MS 304 – FINANCIAL MANAGEMENT - II

Financial Management - II
Paper Code: MS 304
Topic: Leverages
UNIT – 2 - LEVERAGES
Structure of the unit - 2:
Objectives
Concept and Types of Leverage
Operating Leverage – Meaning, Computation of Operating Leverage, Behaviour of
Operating Leverage, Applications of Operating Leverage.
Financial Leverage – Meaning, Computation of Financial Leverage, Behaviour,
Applications of Financial Leverage
Composite Leverage
EBIT-EPS Analysis
Importance of Leverage
OBJECTIVES
After studying this unit, you should be able to
 understand the concepts of financial leverage, operating leverage and total leverage
 explain the computation process of leverages
 assess the behaviour and applications of leverages
 analysis the relationship between EBIT and EPS
 discuss the importance of leverages
CONCEPT AND TYPES OF LEVERAGES
The dictionary meaning of the term leverage refers to : an increased means for
accomplishing some purpose”. It helps us in lifting heavy objects by the magnification of
force when a lever is applied to a function.
James Horne has defined leverage as the employment of an asset or funds for which
the firm pays a fixed cost or fixed return.
Christy and Roder defines leverage as the tendency for profits to change at a faster rate
than sales.
A few essential characteristics of leverage are as follows :
(a) Leverage is applied to the employment of an asset or funds.
(b) Profits tend to change at a faster rate than sales.
(c) There is risk return relationship which is basically found in the same
direction.
(d) If higher is the leverage, higher will be the risk and higher will be the
expected returns.

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Operating Leverage is related to fixed cost. It indicates the impact of changes in sales
on operating income. It is calculated as follows :
Contribution
---------------
EBIT
Financial Leverage depends upon the ratio of debt and preferred stock together to
common shares. It is calculated with the help of EBIT and EBT as below :
EBIT
---------------
EBT
Combined Leverage is the multiplication of operating leverage and financial leverage.

OPERATING LEVERAGE
It takes place when a change in revenue produces a greater change in EBIT.
It is related to fixed costs. A firm with relatively high fixed costs uses much of its
marginal contribution to cover fixed costs.
Meaning
It refers to heavy usage of fixed assets. A few definitions are as follows :
“The use of fixed operating costs to magnify a change in profits relative to a given
change in Sales” - Walker & Petty
“If a high percentage of a firm’s total costs are fixed costs, then the firm is said to
have a high degree of operating leverage. - E F Brigham
It is a function of three factors :
 Fixed costs
 Contribution
 Volume of Sales
A few specific characteristics of operating leverage are as follows :
 It affects assets side of Balance sheet
 It is related to composition of fixed assets
 It is related in fluctuations in business risk
 It affects capital structure and return on total assets.
COMPUTATION OF OPERATING LEVERAGE
The operating leverage can be calculated by the following formula

Contribution C
OL = ------------------ or ---------
EBIT EBIT
where contribution means sales minus variables costs
EBIT means contribution minus fixed costs .

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If contribution is more than fixed cost, it is favourable financial leverage. In case of

vice-versa, it is unfavourable financial leverage.
Illustration No. 1
The following are the details
Selling price per unit Rs. 20
Variable cost per unit Rs. 12
Actual sales 200 units
Installed capacity 300 units
Calculated operating leverage in each of the following two situations.
(i) when fixed costs are Rs. 1000
(ii) when fixed costs are Rs. 800.
Solution :
Statement showing computation of operating leverage

Sales Rs. 4,000 Rs. 4,000

Less Variables Costs Rs. 2,400 Rs. 2,400
Contribution Rs. 1,600 Rs. 1,600
Less – Fixed Costs Rs. 1,000 Rs. 800
Earning Before Tax Rs. 600 Rs. 800
Operating Leverage Rs. 1,600 Rs. 1,600
Rs. 600 Rs. 800
= 2.67 2.0
BEHAVIOUR OF OPERATING LEVERAGE
The behaviour of operating leverage may be measured by the degree of
operating leverage. The degree of operating leverage is the percentage change in
the profits resulting from a percentage change in the sales. It may be put in the
form of the following formula :
Percentage change in EBIT
Degree of Operating Leverage = --------------------------------------
Percentage change in Sales
Illustration No. 2
The following are the details
Selling Price Per Unit Rs. 20
Variable Cost per unit Rs. 12
Actual Sales 200 units
Fixed cost 1000
Calculate degree of operating leverage when sales will be
(a) 150 units
(b) 250 units
(c) 300 units

