LEVERAGES•Leverage is the effect on earnings available to the shareholders due to the use of fixed cost capital•Higher is the leverage, higher is the risk and higher is the expected return

Types of leverages1. Operating leverage2. Financial leverage3. Composite leverage

1. Operating leverage It is defined as the tendency of the operating profit to vary

disproportionately with sales.The firm is said to have high degree of operating leverage if it

employs a greater amount of fixed cost and a small amount of variable cost.

On the other hand, a firm will have a low operating leverage when it employs a greater amount of variable costs and a smaller amount of fixed cost

There will be no operating leverage, if there is no fixed operating costs.

Operating leverage = ContributionOperating profit

Note: Operating profit means earnings before interest and tax(EBIT)

Operating leverage may be favorable or unfavorable. Incase contribution (ie, sales less variable cost) exceeds fixed cost, there is favorable operating leverage. In the reverse case, the operating leverage will be termed as unfavorable.

1. Operating leverage (cont…d)Degree of operating leverage= % change in profit

% change in salesA small drop in sales can be excessively damaging to the

firm’s efforts to achieve profitability, if a firm has a high degree of operating leverage

Eg: 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/unit. Calculate the operating leverage in each of the following three solutions.

a) When fixed cost are Rs 400b) When fixed cost are Rs 1000c) When fixed cost are Rs 1200

1. Operating leverage (cont..d)Statement showing operating leverage

Situation 1

Situation 2

Situation 3

(i) Sales 4000 4000 4000

(ii) Variable cost 2400 2400 2400

(iii) Contribution (S-V) 1600 1600 1600

(iv) Fixed cost 400 1000 1200

(v) Operating profit(C-F) 1200 600 400

(vi) Operating leverage(C :- OP) 1.33 2.67 4.00

The above example shows that the degree of operating leverage increases with every increase in share of fixed cost in the total capital structure. In situation 3 it shows that if sales increases by one rupee, the profit would increase by Rs 4

2. Financial leverageThe use of fixed source of funds such as debt and preference

capital along with equity capital in the capital structure is described as financial leverage or gearing or trading on equity

Degree of financial leverage= % change in EPS % change in EBIT

Eg: A co. has the following capital structure10000 equity shares of Rs 10 each 1000002000, 10% preference shares of Rs 100 each 2000002000, 10% debentures of Rs 100 each 200000

Calculate the EPS for each of the following levels of EBIT(i)Rs 100000 (ii) Rs 60000 (iii) 140000 .The co. is in 50% tax bracketCalculate the financial leverage taking EBIT level under each base

2. Financial leverage(cont…d)Solution Situation

ISituation II

Situation III

EBIT 100000 60000 140000

Less Interest 20000 20000 20000

EBT 80000 40000 120000

Less Tax 40000 20000 60000

PAT 40000 20000 60000

Less preference dividend 20000 20000 20000

Earnings available for equity shareholders

20000 Nil 40000

EPS 2 --- 4a) In case (ii) if the EBIT has decreased by 40% ((ie, from 100000 to 60000)

EPS has decreased by 1000% (ie, from 2/share to Nilb) In case (iii) if the EBIT has increased by 40% (from 100000 to 140000) as

compared to case (i) EPS has increased by 100% (from Rs 2 to Rs 4/share)

3. Composite LeverageComposite leverage= Operating leverage x Financial

leverageIt is the combined effect of operating and financial

leverage.