Module IV

Leverages
Financial Management
2nd Semester MBA
Kavitha Menon
Financing Decisions
 Two components
 To decide as to how much total funds are
needed
 To decide the sources or their
combinations to raise such funds
 Total funds required - based on the
investments decisions
Concept of Leverage
 Leverage is an assisted advantage
 To leverage means to gain an advantage through
the use of a tool.
 In the word of finance, the term is applied to
(i) fixed cost and (ii) cost of fixed
commitment funds (interest, preference
dividend) as being used to maximize the
Earnings Per Share (EPS)
 Relationship between two interrelated
variables

 With reference to a business


 Variables


 Costs, Output, Sales Revenue, EBIT, EPS

Meaning of leverage
 The ability of a firm to use fixed cost assets
or funds to magnify the return to its
owners.
Trading on equity
 Meaning – utilization of non-equity
sources of funds in the overall capital
structure of the company in order to
increase the earnings available to the
equity shareholders
Thus, this is the best device available
to the company to increase the returns
to equity shareholders.

 Trading on equity
Situations A B C D
Total Assets 1000 1000 1000 1000
Financing Pattern:
Equity Capital 1000 800 600 200
Operating
15% Debt Profit 300
- 300
200 300
400 300
800
Less: Interest - 30 60 120
Earnings before taxes 300 270 240 180
Less: taxes (30%) 90 81 72 54
Earnings after taxes 210 189 168 126
Return on equity (%) 21 23.6 28 63

Rs. in ’000
Careful use…
 Benefit will occur only if the firm is
able to earn on the borrowed funds at a
rate higher than the fixed charge loans
 Not suitable when companies have irregular
or unstable earnings
 Restrictions when there is already
sufficient amount of debt in the existing
capital structure
 Not suitable as it is not easy to raise
debt as a company should have sufficient
tangible assets to offer as security or
good credit rating & goodwill to attract
lenders of capital.
 Company should be prepared to accept the
risk attached.
conclusion
 Debt capital is a cheaper source of
capital as compared to a company’s own
capital
 Two reasons –
 The expectations of the lenders of debt
capital on the return on funds i.e.
interest rates are comparatively lower
 Interest paid on debt capital is an
expenditure deductible for tax purposes.
What is business risk ?
 The risk to the firm of being unable to cover
the fixed operating costs
 Uncertainty about future operating income
(EBIT), i.e., how well can we predict
operating income?

Probability Low risk

High risk

0 E(EBIT) EBIT
What determines businesS risk ?
 Uncertainty about demand (sales).
 Uncertainty about output prices.
 Uncertainty about costs.
 Product, other types of liability.

What is financial risk ?
 The risk of being unable to cover required
financial obligations like interest &
preference dividends.
Classification of fixed costs
 Operating fixed costs – rent, salary,
depreciation
 Financial fixed costs – interest costs from
debt
Classification of leverage
Operating leverage
 Indicates the degree of operating or
business risk
 Measures the change in sales quantity and
operating capacity on Earnings before
interest & tax (EBIT)
 Fixed costs remain constant whether sales
increase or decrease. Therefore the
percentage change in operating profit on
account of a change in sales is greater
than the percentage change in sales.
 Dependent on three factors:
 Sales volume/price – variability in demand
or selling prices
 Fixed costs
 Variable costs
To Illustrate…
Case 2 Base Case 1
-50% +50%
Sales in units 1000 2000 3000
Sales revenue
Contribution 100 ,000
50,000 200
100,,000
000 300
150,,000
000
EBITvariable
(-)
(-) costs 50
Fixed costs - ,,000
50 000 100
50 ,000
50,,000
000 150
50 ,,000
100,000000
-100% +100%
Conclusion..
A 50 % increase in sales (from 2000 to 3000
units) results in a 100% increase in EBIT
(from Rs. 50,000 to Rs. 100,000)
 A 50 % decrease in sales (from 2000 to 1000
units) results in a 100% decrease in EBIT
(from Rs. 50,000 to zero)