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Solution :
Computation of degree of operating leverage
Present (i) (ii) (iii)
Items Position

Sales in units 200 150 250 300

Sales in Rs. 4000 3000 5000 6000
Less Variable 2400 1800 3000 3600
Costs in Rs. ------- ------- ------- -------
Contribution 1600 1200 2000 2400
Less Fixed 1000 1000 1000 1000
Costs in Rs. ------- ------- ------- -------
EBIT in Rs. 600 200 1000 1400

Degree of Operating 200 67 133

Leverage ------- ------- -------
25 25 50
-8 + 2.67 + 2.67
If a firm has a high degree of operating leverage, small change in sales will have
large effect on operating income. Similarly, the operating profits of such a firm
will suffer loss as compared to decrease in its sales.
There will not be any operating leverage, if there are no fixed costs.
APPLICATIONS OF OPERATING LEVERAGES
The operating leverage indicates the impact of change in sales on operating
income. If a firm has a high degree of operating leverage, small change in sales will
have large effect on operating income. A few areas of application are as follows :
(1) Operating leverage has an important role in capital budgeting decisions.
Infact, this concept was originally developed for use in capital budgeting.
(2) Long term profit planning is also possible by looking at quantam of fixed
cost investment and its possible effects.
(3) Generally, a high degree of operating leverage increases the risk of a firm.
For deciding capital structure in favour of debt, the impact of further
increase in risk will influence capital structure decision.
FINANCIAL LEVERAGE
It refers to usage of debt in capital structure. It is the use of fixed cost capital
(debt) in the total capitalization of the firm. Fixed cost capital includes loans,
debentures and preferences share capital.
MEANING OF FINANCIAL LEVERAGE
Financial leverage is expressed as the firm’s ability to use fixed financial
cost in such a manner so as to have magnifying impact on the EPS due to any

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change in EBIT (Earning Before Interest and Taxes). In other words, financial
leverage is a process of using debt capital to increase the return on equity.
According to Guthman “Financial leverage is the ability of the firm to use fixed
financial changes to magnify the effect of changes in EBIT on the firms EPS.
The following are the essentials of financial leverage :
(1) It relates to liabilities side of balance sheet
(2) It is related to capital structure
(3) It is related to financial risk
(4) It affects earning after tax and earnings per share
(5) It may be favourable or unfavourable. Unfavourable leverage occurs when
the firm does not earn as much as the funds cost.
COMPUTATION OF FINANCIAL LEVERAGE
The financial leverage can be calculated by the following formula :
EBIT
Financial Leverage = ------------
EBT
where EBIT refers to earnings before interest and tax and EBT refers to earnings
before tax but after interest
Some authorities have used the term financial leverage in the context of
establishing relationship between EBIT and EPS. The financial leverage shows the
percentage change in EPS in relation to percentage change in EBIT.
BEHAVIOUR OF FINANCIAL LEVERAGE
The behaviour of financial leverage may be measured by the degree of
financial leverage. The degree of financial leverage may be in the form of the
following equation :
Percentage change in EBT
Degree of Financial leverage = ------------------------------------
Percentage change in EBIT

Alternatively, this may be calculated in terms of EPS.

Percentage change in EPS

Degree of Financial leverage = ------------------------------------
Percentage change in EBT

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Illustration No. 3
A Ltd. has the following capital structure :

Rs.
Equity share capital (of Rs. 100 each) 1,00,000
10% Preference share capital (of Rs. 100 each) 2,00,000
10% debentures (of Rs. 100 each) 2,00,000
If EBIT is (i) Rs. 1,00,000 (ii) Rs. 80,000 and (iii) Rs. 1,20,000,
Calculate financial leverage under three situations. Assume 50% tax rate.
Solution :
Computation of Financial Leverage
Items (i) (ii) (iii)
EBIT Rs. 1,00,000 Rs, 80,000 Rs. 1,20,000
Less Interest on Debentures Rs. 20,000 Rs. 20,000 Rs. 20,000
---------------- -------------

