Investment Decisions

Investment/Financing Decisions

S.CLEMENT

LEVERAGESLEVERAGES

Financing decisions involve in deciding Financing decisions involve in deciding capital or financial structure.capital or financial structure.

It involves mix of capital and debtIt involves mix of capital and debt Effects of various mix debt & equity on the Effects of various mix debt & equity on the

share holders return in the capital. share holders return in the capital. Company can increase or decease the Company can increase or decease the

debt unlike equity .debt unlike equity . More capital reduces the return for share More capital reduces the return for share

holders. holders.

LEVERAGESLEVERAGES Leverage arises because of presence of Leverage arises because of presence of

fixed cost . when the firm uses assets or fixed cost . when the firm uses assets or funds for which it pays fixed cost. It may funds for which it pays fixed cost. It may be operating or financial.be operating or financial.

When a firm uses fixed asset like When a firm uses fixed asset like machinery, it has a fixed cost which is machinery, it has a fixed cost which is fixed operating cost.fixed operating cost.

Usage of funds for investing in fixed Usage of funds for investing in fixed assets create fixed financial cost (interest)assets create fixed financial cost (interest)

Proportion between fixed cost and sales Proportion between fixed cost and sales give rise to leverage.give rise to leverage.

Why leverageWhy leverage

Leverage indicates relative change in Leverage indicates relative change in profits due to change in sales.profits due to change in sales.

Proportionate change in change in Proportionate change in change in sales may not result same sales may not result same proportionate change in profitsproportionate change in profits

Operating LeverageOperating Leverage Cost can be fixed or variableCost can be fixed or variable Fixed cost can be operating(manufacturing) or financialFixed cost can be operating(manufacturing) or financial Operating cost arise when a fixed asset is put to use to Operating cost arise when a fixed asset is put to use to

produce goods.produce goods. When fixed operating cost is more than VC, company When fixed operating cost is more than VC, company

leverage will be high and vice versa.leverage will be high and vice versa. E.g if sales increase by 25%/ profit may go up by 100 % E.g if sales increase by 25%/ profit may go up by 100 %

(due to high operating leverage) and vice verca.(due to high operating leverage) and vice verca. In absence of any operating cost , there is no leverage. In absence of any operating cost , there is no leverage.

Profit will increase in direct proportion to increase in sales.Profit will increase in direct proportion to increase in sales. Company should use fixed cost assets to bring about Company should use fixed cost assets to bring about

positive co relation between sales and EBIT and EBIT to positive co relation between sales and EBIT and EBIT to EBTEBT

COMPUTATION OF OperatingLeverage =CONTRIBUTION/ COMPUTATION OF OperatingLeverage =CONTRIBUTION/ EBIT EBIT

Operating LeverageOperating Leverage

Production PlanningProduction Planning – to modify – to modify cost structure. E.g. installation of cost structure. E.g. installation of machinery to save labour cost but machinery to save labour cost but increases FC (operating) and increases FC (operating) and decrease in VC.decrease in VC.

Question before finance manager – Question before finance manager – what will be the probability of what will be the probability of increase in sales? increase in sales?


OL relates to implies the use of FA OL relates to implies the use of FA OL explains the relationship regarding OL explains the relationship regarding

changes in sales visa-à-vis profit (EBIT)changes in sales visa-à-vis profit (EBIT) It measures a firms’ ability to use FA to It measures a firms’ ability to use FA to

manage & maximize EBITmanage & maximize EBIT It relates to asset side of the B/SIt relates to asset side of the B/S It is concerned with investing decisionIt is concerned with investing decision It is a first stage leverageIt is a first stage leverage


A company produces & sells 1000 A company produces & sells 1000 units p.a. SP @ Re 200 and VC @ Re units p.a. SP @ Re 200 and VC @ Re 70 per unit. FC (operating) Re 70 per unit. FC (operating) Re 50,000. What is OL.50,000. What is OL.