 Formula

% change in EBIT
Operating Leverage =
% change in sales

Contribution
Operating Leverage =
EBIT
interpretation
Measures the impact of percentage of
increase or decrease in sales on EBIT.
If OL = 6, it means that for every 1% change
in sales, there will be a 6% change in EBIT
in the direction the sales change.
If OL = 1, there is no operating leverage
High OL – component of fixed costs is too
high in the overall cost structure.
Low OL - component of fixed costs is less in
the overall cost structure.
Interpretation…contd..
 OL depends upon fixed operating costs,
hence larger are these costs, higher will be
the firm’s OL and its operating risk
 High OL good when revenues are rising and
bad when they are falling.
 Exercise - 1
 Calculate the OL for each of the 4 firms.
What conclusions do you draw? Assume
sales = 5000 units.
Firm A Firm B Firm C Firm D
Selling price Rs. 20 Rs. 32 Rs. 50 Rs. 70
p.u. Rs. 6 Rs. 16 Rs. 20 Rs. 50
Variable cost
p.u. Rs. 80,000 Rs. 40,000 Rs. 200,000 nil
Fixed
operating
costs
Financial leverage
 Indicates the degree of financial risk
 Measures the change in Earnings before
interest & tax (EBIT) on the Earnings
per Share (EPS)
 Change in EBIT results in a larger
change in EBT (and accordingly in EAT,
also in EPS). This happens because of
fixed commitments on debentures, loans,
etc which do not vary with the EBIT.
They are to be paid regardless of the
amount of EBIT available to pay them
 Will be higher for firm’s with higher
debt-equity ratio
 Formula

% change in EPS
Financial Leverage =
% change in EBIT

EBIT
Financial Leverage =
Dp
EBT −
1− t
 Illustrating effects of financial
leverage
 Two firms with the same operating
leverage, business risk, and EBIT.
 They only differ with respect to their
use of debt (capital structure).

Firm X Firm Y
No debt 12% debt - Rs. 10,000
Rs. 20,000 equity share Rs. 10,000 equity share
capital of Rs. 100 each capital of Rs. 100 each
Tax rate 40% Tax rate 40%
Firm X: unlevered
Economy
Bad Average Good
EBIT 2000 3000 4000
EBTinterest
(-) -2000 -3000 -4000
(-) Tax
EAT 800
1200 1200
1800 1600
2400
EPS (no. of Rs. 6 Rs. 9 Rs. 12
shares – 200)
Firm Y: levered
Economy
Bad Good Average
EBIT 2000 3000 4000
EBTinterest
(-) 1200
800 1200
1800 1200
2800
(-) Tax
EAT 320
480 720
1080 1120
1680
EPS (no. of Rs. 4.80 Rs. 10.80 Rs. 16.80
shares – 100)
 To Illustrate…
Case 2 Base Case 1
-40% +40%
EBIT 6000 10000 14000
EBTInterest on
(-) 2000
4000 2000
8000 2000
12000
debentures
EATTax @ 35%
(-) 1400
2600 2800
5200 4200
7800
(-) Preference
Earnings available to 2000 2000 2000
Dividend
equity
EPS (no.shareholders
of shares – 600
Rs. 0.60 3200
Rs. 3.20 5800
Rs. 5.80
1000) -81.25% +81.25%
Conclusion..
 A 40 % increase in EBIT (from Rs. 10000 to Rs.
14000 ) results in a 81.25% increase in EPS
(from Rs. 3.20 to Rs. 5.80)
 A 40 % decrease in EBIT (from Rs. 10000 to
Rs. 6000 ) results in a 81.25% decrease in
EPS (from Rs. 3.20 to Rs. 0.60)


Combined leverage
 Also known as Composite Leverage
 Indicates the degree of total or overall risk
 A firm having both OL & FL will have wide
fluctuations in the EPS for even a small
changes in the sales level

 formula
Contribution
Composite Leverage =
EBT

% change in EPS
Composite Leverage =
% change in sales

Composite Leverage = OL * FL
Exercise - 1
A firm has sales of Rs. 10 lakhs, variable cost
of Rs. 7 lakhs & fixed costs of Rs. 2 lakhs. It
has a debt of Rs. 5 lakhs @ 10% interest.
 What are the operating, financial &
combined leverages?
 If the firm wants to double its EBIT, how
much of a rise in sales would be needed on
a % basis?
 Exercise - 2
 The following information is available in respect of 2
firm, P Ltd. & Q Ltd. (Rs. in lakhs)
 P Ltd. Q Ltd.
Sales 500 1000
(-) variable cost
Contribution 200
300 300
700

