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Leverages

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Page 1: Leverages 1

Leverages

Page 2: Leverages 1

Meaning: The term Leverage in general refers to a relationship between two interrelated variables. In financial analysis it represents the influence of one financial variable over some other related financial variable. The financial variables may be costs, output, sales revenue, Earnings Before Interest & Tax (EBIT), Earnings Per Share (EPS)

There are three commonly used measures of leverage in financial analysisOperating LeverageFinancial LeverageCombined Leverage

Operating LeverageOperating Leverage is defined as the “firm’s ability to use fixed operating costs to magnify effects of changes in sales on its earnings before interest and taxes”.

When there is an increase or decrease in sales level the EBIT also changes. The effect of change in sales on the level EBIT is measured by operating leverage.

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The operating leverage is calculated as:

Increase in EBIT

% of Change in EBIT or

Increase in Sales% of Change in Sales

.

EBIT

Sales

Operating leverage occurs- When a firm has fixed costs which must be met regardless of volume of sales. When the firm has fixed costs, the % change in profits due to change in sales level is greater than the % change in sales.

XYZ Ltd. Sells 100 units Rs. 20 per unit. The cost of production is Rs.14 per unit. The firm has a fixed cost of Rs. 100. Assume that the sale of company XYZ Ltd increases by 40%. The present and expected cost and profits would be as follows:

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Present (Rs) Expected (Rs)

Sales 2,000 (100 units @ Rs.20)

2,800(140 units @ Rs.20)

Less: Variable cost 1,400(100 units @ Rs.14)

1,960(140 units @ Rs.14)

Contribution 600 840

Less: Fixed Cost 100 100

EBIT / Operating Profit 500 740

EBIT / EBIT .240 / .500Operating Leverage = = 1.2

Increase in sales / Sales .800 / .2,000

Increasein Rs Rs

Rs Rs

The operating leverage of 1.2 means that 1% increase in sales would result into 1.2% increase in operating profit. In the example given above % increase in EBIT is 48%

and % increase in sales is 40%.

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A firm will not have an operating leverage if there are no fixed costs and the total cost is variable in nature. In such cases, the operating profits or EBIT varies in direct proportion to the changes is sales level.

Present (Rs) Expected (Rs)

Sales 2,000 (100 units @ Rs.20)

2,800(140 units @ Rs.20)

Less: Variable cost 1,400(100 units @ Rs.14)

1,960(140 units @ Rs.14)

EBIT / Operating Profit 600 840

EBIT / EBIT .240 / .600Operating Leverage = = 1

Increase in sales / Sales .800 / .2,000

Increasein Rs Rs

Rs Rs

The operating leverage of 1 means that increase in operating profit(40% in this example) is in direct proportion to increase in sales (40% in this example)

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The operating leverage at any level of sales is called its Degree. The degree of operating leverage is calculated as ratio of contribution to the EBIT

Degree of Operating Leverage = EBIT

Contribution

Particulars `

Sales 4,000

Less: Variable Cost 2,000

Contribution 2,000

Less: Fixed Cost 600

Operating Profit (EBIT) 1,400

.2000Degree of Operating Leverage = =1.429

.1,400

Rs

Rs

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The Degree of operating leverage varies with a change in the level of sales

Sales (Units) 200 250

Sales revenue @ (Rs.20 per unit) 4,000 5,000

Less: Variable cost 2,000 2,500

Contribution (Rs.) 2,000 2,500

Less: Fixed cost 600 600

Operating Profit (EBIT) 1,400 1,900

Degree of operating leverage 2,000/1,400 = 1.429

2,500/1900= 1.315

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Significance of Operating leverage:

It tells the impact of changes in sales on operating income

A firm having D.O.L ( Degree of Operating Leverage) can experience a magnified effect on EBIT for even a small change in sales level

Higher D.O.L can dramatically increase the operating profits. But if there is decline is sales level, E B I T may be wiped out and a loss may be operated.

Operating leverage depend on Fixed cost.

If the fixed costs are higher, the higher would be firm’s operating leverage and its operating risks.

If operating leverage is high, it automatically means that the break-even point would also be reached t a high level of sales.

In the case of higher operating leverage, the margin of safety would be low.

Therefore, it is preferred to operate sufficiently above break-even point to avoid the danger of fluctuations in sales and profits.

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Financial Leverage:Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT/Operating Profit on the firm’s earning per share.

The financial leverage occurs when a firm’s capital structure contains obligation of fixed financial charges e.g. interest on debenture, dividend on preference shares etc. along with the owners equity to enhance earnings of equity shareholders.

The fixed financial charges do not vary with the operating profits or EBIT. They are fixed and are to be paid irrespective of level of operating profits or EBIT.

