisation of share prices, the market price of shares of a firm with two different financial plans should be identical. Thus, on the basis of level of EBIT which ensures identical market price for alternative financial plans, the indifference point can be symbolically computed by Equation 10.

where PE1 = P/E ratio of unlevered plan and P/E2 = P/E ratio of levered plan.

)10(

N

Dt1IXE/P

N

t1XE/P

2

p

2

1

1

Example 8

Determine the indifference point at which market price of equity shares of a corporate firm will be the same from the following data:

1. Funds required, Rs 50,000.2. Existing number of equity shares outstanding, 5,000 @ Rs 10 per share.3. Existing 10% debt, Rs 20,0004. Funds required can be raised either by (a) issue of 2,000 equity shares,

netting Rs 25 per share or (b) new 15 per cent debt.5. The P/E ratio will be 7 times in equity alternative and 6 times in debt

alternative.6. Corporate tax rate, 35 per cent.

Confirmation Table

Particulars 15% Debt issue Equity issue

EBIT Rs 47,000 Rs 47,000

Less: Interest 9,500 2,000

Earning before taxes 37,500 45,000

Less: Taxes 13,125 15,750

Earning after taxes 24,375 29,250


Earnings per share 4.875 4.18

P/E ratio (times) 6 7

Market price of the share 29.25 29.25

47,000 Rs xi.e. 2,13,850, Rs or4.55x

37,050) Rs 7(3.9x 9,100) Rs or5(4.55x

5,000

6,175Rs0.65x

7,000

1,300Rs0.65x

5,000

0.659,500Rsx6

7,000

0.652,000Rsx7Or

N

t1IIxP/E

N

t1IxP/E

2

212

1

11

Measures of Financial Leverages

Financial leverage measures the degree of the use of debt and other fixed-cost sources of fund to finance the assets the firm has acquired. As shown above, the use of debt has a magnifying effect on the earnings per share. It can be said that the higher the proportion of debt in the capital structure, the higher is the financial leverage and vice-versa. Broadly speaking, financial leverage can be measured in two ways: (i) stock terms, and (ii) flow terms.

1) Stock Terms

It can be measured either by (a) a simple ratio of debt to equity, or (b) by the ratio of long-term debt plus preference share to total capitalisation. Each of these measures indicates the relative proportion of the funds to the total funds of the firm on which it is to pay fixed financial charges.

2) Flow Terms

The financial leverage can be measured either by (a) the ratio of EBIT to interest payments or (b) the ratio of cash flows to interest payment, popularly called the debt service capacity/coverage. These coverage ratios are useful to the suppliers of the funds as they assess the degree of risk associated with lending to the firm.

In general, the higher the ‘stock’ ratios and the lower the ‘flow’ ratios, the greater is the risk and vice-versa.

COMBINED LEVERAGE: TOTAL RISK

Combined leverage is the product of operating leverage and financial leverage.

Total risk is the risk associated with combined leverage.

DCL = DOL X DFL (11)

Thus, the DCL measures the percentage change in EPS due to percentage change in sales. If the degree of operating leverage of a firm is 6 and its financial leverage is 2.5, the combined leverage of this firm would be 15(6 x 2.5). That is, 1 per cent change in sales would bring about 15 per cent change in EPS in the direction of the change in sales. The combined leverage can work in either direction. It will be favourable if sales increase and unfavourable when sales decrease because changes in sales will result in more than proportionate returns in the form of EPS.

(13)IEBIT

onContributi

IEBIT

EBIT

EBIT

onContributiDCL

(12)salesin change %

EPSin change %

EBITin change %

EPSin change %

salesin change %

EBITin change %DCL

Exhibit 18.1 DOL, DFL and DCL of RIL, 2001-2009

YearYear DOL DFL DCL

2001 2.40 1.30 3.12

2002 2.59 1.41 3.65

2003 2.48 1.32 3.28

2004 2.34 1.23 2.88

2005 1.92 1.16 2.23

2006 1.98 1.08 2.14

2007 1.83 1.08 1.98

2008 1.52 1.05 1.60

2009 1.64 1.10 1.80

Mean 2001-2009 2.08 1.19 2.52

Mean 2001-2005 2.35 1.28 3.03

Mean 2006-2009 1.74 1.08 1.88

The degree of operating leverage (DOL), financial leverage (DFL) and combined leverage (DCL) of the Reliance Industries Ltd (RIL) in summarised in Exhibit 18.1.

SOLVED PROBLEMSOLVED PROBLEM

IMPORTANT FORMULAIMPORTANT FORMULADegree of Operating Leverage is computed in two ways:

1 Percentage change in EBIT / Percentage change in Sales2(Sales – Variable Cost) / EBIT

Degree of Financial Leverage is computed in following ways:

1 Percentage change in EPS / Percentage change in EBIT2EBIT / (EBIT - I) when Debt is used3EBIT / { (EBIT – I – Dp / (1-t) } when Debt as well as preference capital is used.4EBIT / { (EBIT – I – (Dp + Dt) / (1-t) } when dividends paid on preference share capital is subject to dividend tax

Documents

Operating & Financial Leverage