OL = Contribution/EBITOL = Contribution/EBIT


Sales (1000*200) 200000Sales (1000*200) 200000 Less Vc (1000*70) 70000Less Vc (1000*70) 70000 Contribution (sales – VC)130000Contribution (sales – VC)130000 Less FC 50000 Less FC 50000 EBIT 80000EBIT 80000 OL 130000/80000 = 1.625OL 130000/80000 = 1.625

CASE STUDYCASE STUDY

A company sells 80,000 units of a A company sells 80,000 units of a products. SP per unit Re 8 and VC @ products. SP per unit Re 8 and VC @ 2. FC Re 330000.what wil be the 2. FC Re 330000.what wil be the profit if the company sellsprofit if the company sells

AA) ) 96,000 units96,000 units B) 64,000 unitsB) 64,000 units

unitsunits 8000080000 9600096000 6400064000

Sales Sales 640000640000 768000768000 512000512000

Less VCLess VC 160000160000 192000192000 128000128000

ContributionContribution 480000480000 576000576000 384000384000

Less FCLess FC 330000330000 330000330000 330000330000

EBITEBIT 150000150000 246000246000 5400054000

% change in % change in salessales

-- 128/640 128/640 *100=*100=

20%(+)20%(+)

128/640 128/640 *100 =*100 =

20 (-)20 (-)

% change in% change in

EBIT EBIT 96/150 96/150 *100=*100=

+64%+64%

96/150*96/150*

100 = 100 =

-64%-64%

Degree of OLDegree of OL

It measures the ratio of percentage It measures the ratio of percentage change in EBIT to percentage change in change in EBIT to percentage change in sales.sales.

Degree of OL = % of change in EBIT/% of Degree of OL = % of change in EBIT/% of change in saleschange in sales

E.g. increase in sales is 20% and profit @ E.g. increase in sales is 20% and profit @ 64%.64%.

Degree of OL = 64/20 = 3.2.Degree of OL = 64/20 = 3.2. If sales increase by RE 1,profit will If sales increase by RE 1,profit will

increase by Re 3.2. & vice versaincrease by Re 3.2. & vice versa


Estimated BE production is 2000 @ Estimated BE production is 2000 @ SP of RE 14 per unit. VC Re 9 per SP of RE 14 per unit. VC Re 9 per unit. Calculate degree of OL if unit. Calculate degree of OL if

A) production @ 2500 unitsA) production @ 2500 units B) production @ 3000 unitsB) production @ 3000 units FC - (2000*14) – (2000*9)FC - (2000*14) – (2000*9) Re 28000 – 18000 = 10000Re 28000 – 18000 = 10000

ParticularsParticulars 2500 units2500 units 3000 units3000 units

Sales @ 14 p.u.Sales @ 14 p.u. 3500035000 4200042000

Less VCLess VC 2250022500 2700027000

ContributionContribution 1250012500 1500015000

Less FCLess FC 1000010000 1000010000

EBITEBIT 25002500 50005000

OLOL 12500/2500 =12500/2500 =

5515000/5000 =15000/5000 =

33

% change in % change in salessales

-- 7000/350007000/35000

*100 =20%*100 =20%

% ch.in profits% ch.in profits -- 2500/25002500/2500

*100 = 100%*100 = 100%


% of change in profits 100 % (2500 to % of change in profits 100 % (2500 to 5000)5000)

% of change in sales 20% (35000 to % of change in sales 20% (35000 to 42000)42000)

OL = % change in EBIT/% change in salesOL = % change in EBIT/% change in sales OL 100/20 = 5OL 100/20 = 5 Conclusion – 20% increase in sales result Conclusion – 20% increase in sales result

in 100 % in profits. Highly leveraged in 100 % in profits. Highly leveraged company.company.

Financial LeverageFinancial Leverage It relates to fixed financial cost such It relates to fixed financial cost such

as interest on TL/Debentures/Pref. as interest on TL/Debentures/Pref. Dividend etcDividend etc

It establishes relationship between It establishes relationship between EBIT&EBTEBIT&EBT

It measures firms’ ability use fixed FC It measures firms’ ability use fixed FC optimize EBToptimize EBT

It is concerned with financing It is concerned with financing decisiondecision

It is second stage leverageIt is second stage leverage FL is favorable when FC < earnings FL is favorable when FC < earnings

Financial LeverageFinancial Leverage

Financial arises from fixed financial Financial arises from fixed financial cost. E.g. Debentures/Term loans – cost. E.g. Debentures/Term loans – rate of interest is fixed.rate of interest is fixed.

