Leverages Notes

Krupanidhi School of Management. Prof.CA.B.V.RUDRAMURTHYFinanancial Management

LEVERAGES

MEANING:The term Leverage refers to the firm’s ability to use fixed cost funds to magnify

the return to the shareholders. In other words Leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs like interest obligation, irrespective of the level of operating.

MASTER TABLE FOR LEVERAGES:Particulars Rs

Sales XXXLess: Variable cost XXXContribution XXXLess: Fixed cost XXXEarnings before interest and tax (EBIT)/ GP/ Operating Profit XXXLess: Interest XXXEarnings Before Tax (EBT) XXXLess: Tax XXXEarnings after tax (EAT) XXXLess: Preference Dividend XXXLess: Preference Dividend tax XXXEarnings Available To Equity Shareholders (EAESH) XXXDivided by Number of Equity shares XXX= Earnings Per Share (EPS) XXXX Price Earning Ratio (PER) XXX= Market Price Per Share (MPS) XXX

PER = MPS/EPSEPS x PER = MPS

TYPES OF LEVERAGES:

1. OPERATING LEVERAGE:It measures the percentage change in EBIT for percentage change in sales.

Operating leverage may be defined as the effect of fixed expenses on the level of Net income, the changes in net income and the level of business risk. Business risk also called as Operating risk is the risk associated with the normal day to day operations of the firm. The components of business risk are the chances that the firm will fail to create sufficient earnings before interest and taxes and the variability of earnings before interest and taxes.Operating Leverage = Contribution

EBITDegree of Operating Leverage = %Change in EBIT

%Change in Sales

2. FINANCIAL LEVERAGE:

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It measures the percentage change in EPS for percentage change in EBIT.Financial Leverage may be defined as the effect of interest on the level of EPS, changes in EPS and Financial Risk. The components of Financial Risk is the chances of the firm will fail because of its inability to meet interest burden and the variability of earnings available to equity shareholders caused by fixed financial charges. The objective of using financial leverage is to finance the incremental capital required through debt financing which is relatively cheaper compared to equity financing. This magnifies the extra return to equity shareholders and hence Financial leverage is also called as “Trading on equity”.

Trading on Equity:According to this concept borrowing in debt is feasible provided Return on Investment is greater than Borrowing Cost. The difference between Return on Investment & Borrowing Cost is enjoyed by the equity shareholders. But however too much of debt financing is not advisable since the organization may fall into a ‘DEBT TRAP’An ideal debt equity ratio of 1:2 is always preferable to be maintained.Financial Leverage = EBIT

EBTDegree of Financial Leverage = %Change in EPS

%Change in EBIT

3. COMBINED OR COMPOSITE OR TOTAL LEVERAGE:It measures the percentage change in EPS for percentage change in SALES.

Combined Leverage may be defined as the effect of both Fixed expenses and interest on the level of EPS, changes in EPS and Total risk associated with it.Combined Leverage = Contribution

EBTDegree of Combined Leverage = %Change in EPS

%Change in sales

4. RETURN ON INVESTMENT LEVERAGE:ROI Leverage = Asset turnover x Profit margin. = Sales x EBIT

Total assets Sales

ROI Leverage = EBIT SalesReturn on Investment measures the firm’s operational efficiency.

INDIFFERENCE CURVE OR INDIFFERENCE POINT:

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It is at that level of EBIT, EPS of two different alternatives be same.Alternative ‘A’ EPS = Alternative ‘B’ EPS EPS = EAESH/ No. Of ESLet EBIT be ’X’,EPS = (X-I) (1-T) – PD = EPS = (X-I) (1-T) – PD

No. Of ES No. Of ES

Where:T = Tax rate.PD = Preference dividend.ES = Equity shares.

FINANCIAL BEP: (FBEP)It is that level of EBIT at which EPS for a proposal is 0.

PROBLEMS:

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1. The installed capacity of a factory is 600 units actual capacity used is 400 units. Selling price per unit is Rs.10. Variable cost is Rs.6. Calculate the Operating leverage in each of the following situations:

a) When fixed cost is Rs.400b) When fixed cost is Rs.800c) When fixed cost is Rs.1000d) When fixed cost is Rs.1500

Also comment on the results obtained. 2. A company has a choice of the following 3 financial plans. You are required to calculate the financial leverage in each of the following cases & interpret the results.

Particulars X Y ZOperating Profit 400 400 400Equity share capital 3000 2000 1000Debt 1000 2000 3000Interest @ 10% is chargeable in all cases.

3. The following data is available for X ltd. Selling price per unit Rs.120, variable cost per unit Rs.70, fixed cost Rs.2,00,000.

a) What is the Operating Leverage when X ltd produces & sells 6,000 units?b) What is the percentage change that will occur in EBIT of X ltd if output increases

by 5%.