Financial leverage is calculated as follows:

% changes in EPS Increase in EPS/EPSFinancial Leverage = =

%Changes in EBIT Increase in EBIT/EBIT

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Particulars Company A Company B

Equity Share capital of Rs.10 each 16,00,000 6,00,000

12% Debentures 1,00,000 11,00,000

Net Capital employed 17,00,000 17,00,000

Earnings Before interest and taxes (EBIT) 5,10,000 5,10,000

Less: Debenture interest 12,000 1,32,000

Profit before tax (PBT) 4,98,000 3,78,000

Less: Tax @35% 1,74,300 1,32,300

Profit after tax (PAT) 3,23,700 2,45,700

Earnings available for equity share holders 3,23,700 2,45,700

Number of shares 1,60,000 60,000

EPS 2.02 4.09

The companies had the same return on investment, 30% (5,10,000/17,00,000)X100But the EPS is almost 2 times in the case of company B as compared to company A.

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Significance of Financial Leverage:

Financial leverage helps the finance manager in designing the appropriate Capital Structure.

Financial leverage is double edged sward. On the one hand it increases earning per share and on the other hand it increases financial risk. High financial leverage means high fixed financial cost and high financial risk.

The finance manager, therefore, is required to trade off. i.e. has to bring a balance between risk and return

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EPS and ROE Calculations

For calculating ROE either the book value or the market value equity may be used.

N

)T1)(INTEBIT(

N

PAT=EPS

shares ofNumber

after taxProfit =shareper Earnings

S

)TINT)(1(EBIT=ROE

equity of Value

after taxProfit =equityon Return

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Effect of Financial Plan on EPS and ROE: Constant EBIT

The firm is considering two alternative financial plans:

(i) either to raise the entire funds by issuing 50,000

ordinary shares at Rs 10 per share, or

(ii) to raise Rs 250,000 by issuing 25,000 ordinary

shares at Rs 10 per share and borrow Rs 250,000 at

15 per cent rate of interest.

The tax rate is 50 per cent.

Financial Plan

All-equity

(Rs)

Debt- equity

(Rs)

1. Earnings before interest and taxes, EBIT 120,000 120,000

2. Less: interest, INT 0 37,500

3. Profit before taxes, PBT = EBIT – INT 120,000 82,500

4. Less: Taxes, T (EBIT – INT) 60,000 41,250

5. Profit after taxes, PAT = (EBIT – INT) (1

– T)60,000 41,250

6. Total earnings of investors, PAT + INT 60,000 78,750

7. Number of ordinary shares, N 50,000 25,000

8. EPS = (EBIT – INT) (1 – T)/N 1.20 1.65

9. ROE = (EBIT – INT) (1 – T)/S 12.0% 16.5%

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Effect of Leverage on ROE and EPS

Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i

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Combining Financial and Operating 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

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XYZ Ltd, sells 2000 units @ Rs. 10 per unit. The variable cost of production is Rs. 7 and Fixed cost is Rs.1000. The company raised the required funds by issue of 100, 10% debentures @ Rs. 100 each and 2000 equity shares @ Rs.10 per share. The sales of XYZ Ltd. Is expected to increase by 20%. Assume tax rate of company is 50%. You are required to calculated the impact of increase in sales on earnings per share.

Particulars Present Expected

Sales level (Units) 2,000 2,400

Sales (Rs.): (A) 20,000 24,000

Less: Variable cost (Rs.): (B) 14,000 16,800

Contribution (Rs. (A)-(B) 6,000 7,200

Less: Fixed cost 1,000 1,000

Operating profit/EBIT 5,000 6,200

Less Interest (Rs.) 1,000 1,000

Profit Before Tax 4,000 5,200

Less Tax 2,000 2,600

Profit After tax 2,000 2,600

No.of equity shares 2,000 2,000

Earning per share 1 1.3

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Q. The Royal Industries, a well established firm in plastics, is considering the

purchase of one of the two manufacturing companies up for sale. The financial

manager of the company has developed the following information about the two

companies. Both companies have total assets of Rs 15,00,000 at the end of March.

Operating statements for the year ending March 31

Sales revenue Rs 30,00,000 Rs 30,00,000

Less: Cost of goods sold 22,50,000 22,50,000

Less: Selling expenses 2,40,000 2,40,000

Less: Administrative expenses 90,000 1,50,000

Less: Depreciation 1,20,000 90,000

EBIT 3,00,000 2,70,000

Cost of goods sold 9,00,000 18,00,000

Selling expenses 1,50,000 1,50,000

Total variable costs 10,50,000 19,50,000

(a) Prepare operating statements for both the companies assuming that sales

increase by 20 per cent. However, the total fixed costs are likely to remain

unchanged and the variable costs are a linear function of sales.

(b) Calculate the degree of operating leverage by both the methods you know.

(c) If the Royal Industries wishes to buy a company which has lower degree of

business risk, which one would it be?

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(i) Operating statement of X Ltd. and Y Ltd.