FL measures the firms ability to use FL measures the firms ability to use fixed FC to bring about changes in fixed FC to bring about changes in EBIT/EBT .EBIT/EBT .

FL is favorable when earnings is FL is favorable when earnings is more than FC and vice versa.more than FC and vice versa.

Financial LeverageFinancial Leverage - - EffectEffect

Share holders earnings – depends upon Share holders earnings – depends upon relationship between EBIT and Fixed FC. If relationship between EBIT and Fixed FC. If EBIT is more than FC, it will hace positive EBIT is more than FC, it will hace positive imapct on EPS.imapct on EPS.

Financial Risk – more the the proportion of Financial Risk – more the the proportion of debt, more the financial risk. E.g. 10% debt, more the financial risk. E.g. 10% increase operating profit results in 20% increase operating profit results in 20% increase in EPS and 10% drop in OP, will increase in EPS and 10% drop in OP, will result in 20% drop in EPS.result in 20% drop in EPS.


Company capital structure -Company capital structure -1000,10% debentures of Re 100 1000,10% debentures of Re 100 each & 5000 equity shares of RE 10 each & 5000 equity shares of RE 10 each.each.

EBIT – 50000,80000 & 20000.EBIT – 50000,80000 & 20000. What is the impact on EPS ?What is the impact on EPS ?


FL = EBIT/EBTFL = EBIT/EBT Fixed FC - effect on earningsFixed FC - effect on earnings EBIT/ EBT (Earnings before Tax but EBIT/ EBT (Earnings before Tax but

after Interest) after Interest) , Sales – Rs 50000,, Sales – Rs 50000,

VC – 25000, FC – 15000, Int. 5000VC – 25000, FC – 15000, Int. 5000

10000/5000 – FL = 210000/5000 – FL = 2

SALESSALES 5000050000 6000060000 4000040000

VCVC 2500025000 3000030000 2000020000

CONT.CONT. 2500025000 3000030000 2000020000

FCFC 1500015000 1500015000 1500015000

EBITEBIT

INT.INT.1000010000

500050001500015000

5000500050005000

50005000

EBTEBT 50005000 1000010000 00

FLFL 10/510/5

= 2= 22*50002*5000

=2*5000=2*5000

+10000+10000

2*50002*5000

= -1000= -1000

CHANGES IN EBIT TO EBT

11 22 33

EBITEBIT 5000050000 8000080000 2000020000

Less Less interestinterest

1000010000 1000010000 1000010000

EBTEBT 4000040000 7000070000 1000010000

Less Less tax(50%)tax(50%)

2000020000 3500035000 50005000

EATEAT 2000020000 3500035000 50005000

EPSEPS 44 77 11

%in EBIT%in EBIT -- +60%+60% -60%-60%

%chg. EPS%chg. EPS -- +75%+75% -75%-75%

EBIT LEVELS

EPS for various levelsEPS for various levels

XYZ COMPANY –EBIT Re XYZ COMPANY –EBIT Re 15000,24000& 6000.15000,24000& 6000.

8% debentures 250008% debentures 25000 10% preference shares 2000010% preference shares 20000 1000 equity of RE 100001000 equity of RE 10000 Tax rate 50%Tax rate 50% What would be the effect on EPS @ What would be the effect on EPS @

different.different.

11 22 33

EBITEBIT 1500015000 2400024000 60006000

-INT.-INT. 20002000 20002000 20002000

EBTEBT 1300013000 2200022000 40004000

-TAX-TAX 65006500 1100011000 20002000

-Pref.divnd.-Pref.divnd. 20002000 20002000 20002000

Ear. For eshEar. For esh 45004500 90009000 NilNil

No. of ESHNo. of ESH 10001000 10001000 --

EPS EPS 4.54.5 9.009.00 --

%CH.EBIT%CH.EBIT -- +60%+60% --

% CH.EPS% CH.EPS -- 100%100% --

FLFL 15/9=1.6715/9=1.67 24/18 = 1.3324/18 = 1.33 --

Composite leverageComposite leverage

CL measures composite effect of all CL measures composite effect of all the fixed cost (operating and the fixed cost (operating and financial)financial)