EBT Rs. 80,000 Rs. 60,000 Rs. 1,00,000

Less Income Tax Rs. 40,000 Rs. 30,000 Rs. 50,000
---------------- -------------

PAT Rs. 40,000 Rs. 30,000 Rs. 50,000

Less Preference Dividend Rs. 20,000 Rs. 20,000 Rs. 20,000
---------------- -------------

Earnings for Equity Shareholders Rs. 20,000 Rs. 10,000 Rs. 30,000
No. of Shares Rs. 10,000 Rs. 10,000 Rs. 10,000
EPS 2 1 3
Financial Leverage EBIT Rs. 1,00,000 Rs. 80,000 Rs. 1,20,000
-------- --------------- ------------- ---------------
EBT Rs. 20,000 Rs. 10,000 Rs. 30,000

5 8 4

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APPLICATIONS OF FINANCIAL LEVERAGES

Financial leverage is useful in
(i) Capital structure planning
(ii) Profit Planning

Financial leverage helps the finance managers while devising the capital structure of the
company. A high financial leverage means high fixed financial costs and high financial
risk. Increase in fixed financial costs may force the company into liquidation.
COMPOSITE LEVERAGE
Both operating and financial leverage magnify the returns. There is combined
effect of these leverages on income. Both the leverages are closely concerned with the
firm's capacity to meet its fixed costs (both operating and financial). In case both the
leverages are combined, the result obtained will disclose the effect of change in sales
over change taxable profit.
Composite Leverage = Operating Leverage * Financial Leverage
Contribution
It may be expressed as = -------------------
EBT
The degree of combined leverage is computed in the following manner :

Percentage change in EPS

Degree of Combined leverage = ----------------------------------------------
Percentage change in Sales Volume
Illustration No. 4
The following particulars are available :
Sales Rs. 1,00,000
Variable Cost Rs. 70,000
Fixed Cost Rs. 20,000
Long term loans Rs. 50,000
At 10 percent
Compute the combined leverage.
Solution :
30,000
Operating Leverage = ------------ = 3
10,000

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10,000
Financial Leverage = ------------ = 2
5,000

30,000
Combined Leverage = ------------ = 6 (or 3* 2 = 6)
5,000
EBIT - EPS ANALYSIS
This is a method to study the effect of leverage. It involves the comparisons of
alternative methods of financing under various alternative financing proposals. A firm
may raise funds in either of the following alternatives :
(i) Exclusive use of equity capital
(ii) Exclusive use of debt
(iii) Various combinations of debt and equity
(iv) Various combinations of debt, equity and preferences capital

Illustration No. 5
A company is contemplating to raise additional fund of Rs. 20,00,000 for setting up a
project. The company expects, EBIT of Rs. 8,00,000 from the project. Following
alternative plans are available :

(a) To raise Rs. 20,00,000 by way of equity share of Rs. 10 each

(b) To raise Rs. 10,00,000 by way of equity shares and Rs. 10,00,000 by way of debt @ 10%.
(c) To raise Rs. 6,00,000 by way of equity and rest Rs. 14,00,000 by way of preferences
shares @ 14%.
(d) To raise Rs. 6,00,000 by equity shares
Rs. 6,00,000 by 10% equity
Rs. 8,00,000 by 14% Preference shares

The company is in 60% tax bracket which option is best ?

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Solution :

EBIT - EPS Analysis

in Rs.
Particulars Options

A B C D

EBIT 8,00,000 8,00,000 8,00,000 8,00,000

Less Interest - 1,00,000 - 60,000
EBT 8,00,000 7,00,000 8,00,000 7,40,000
Less Tax 4,80,000 4,20,000 4,80,000 4,44,000
EAT 3,20,000 2,80,000 3,20,000 2,96,000
Less Dividend for - - 1,96,000 1,12,000
Preference shares
Earnings for equity 3,20,000 2,80,000 1,24,000 1,84,000
Shareholders
Number of Equity 2,00,000 1,00,000 60,000 60,000
shares
EPS 1.6 2.8 2.07 3.07

Option D is the best as EPS is the maximum in this case.

