Leverages

MeaningLeverage is an investment

technique in which you use a small amount of your own money to make an investment of much larger value.

In that way, leverage gives you significant financial power.

The amount of debt used to finance a firm's assets.

A firm with significantly more debt than equity is considered to be highly leveraged.

The amount of debt used to finance a firm's assets.

A firm with significantly more debt than equity is considered to be highly leveraged.

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations.

Debt is that which is owed; usually referencing assets owed, but the term can cover other obligations.

EquityThe difference between the market value of a property & the claims held against it .

The difference between the market value of a property & the claims held against it .

Leverage allows

greater potential returns to the investor than otherwise would have been available but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Leverage allows

greater potential returns to the investor than otherwise would have been available but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Risk associated

• The most obvious and apparent risk of leverage is that if price changes unexpectedly, the leveraged position can end up leading to severe losses.

• Another limitation of trading on equity is on account of the fact that every rupee of extra debt increases the risk and hence the rate of interest on increasing. it becomes difficult for the company to obtain further debt without offering extra securities and higher rate of interest reducing their earnings

Types of Leverages

• Operating leverage

• Financial leverage

Operating leverage

• A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs.

Financial leverage

• Financial leverage may b defined as the tendency of the residual net income to vary disproportionately with the operating profit.

• It indicates the change that takes place in the taxable income as the result of the change in the operating profit.

• FL = OP(EBIT)/ PBT

Degree of leverage

• Degree of financial leverage

• Degree of operating leverage

• Degree of combined leverage

Degree of financial leverage

• DFL= EBIT/PBT

OR

DFL= %change in EPS

%change in EBIT

Degree of operating leverage

• DOL = Contribution/PBT

OR

DOL = %change in EBIT

%change in SALES

Degree of combined leverage

• DCL= DFL * DOL

OR

%change in EPS

%change in sales

Case study

• XYZ ltd. Firm has a capital structure exclusively comprising of ordinary shares amounting to Rs. 1000000 . The firm now wishes to raise additional Rs 1000000 for expansion . The firm has 4 alternative financial plans :

• It can raise the entire amount in the form of equity capital• It can raise 50% as equity capital and 50% as 5% debentures• It can raise the entire amount as 6% debentures• It can raise 50% as equity capital and 5% preference capital.

• Further assume that the existing EBIT is Rs. 120000.

The tax rate is 50%,outstanding ordinary shares 10000

And the market price per share is 100 under all the 4 alternatives.

• Which financial plan should the firm select?????

Solution

Financial plans

A B C D

EBIT 120000 120000 120000 120000

Less: Interest -- 25000 60000 --

EBT 120000 95000 60000 120000

Taxes(50%) 60000 47500 30000 60000

PAT 60000 47500 30000 60000

Less: pref. div.(5%)

-- -- -- 25000

Earning to ordinary sh.holders

60000 47500 30000 35000

No. of shares 20000 15000 10000 15000

EPS 3.0 3.17 3 2.33

Thank you