4. The capital structure of progressive corporation ltd consists of equity share capital of Rs.10,00,000 of Rs.100each & 20% debentures of Rs.10,00,000. Sales increases by 25% from 2,00,000 units to 2,50,000 units. Selling price per unit is Rs.10, Variable cost amounts to Rs.6 per unit. Fixed expenses amounts to Rs.2,50,000 IT is assumed @ 30%. You are required to calculate:

a) Percentage increase in EPS.b) DFL @ 2,00,000 units & 2,50,000 units.c) DOL @ 2,00,000 units & 2,50,000 units.

Interpret your results for change in sales units from 2,00,000 units to 2,50,000.

5. SB ltd furnishes the following information to prepare their income statement & also to find out various types of leverages.Sales: Rs.20,00,000 Variable cost:Rs.60% of sales, Fixed cost:Rs.3,00,000.The Company has issued debentures of Rs.2,00,000 @ rate of 5% interest. If there is increase in sales to an extent of 20%, what is the impact on its EPS? Assuming the co., has issued 1,00,000 equity shares. Tax rate is 50% also calculate % change in EBIT.

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6. Calculate Financial leverage, Operating leverage and Combined leverage under situation A and B, financial plans I and II respectively from the following relating to the operations and capital structure of ABC ltd.Installed capacity 1,000 units.Actual production and sales 800 units.Selling price per unit Rs.20.Variable cost per unit Rs.15.Fixed costs:Situation – A: Rs.800Situation – B: Rs.1500Capital Structure:

Source Plan I Plan IIEquity CapitalDebtCost of Debt @ 10%.

Rs.5000Rs.5000

Rs.7000Rs.3000

7. 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 operation and capital structure of ABC Co. Also find out the combination of Operating and Financial leverage which gives the highest value and the least value.Installed capacity 1200 units.Actual production and sales 800 units.Selling price per unit Rs.15.Variable cost per unit Rs.10.Fixed cost:Situation A: Rs.1,000.Situation B: Rs.2,000.Situation C: Rs.3,000.Capital Structure:

Source Plan I Plan II Plan IIIEquity CapitalDebtCost of Debt @ 15%.

Rs.5000Rs.5000

Rs.7500Rs.2500

Rs.2500Rs.7500

8. The selected financial data for A, B & C Co’s for the current year ending 31st march as Follows:Particulars A B CVariable Exp as a % of sales 66.67% 75% 50%Interest Expenses 200 300 1000Degree of Operating Leverage 5 6 2Degree of Financial Leverage 3 4 2Income Tax rate 0.30 0.30 0.30

a) Prepare Income statement for A, B & C companies.b) Comment on the financial position & structure of these companies.

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9. A firm sales, VC & fixed cost amounts to Rs.75,00,000, 42,00,000 & 6,00,000 respectively. It has borrowed Rs.45,00,000 @ 9% interest and its equity capital is Rs.55,00,000.

a) What is the firm return on Investment?b) Does the firm have a favourable financial leverage?c) If the firm belongs to an industry whose asset turnover ratio is 3, does it have high or low asset leverage?d) What are the operating, financial & combined leverages of the firm?e) If sales drops to Rs.50,00,000 what will be the new EBIT?f) At what level will the EBT of the firm becomes 0.

10. PQR Company’s balance sheet is as follows:

LIABILITES Rs ASSETS Rs Equity Capital(Rs.10 per share)10% long term debtRetained EarningsCurrent Liabilities

60,000

80,00020,00040,000

Fixed assetsCurrent assets

1,50,000 50,000

2,00,000 2,00,000The company’s total assets turnover ratio is 3. Its fixed operating cost are Rs.1,00,000 and variable cost ratio is 40%. The income tax rate is 30%.a) Calculate for the company all the three types of leverages.b) Determine the likely level of EBIT if EPS is (a) Rs.1 (b)Rs.3 (c) Rs.0.

11. It is proposed to start a business requiring a capital of Rs.10,00,000 and an assured return of 15% on investments. Calculate the EPS, if:

a) The entire amount is raised by means of Rs.100 equity shares.b) If 50% is raised through equity of Rs.100 each and the remaining 50% through

Rs.100, 8% Preference shares.c) If 50% is raised through equity and the remaining 50% through 10% Debentures.

Assume tax rate @ 30%.

12. A company ltd, has a capital of Rs.1,00,000 divided into shares of Rs.10 each. It has a major expansion program requiring an investment of Rs.50,000. The management is considering the following alternatives for raising the amount.a) Issue of 5,000 shares of Rs.10 each.b) Issue of 5,000, 10% preference shares of Rs.10 each.c) Issue of 10% Debentures of Rs.50,000.The company’s present earnings before interest and tax (EBIT) is Rs.30,000 pa. You are required to calculate the effect of each of the above modes of financing on the earnings per share presuming:1. EBIT continues to be the same even after expansion.2. EBIT increases by Rs.15,000.3. Assume tax rate @ 30%.

