Upload
rupesh-waybhase
View
240
Download
1
Embed Size (px)
Citation preview
7/31/2019 Leverages Ppt
1/24
7/31/2019 Leverages Ppt
2/24
Leverage
Leveraging is a way to use funds whereby most of the money is raised by borrowing
rather than by stock issue (for a company) or use of capital (by an individual). At its
most basic, leveraging means taking out a loan so that you can invest the money and
hoping your investment makes more money than you will have to pay in interest on
the loan.
The word leverage derived from the word lever, which is an engineering term
Using lever it is possible to lift greater weights by exerting less efforts
When highly leveraged organization increases its sales by certain percentage, its profit
increases by a larger percentage
7/31/2019 Leverages Ppt
3/24
DEBT EQUITY
Decisions about leverage
Too much Equity = underleveraged firm
7/31/2019 Leverages Ppt
4/24
DEBT EQUITY
Decisions about leverage
Too much debt = overleveraged firm
7/31/2019 Leverages Ppt
5/24
DEBT EQUITY
Decisions about leverage
The decision is a tradeoff between Risks and Returns. A firm should adopt a
policy that minimizes risks and maximizes returns
7/31/2019 Leverages Ppt
6/24
Types of Leverages
Return on Investment Leverage
Asset Leverage
Operating Leverage
Financial Leverage
Total Leverage
Fixed charges Leverage
Combined Leverage
7/31/2019 Leverages Ppt
7/24
Advantages of leveraged lending
Two principal advantages of leveraged lending that make it a possible
solution for these clients are:
Potential for Accelerated Capital Growth provided by taking advantage of
compounding investment income.
The key is to ensure that the leveraged investments produce income mainly
in the form of capital gains. Note: that compared to interest income, capitalgains income is taxed much more favourably.
Possible Tax Advantages A clients interest payments may be tax
deductible if the client borrows to invest in a non-registered investment.
To benefit, the loan interest rate does not necessarily have to be less than orequal to the investment rate of return due to the tax deductibility that
reduces the cost of a leveraged lending strategy.* However, the after-tax
rate of return must be higher than the after-tax cost of the interest.
7/31/2019 Leverages Ppt
8/24
The risks of leveraged lending
Reduce emotional or financial strain that can result if interest rates rise or cash flow
changes by minimizing debt-servicing requirements. For example: rather than borrowing to100% of a clients limit, borrow 10% to
50% of the maximum available.
Consider loans that do not require margin calls.
Limitations of Financial Leverage
1. It may cause dividends to disappear altogether and, indeed, may be responsible for the
insolvency and even bankruptcy of a corporation.
2. Companies enjoying a fairly regular income can employ borrowed funds more safely than
those with widely fluctuating incomes.
3. Beyond a certain point, additional capital cannot be employed to produce a return in
excess of the payments which must be made for its use or sufficiently in excess thereof isjustify its employment.
4. The bigger the amount of funds borrowed, the higher the interest rate of corporation may
be forced to pay in order to market its successive Issues of bonds.
7/31/2019 Leverages Ppt
9/24
Formula To Calculate DOL
Degree of operating leverage
The degree of operating leverage (DOL) is Defined as
the percentage change in the earning before taxes
relative to the given percentage change in the sale
DOL= %Change in EBIT
%Change in sales
DOL = Change in EBIT/EBIT
Change in sales/sales
7/31/2019 Leverages Ppt
10/24
DOL measures the firm business risk
It helps in understanding the impact ofchange in sales on operating income of thefirm
It helps to make production planningproper
7/31/2019 Leverages Ppt
11/24
Formula To Calculate DOL
Degree of Financial leverage
When the economic conditions are good and the firms EBITis increasing its EPS increases faster with more debt in the
capital structure .The degree of financial leverage (DFL) is
defined as percentage change in EPS due to give percentage
in EBIT
DFL= %change in EPS
%change in EBIT
7/31/2019 Leverages Ppt
12/24
Helps in designing appropriate capitalstructure of the firm
Indicates market prices of the shares.
Enables understand how EPS wouldchange given a certain change in EBIT.
7/31/2019 Leverages Ppt
13/24
The share capital of the company is Rs 10, 00,000 with share of face
value of Rs 10.The Company has debt capital of Rs 6, 00,000 at 10%
rate of interest. The sales of the Firms are3, 00,000 units per annum at
the selling price of 5 per unit and the variable cost is 3 per unit. The
fixed cost amount to Rs 2, 00, 000. The company pays taxes at 35%. Ifthe sales increases by 10%,calculate:
Percentage increase in EPS
Degree of operating leverage at the two level
Degree of financial leverage at the two level
7/31/2019 Leverages Ppt
14/24
Combining Effect of Financial and Operating Leverages
Operating leverage affects a firms operating profit (EBIT),while financial leverage affects profit after tax or the earningsper share.
The degrees of operating and financial leverages is combined tosee the effect of total leverage on EPS associated with a givenchange in sales.
In short, combined leverage= Operating leverage * Financialleverage.
7/31/2019 Leverages Ppt
15/24
Combining Effect of Financial and Operating Leverages
OL causes changes in sales revenue to cause greater changes in EBIT
FL causes changes in EBIT to create greater changes in EPS
Combining OL and FL causes rather large variations in EPS
Source: Pearson Prentice Hall 2011
7/31/2019 Leverages Ppt
16/24
Degree of combined leverage
Definition of DCL:-A degree of combined leverage that summarizes the combined effectthe degree of operating leverage (DOL), and the degree of financialleverage has on earnings per share (EPS), given a particular changein sales.
For illustration, the formula is:
As long as the DCL is greater than 1, there is combined leverage .
7/31/2019 Leverages Ppt
17/24
Degree of Combined Leverage
If we have the data, we can use this formula:
DCL = Sales - Variable CostsEBIT - INT
Q(S - V)___
Q(S - V) - F -INT=
7/31/2019 Leverages Ppt
18/24
Problem Set
A firm selling price of its product is $100 per unit. The variable cost
per unit is $50 and the fixed operating costs are $50,000 per year.
The fixed interest expenses (non-operating) are $25,000 and thefirm has 10,000 shares outstanding. Let us calculate the percentage
change in EPS and evaluate the degree of combined leverage
resulting from sale of
1) 2000 units &
2) 3000units.Tax rate =35%.
7/31/2019 Leverages Ppt
19/24
Solution
7/31/2019 Leverages Ppt
20/24
What does this tell us?
If DCL = 4, then a 1% increase in sales will result in a 4% increase in
earnings per share.
A small change in sales is magnified into a larger change in earnings per
share.
Stock-
holdersEBIT EPSSales
7/31/2019 Leverages Ppt
21/24
EBIT EPS Analysis :Choice of Best Plan
comparison of alternative methods of financing
under various assumptions of EBIT
choice to raise funds for financing:
(i) exclusively use equity capital
(ii) exclusively use debt,
(iii) exclusively use preference capital,
(iv) use any combination of any different proportions.
Largest EPS
7/31/2019 Leverages Ppt
22/24
IllustrationSuppose a firm has a capital structure exclusively comprising of
ordinary shares amounting to $ 10,00,000. The firm now wishes toraise additional $ 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 $ 1,20,000, the tax rate is35 per cent, outstanding ordinary shares 10,000 and the market priceper share is $ 100 under all the four alternatives. Which financingplan should the firm select?
7/31/2019 Leverages Ppt
23/24
Indifference Point
7/31/2019 Leverages Ppt
24/24