Particulars X Ltd Y Ltd

Sales revenue Rs 36,00,000 Rs 36,00,000

Less:Cost of goods sold 24,30,000 26,10,000

selling expenses 2,70,000 2,70,000

administrative expenses 90,000 1,50,000

depreciation 1,20,000 90,000

EBIT 6,90,000 4,80,000

Cost of goods sold break-up

Variable costs 10,80,0001 21,60,0002

Fixed costs 13,50,000 4,50,000

24,30,000 26,10,000

130 per cent of sales260 per cent of sales

(ii) DOL(X) = (D EBIT ÷ EBIT)/(D Sales ÷ Sales) = (Rs 3,90,000 ÷ Rs 3,00,000)

(Rs 6,00,000 ÷ Rs 30,00,000) = 6.5.

DOL(Y) = (Rs 2,10,000 ÷ Rs 2,70,000)/(Rs 6,00,000 ÷ Rs 30,00,000) = 3.88.

Alternatively,

DOL(X) = (Sales – VC)/(Current EBIT) = (Rs 30,00,000 – Rs 10,50,000)/3,00,000 = 6.5.

DOL(Y) = Rs 30,00,000 – Rs 19,50,000)/2,70,000 = 3.88.

(iii) Royal Industries Ltd should purchase Y Ltd.

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Q.(a) The following figures relate to two companies: (Rupees in lakh)

Particulars P Ltd Q Ltd

Sales 500 1,000

Variable costs 200 300

Contribution 300 700

Fixed costs 150 400

EBIT 150 300

Interest 50 100

Profit before tax 100 200

You are required to: (i) calculate the operating, financial and combined leverage for the

two companies; and (ii) comment on the relative risk position of the firms.

(b) (i) Find out operating leverage from the following data:

Sales, Rs 50,000

Variable costs, 60 per cent

Fixed costs, Rs 12,000

(ii) Find the financial leverage from the following data:

Net worth, Rs 25,00,000

Debt/Equity, 3:1

Interest rate, 12 per cent

Operating profit, Rs 20,00,000

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(a) Determination of operating, financial and combined leverage (Rupees in lakh)

P Ltd Q Ltd

Sales 500 1,000

Less variable cost 200 300

Contribution 300 700

Fixed cost 150 400

EBIT 150 300

Less interest 50 100

EBT 100 200

DOL (contribution/EBIT) 2 2.33

DFL (EBIT/EBIT – I) 1.5:1 1.5

DCL (DOL ´ DFL) 3 3.5

Q Ltd has higher operating as well as total risk.

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Q. Calculate operating leverage and financial leverage under situations A, B and C, and

financial plans I, II and III respectively from the following information relating to the

operations and capital structure of XYZ Company for producing additional 800 units.

Also, find out the combination of operating and financial leverages which gives the

highest value and the least value. How are these calculations useful to the finance

manager of the company?

Selling price per unit, Rs 30

Variable cost per unit, 20

Fixed costs:

Situation A Rs 2,000

Situation B 4,000

Situation C 6,000

Capital structure:

Financial plan

Particulars I II III

Equity Rs 10,000 Rs 15,000 Rs 5,000

Debt (0.12) 10,000 5,000 15,000

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Determination of DOL in situations A, B and C.

Particulars Situations

A B C

Sales revenue (800 X Rs 30) Rs 24,000 Rs 24,000 Rs 24,000

Less variable costs (800 X Rs 20) 16,000 16,000 16,000

Contribution 8,000 8,000 8,000

Less fixed costs 2,000 4,000 6,000

EBIT 6,000 4,000 2,000

DOL (contribution/EBIT) 1.33 2 4

(Contd.)

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Determination of DFL in various situations and under alternative financial plans

Particulars Alternative financial plans

I II III

Situation A:

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

Less interest 1,200 600 1,800

EBT 4,800 5,400 4,200

DFL (EBIT/(EBIT – I) 1.25 1.11 1.43

Situation B:

EBIT 4,000 4,000 4,000

Less interest 1,200 600 1,800

EBT 2,800 3,400 2,200

DFL 1.43 1.18 1.82

Situation C:

EBIT 2,000 2,000 2,000

Less interest 1,200 600 1,800

EBT 800 1,400 200

DFL 2.5 1.43 10

(Contd.)

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Determination of combined leverage in situations A, B and C and under financial plans, I, II and III.

Particulars Situation A Situation B Situation C

I II III I II III I II III

DOL 1.33 1.33 1.33 2 2 2 4 4 4

DFL 1.25 1.11 1.43 1.43 1 .18 1.82 2.5 1.43 10

DCL 1.66 1.48 1.90 2.86 2.36 3.64 10 5.72 40

(i) Situation A (with fixed costs = Rs 2,000) under financial plan II (equity = Rs 15,000)

gives the lowest DCL (1.48).

(ii) Situation C (with fixed costs = Rs 6,000) under financial plan III (debt = Rs 15,000)

gives the highest DCL (40).