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13. 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 capital of Rs.10,00,000 for expansion. Suggest the firm to select the best alternative.Alternative A: It can raise the entire amount in the form of equity share capital.Alternative B: It can raise 50% as equity & 50% as debentures @ the rate of 5% interest.Alternative C: It can raise the entire amount in the form of debentures @ 6% interest.Alternative D: It can raise 50% as Equity share capital and 50% as 5% Preference share capital. Further assume existing EBIT is Rs.1,20,000, tax rate is 30%, Outstanding Ordinary shares is 10,000 shares, market price is Rs.100 per share under all the 4 alternatives.At what rate of preference dividend will you accept alternative D in similar lines of alternative B.

14. ABC Ltd needs Rs.10,00,000 for expansion. The expansion is expected to yield an annual EBIT of Rs.1,50,000. In choosing a financial plan, AB ltd has an objective of maximizing earnings per share. It is considering the possibility of issue of equity shares and raising debt of Rs.1,00,000 or Rs.4,00,000 or Rs.6,00,000. The current market price per share is Rs.25 and is expected to drop to Rs.20 if the funds are borrowed in excess of Rs.5,00,000. Funds can be borrowed at the rates indicated below:a) Up to Rs.1,00,000 @ 8%.b) Over Rs.1,00,000 up to Rs.5,00,000 at 12%.c) Over Rs.5,00,000 @ 20%.Assume a tax rate of 50%. Determine the EPS for the three financing alternatives and help ABC Ltd to select the best possible mix.

15. Two firms A and B have the following information:FIRMS SALES (LAKHS) VARIABLE

COST (LAKHS)FIXED COST

(LAKHS)AB

1,8001,500

450750

900375

You are required to calculate: Profit to sales ratio. Break even point. Degree of operating leverage for both the firms. Comment on the positions of the firms. If sales increases by 25%, what shall be the impact on the profitability of the two

firms?

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16. Ajay ltd is considering expansion of its plant capacity to meet the growing demand. The company would finance the expansion either with 15% debentures or issue of 10,00,000 shares of Rs.10 each. The funds requirement is Rs.100,00,000. The company’s profit and loss statement before expansion is as follows:

Particulars Rs.SalesLess: Total cost

EBITLess: InterestEBTLess: Tax @ 50%EATNumber of Shares (lakh)EPS

1,5001.000

50050

450225225504.5

The company’s expected EBIT with associated probabilities after expansion is as follows:

EBIT(Rs lakh) PROBABILTY250450550600

0.100.300.400.20

You are required to calculate the company’s expected EBIT and EPS and standard deviation of EPS and EBIT for each plan.

17. B ltd manufactures product X. Its current financial and production figures are as follows:Unit selling price = Rs.50Unit variable cost = Rs.30Fixed cost = Rs.3,00,000.Output = 25,000 units.

What is B ltd, current level of profit. What will be the percentage change in profits if output increases by 10%. What will be the percentage change in profits if output decreases by 10%. What will be the percentage change in profits if selling price increases by 10%. What will be the percentage change in profits if variable cost decreases by 5%.

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18. From the following information available for 5 companies, calculate:a) EBIT, b) EPS, c) Operating Leverage, d) Financial Leverage and e) Combined Leverage.

PARTICULARS A B C D ESelling price per unitVariable cost per unitQuantity in unitsFixed costInterestTax rateNumber of equity shares

1510

20,00030,00015,0000.305,000

2015

25,00040,00020,0000.307,500

25 20

35,00050,00025,0000.30

10,000

30 2540,00060,00030,0000.30

12,000

35 3045,00070,00035,0000.30

10,000

19. The financial manager of a company has formulated various financial plans to finance Rs.30,00,000 to implement various capital budgeting projects.Alternative A: Either equity cap of Rs.30,00,000 or 13% preference share capital of Rs.10,00,000 & Rs.20,00,000 of equityAlternative B: Either equity capital of Rs.30,00,000 or Rs.15,00,000 10% debentures & Rs.15,00,000 equityAlternative C: Either equity capital of Rs.30,00,000 or 13% preference share capital of Rs.10,00,000 subject to dividend tax of 10%, Rs.10,00,000 10% debentures & Rs.10,00,000 of equity.Alternative D: Either equity share capital of 20,00,000 & 10% debentures of Rs.10,00,000 or 13% preference share capital of Rs.10,00,000, 10% debentures of Rs.8,00,000 & Rs.12,00,000 of equity.You are required to determine the indifference point for each of the financial plans assuming 30% tax & face value of each equity share is Rs.100.

20. Calculate the level of EBIT at which the indifference point between the following financing alternative will occur: Equity share capital of Rs.10,00,000 or 10%debentures of Rs.10,00,000. Equity share capital of Rs.10,00,000 or 10%Preference shares of Rs.10,00,000. Equity share capital of Rs.10,00,000 or 10%Preference shares of Rs.5,00,000 and

10%debentures of Rs.5,00,000.Assume the corporate tax rate to be 50% and the price of each ordinary shares, preference shares and debentures is Rs.100 each. Number of shares outstanding is 10,000 shares.

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Leverages Notes