(-)
EBITFixed Cost 150 400
300

(-)
PBT Interest 50
100 100
200




U R required to calculate different leverages for both
the firms & also comment on their relative risk
position
 Exercise - 3
 Calculate the degree of OL, FL & CL:
Firm X Firm Y Firm Z
Output (units) 60,000 15,000 100,000
Fixed costs 7,000 14,000 1,500
Variable cost p.u. 0.20 1.50 0.02
Interest on
borrowed funds 4,000 8,000 -
Selling price p.u. 0.60 5.00 0.10
Exercise - 4
 Calculate
% change in EPS if the sales are
expected to increase by 5%.
 EBIT – Rs. 11,20,000
 PBT – Rs. 320,000
 Fixed costs – Rs. 700,000
Exercise - 5
 XYZ & Co. has 3 financial plans – Plan I,
Plan II, Plan III. calculate OL & FL and
the highest and lowest value of CL:
Production 800 units
Selling Price p.u. Rs. 15
Variable cost p.u. Rs. 10
Fixed cost: Situation A Rs. 1000
 Situation B Rs. 2000
 Situation C Rs. 3000


Capital Plan I Plan II Plan III

structure
Equity Capital Rs. 5000 7500 2500
12% debt 5000 2500 7500
Exercise - 6
Sales Rs. 200,000
(-) Variable Cost @ 30%
Contribution Rs. 60,000
140,000
(-)
EBITFixed cost Rs. 100,000
40,000
(-) Interest
Profit before tax 5000
Rs. 35000

1 By what % will the taxable income increase if

EBIT increases by 6%?
2 By what % will the EBIT increase if there is a
10% increase in sales?
3 By what % will the taxable income increase if
the sales increases by 6%?
EBIT-EPS Analysis
EBIT-EPS Analysis
A method of study of the effect of
leverage.
 Involves comparison of alternative
methods of financing under various
assumptions of EBIT.
 A firm has the choice to raise funds for
financing its investment proposals from
different sources in different
proportions.
 That combinations which gives the
largest EPS would be selected.
 Exercise -1
A firm has a capital structure exclusively
comprising of ordinary shares amounting to
Rs. 10,00,000. The firm now wishes to raise
additional Rs. 10 lakhs for expansion. The
firm has the following 4 alternative
financial plans:
raise
 the entire amount in the form of equity capital
raise
 50% as equity and 50% as 5% debentures
raise
 the entire amount as 6% debentures
raise

50% as equity and 50% as 5% preference capital.


 Assume the existing EBIT is Rs. 120,000, tax

rate 35%, outstanding ordinary shares –
10,000. Market price per share is Rs. 100
under all the four alternatives
Exercise -2
A Ld. has a share capital Rs. 1 lakh
divided into shares of Rs. 10 each. It has a
major expansion program requiring an
investment of another Rs. 50,000. The
management is considering the following
alternatives for raising this amount:
1 Issue of 5000 equity shares of Rs. 10 each
2 Issue of 5000, 12% preference shares of
Rs. 10 each.
3 Issue of 10% debentures of Rs. 50,000
The company’s present EBIT are Rs. 40,000 p.a.

subject to tax @ 50%. Calculate the effect

of each of the above plans on EPS presuming:
(a)EBIT continues to be the same even after
expansion
Indifference point
Indifference point/level
 The EBIT level at which the EPS is the
same for two alternative financial
plans.
 EBIT level beyond which the benefits of
financial leverage accrue with respect
to EPS.
 Point at which EPS is the same whatever
may be the medium of finance.
 EBIT-EPS Chart

6 Debt
Earnings per Share (Rs.)

5
Indifference point
between debt and
4
Equity shares Equity
financing
3

0
0 100 200 300 400 500 600 700

Highest EBIT (Rs. thousands)