CL will disclose effect of changes in CL will disclose effect of changes in sales over cjnage in taxable profit(or sales over cjnage in taxable profit(or EPS)EPS)

FORMULA – CONTRIBUTION/EBTFORMULA – CONTRIBUTION/EBT


SALES – Re 1.00 lacSALES – Re 1.00 lac VC (40% of sales) 40 000VC (40% of sales) 40 000 Fixed operating cost 30000Fixed operating cost 30000 Fixed financial cost 10000Fixed financial cost 10000 Calculate CL.Calculate CL. Calculate CL.IS 5% increase in salesCalculate CL.IS 5% increase in sales

SalesSales 100000100000 105000105000

VCVC 4000040000 4200042000

ContributionContribution 6000060000 6300063000

FC – OperatingFC – Operating 3000030000 3000030000

EBITEBIT 3000030000 3300033000

FC- FinancialFC- Financial 1000010000 1000010000

PBTPBT 2000020000 2300023000

CLCL 60000/20000 =60000/20000 =

33


Sales @100000 .CL is 3Sales @100000 .CL is 3 It indicates 1% increase in sales will It indicates 1% increase in sales will

result in 3 in EBTresult in 3 in EBT Sales 1050000 (5% increase)Sales 1050000 (5% increase) Profit Re 23000 ( 15% increase)Profit Re 23000 ( 15% increase) (23 -20/20 *100)(23 -20/20 *100)


Capital structure of Ever Grow LtdCapital structure of Ever Grow Ltd Equity Re 3,00,000 (Re 10 each)Equity Re 3,00,000 (Re 10 each) 10% debentures Re 3,00,00010% debentures Re 3,00,000 Increase in sales from 30000 to Increase in sales from 30000 to

36000 units. SP @ Re 10 per unit36000 units. SP @ Re 10 per unit FC 50,000. VC Re 6 per unit.FC 50,000. VC Re 6 per unit. Tax rate 50%Tax rate 50% Compute OL,FL & CL.Compute OL,FL & CL.

30000 30000 UNITSUNITS

36000 36000 UNITS UNITS

sales@10sales@10 300000300000 360000360000

- VC@6- VC@6 180000180000 216000216000

Contrib.Contrib. 120000120000 144000144000

-FC-FC 5000050000 5000050000

EBITEBIT 7000070000 9400094000

InterestInterest 3000030000 3000030000

EBTEBT 4000040000 6400064000

tax@50%tax@50% 2000020000 3200032000

PATPAT 2000020000 3200032000

No.of ESNo.of ES 3000030000 3000030000

EPSEPS 0.670.67 1.071.07

OL/FL/CLOL/FL/CL

OL 120/70 =1.72 & 144/94 = 1.53OL 120/70 =1.72 & 144/94 = 1.53 FL 70/40 = 1.75 & 94/64 = 1.47FL 70/40 = 1.75 & 94/64 = 1.47 CL 120/40 = 3.00 & 144/64= 2.25 CL 120/40 = 3.00 & 144/64= 2.25

OL/FL/CLOL/FL/CL

% of change in sales % of change in sales 60000/30000*100 =60000/30000*100 =20%20% % of change in EBIT % of change in EBIT 24000/70000 *100 = 24000/70000 *100 = 34.29%34.29% %of change in EPS %of change in EPS 1.07- .67/.67*100 = 1.07- .67/.67*100 = 60%`60%`

companycompany Int.cost ( in Int.cost ( in cr)cr)

Int/PBIT %Int/PBIT % PAT(crPAT(cr)r)r

Escorts Escorts 142142 78.478.4 3939

India cementsIndia cements 149149 74.974.9 4545

BPCLBPCL 212212 58.358.3 130130

Nagarguna Nagarguna fertiferti

131131 54.354.3 6767

Arvind millsArvind mills 130130 46.846.8 127127

HPCLHPCL 159159 27.127.1 406406

MrplMrpl 188188 23.223.2 372372

JSW steelJSW steel 360360 20.820.8 857857

IOCIOC 10221022 13.213.2 49154915

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Investment Decisions