IMPORTANCE OF LEVERAGES
Leverages have the magnifying effect. Operating leverage magnifies EBIT with
respect to contribution while financial leverage magnifies EPS with respect to EBIT.
Financial leverage enhances the EPS without an additional investment. By having
judicious assets mix and financing mix, EPS may be increased. A few areas
identified in this regard are as follows :
Investment in fixed assets (Operating leverage)
Capital structure planning (Financial leverage)
Profit planning (Combined leverage)
Monitoring business and financial risk
Maximising the value of share
Improving EPS
Judicious mixture of operating leverage and financial leverage.

A firm with high operating leverage should not have a high financial leverage.
Similarly, a firm having low operating leverage will stand to gain by having a high
financial leverage. If both leverages are increased, the possibility of bearing more risk
will increase.

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PRACTICAL PROBLEMS
Few practical problems of leverages along with solution are given for better understanding:
Illustration No. 6
A company has three alternative plans :
A B C
Rs. Rs. Rs.
Equity Capital 30,000 15,000 45,000
Debt @ 10% 30,000 45,000 15,000
EBIT Rs. 6,000
Calculate financial leverage.
Solution :
Computation of Financial Leverage in Rs.
Particulars A B C
EBIT 6,000 6,000 6,000
Less - Interest 3,000 4,500 1,500
--
Profit Before Tax 3,000 1,500 4,500
Financial Leverage 2 4 1.33
Illustration No. 7
Given below the following data of two companies :
Particulars A Ltd. B. Ltd.
Sales 4,00,000 3,50,000
Variable Cost 40% of Sales 40% of Sales
Fixed Cost 25,000 30,000
Interest 1,40,000 80,000
Calculate degree of operating leverage and degree of financial leverage.
Solution :
Statement showing computation of OL and FL
in Rs.
Particulars A Ltd. B Ltd.

Sales 4,00,000 3,50,000

Less - Variable Cost 1,60,000 1,40,000
Contribution 2,40,000 2,10,000
Less - Fixed Cost 25,000 30,000
EBIT 2,15,000 1,80,000

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Degree of Operating 1.12 1.17

Leverage
Interest 1,40,000 80,000
EBT 2,75,000 1,00,000
Degree of Financial 2.87 1.80
Leverage
Illustration No. 8
The following data is available for ABC Ltd.
Rs.
Sales 7,50,000
Variable Cost 4,20,000
Fixed Cost 60,000
Debt 4,50,000
Interest on Debt @ 9%
Equity Capital 5,50,000

Calculate ROI, Operating, financial and combined leverage. Also ascertain the
level at which EBIT will be zero.
Solution :
Return on Investment
Sales - Variable Cost - Fixed Cost
EBIT = Rs. 7,50,000 - Rs. 4,20,000 - Rs. 60,000 = Rs. 2,70,000
Rs. 2,70,000
ROI = ------------------ * 100 = 27%
Rs. 10,00,000
Operating Leverage

C Rs. 3,30,000
------- = ------------------ = 1.22
EBIT Rs. 2,70,000
Financial Leverage

EBIT Rs. 2,70,000

------- = ------------------ = 1.17
EBT Rs. 2,29,500

Combined Leverage = 1.17 * 1.22 = 1.43 Sales

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when EBIT will be zero

Rs. 3,30,000
P/V Ratio = ------------------ * 100 = 44%
Rs. 7,50,000

Fixed Cost = 60,000 + 40,500 = 1,00,500

Rs. 1,00,500

BEP = ------------------ = Rs. 228409

44%

Illustration No. 9
The following details are available :
Existing equity capital 10,000 shares of Rs. 10 each
Proposals to Raise Rs. 1,00,000 with following alternatives
(a) Debt at 10%
(b) Equity capital @ Rs. 10 per share
(c) Preference shares of Rs. 10 each @ 12% dividend
EBIT Rs. 80,000
Tax Rate 50%
Advise which of the method of financing would be most suitable.
Which is the most optimum proposal of financing?
Solution :
Optimum proposal of financing
in Rs.
Particulars I II III

EBIT 80,000 80,000 80,000

Less - Interest 10,000 - -
EBT 70,000 80,000 80,000
Tax 35,000 40,000 40,000
EAT 35,000 40,000 40,000
Less – Dividend for - - 12,000
Preferences shares
Earnings per shareholders 35,000 40,000 28,000
No. of shares 11,000 10,000 10,000
EPS 3.18 4.00 2.80

Proposal – II is the optimum proposal, as it has the highest EPS compare to other two proposals.

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