EPS
interpretation
 The greater the likely level of EBIT
than the indifference point, the
stronger is the case for using levered
financial plans to maximize the EPS.
 Conversely, the lower the likely level of
EBIT in relation to the indifference
point, the more useful the unlevered
financial plan would be from the
viewpoint of EPS.
interpretation
Which of the financing alternatives should
we use to raise the money?  It all depends
on our sales forecast.  Calculate the level
of EBIT at which EPS is the same, say X.
If the new level of EBIT is:
 less than X , use equity capital
financing . EPS will be higher than the
other two alternatives as long as
sales are weak enough to keep us below
this EBIT level , X .   As sales and EBIT
fall , the fact that we don't have to
pay a fixed interest or dividend
payment is a big advantage and offers
the company a great deal of
flexibility .
 above X , we would use tend to use debt
financing .   The EPS level is maximized
by using debt as long as sales are
high enough to keep us above the EBIT
level , X . As sales increase , the higher
 Formula
Equity Shares Vs Debentures :
X (1 − t ) ( X − I )(1 − t )
=
N1 N2
Equity Shares Vs Pr eference Shares :
X (1 − t ) X (1 − t ) − D p
=
N1 N2
Where – X = EBIT N – Number of securities
t – corporate income tax
 Formula
Equity SharesVs Debentures & Pr eference Shares:
X (1 − t ) ( X − I )(1 − t ) − D p
=
N1 N2
Equity Shares Vs Pr eferenceshares with DDT
X (1 − t ) X (1 − t ) − D p (1 + D t )
=
N1 N2
Where – X = EBIT N – Number of securities
Dt – DDT Dp = preference dividend
Exercise - 1
 A new project under consideration requires a
capital outlay of Rs. 300 lakhs for which
the funds can either be raised by the issue
of equity shares of Rs. 100 each or by the
issue of equity shares of the value of Rs.
200 lakhs and by the issue of 15% loan of
Rs. 100 lakhs.
 Find out the indifference point, given tax
rate is 50%
Exercise - 2

A firm is considering alternative proposals to
finance its expansion plan of Rs. 400,000. 2
such proposals are:
1 Issue of 15% loans of Rs. 200,000 & issue of
2000 equity shares of Rs. 100 each &
2 Issue of 4000 equity shares of Rs. 100 each

Given tax rate is 50%, & assuming EBIT of Rs.
70,000 & Rs. 80,000, which alternative is
better?

Also compute the indifference level of EBIT of
the two financial plans
 Exercise - 3
 The financial manager of a co. has
formulated various financial plans to
finance Rs. 30 lakhs required to implement
Eithervarious capital
Equity Share budgeting
Capital Eitherprojects :
Equity Share Capital
of Rs. 30 lakhs or Rs. 15 of Rs. 30 lakhs or 13%
lakh
 10% debentures and Rs. preference shares of Rs. 10
15 lakhs equity lakhs and Rs. 20 lakhs
 ESC of Rs. 30 lakhs Either
Either equity ESC of Rs. 20 lakhs
or 13% preference shares of and 10% debentures of Rs.
Rs. 10 lakhs (subject to 10 lakhs or 13% preference
DDTof 10%). Rs. 10 lakh shares of Rs. 10 lakhs, 10%
10% debentures and Rs. 10 debentures of Rs. 8 lakhs
lakh
 equity and Rs. 12 lakhs equity


 Calculate indifference point in each of
the above cases, assuming tax rate 35%
 Exercise - 4
A company needs Rs.
 500,000 for construction of a
new plant. The following 3 financial plans are
feasible:
1 The company may issue 50 lakh ordinary shares at
Rs. 10 each
2 The company may issue 25 lakh ordinary shares at
Rs. 10 each & 250,000 debentures of Rs. 100
each bearing 8% interest
3 The company may issue 25 lakh ordinary shares at
Rs. 10 each & 250,000 preference shares at Rs.
100 per share bearing 8% dividend.
If the company’s EBIT are Rs. 20 lakhs, Rs. 40 lakhs

& Rs. 100 lakhs, what are the EPS under each plan?
Which alternative would you recommend & why?
Assume corporate tax rate is 35%.
If the company finances the construction using

debt, PE ratio is expected to be 5, else it will

remain at 7.5. Calculate market price per share.