Operating, financial and combined leverage

Operating leverage, Financial leverage, Combined leverage, EBIT-EPS analysis

1. OPERATING, FINANCIAL & COMBINED LEVERAGE PRESENTED BY SIMRAN KAUR

2. LEVERAGE Leverage is the employment of an asset/source of finance for which firm pays fixed cost/fixed return If earnings available to shareholders less than variable cost exceed the fixed cost, or earnings before interest and taxes exceed the fixed return requirement, the leverage is called favourable

3. TYPES OF LEVERAGE OPERATING LEVERAGE : leverage associated with investment (asset acquisition) activities FINANCING LEVERAGE : leverage associated with financing activities

4. OPERATING LEVERAGE Operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earning before interest and taxes. It is determined by the relationship between the firm’s sales revenues and its earning before interest and taxes. It is caused due to fixed operating expenses in a firm.

5. OPERATING LEVERAGE The operating costs of a firm fall into three categories: Fixed costs : which don’t vary with sales volume Variable costs : which vary directly with sales Semi-variable or Semi-fixed costs : which are partly fixed and partly variable

6. DEGREE OF OPERATING LEVERAGE (DOL) DOL measures in quantitative terms the extent or degree of operating leverage The greater the DOL, the higher is the operating leverage DOL = EBIT = Q(S-V)-F Where Q = sales quantity in units S = selling price per unit V = variable cost per unit F = total fixed cost  

7. DEGREE OF OPERATING LEVERAGE (DOL) Since DOL depends on fixed operating costs, it largely follows that the larger the fixed operating costs, the higher is the degree of operating leverage of the firm. Higher operating leverage is good when revenues are rising and bad when they are falling.

8. FINANCIAL LEVERAGE Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on EPS It is caused due to fixed financial costs (interests) to the firm It represents the relationship between the firm’s earnings before interest and taxes (operating profits) and the earnings available for ordinary shareholders

9. FINANCIAL LEVERAGE Use of fixed interest source of funds provides increased return on equity investment without additional requirements of funds from shareholders. Thus, it is also called “trading on equity” It measures the degree of the use of debt and other fixed cost sources of fund to finance the assets of the firm has required It can be expressed in “Stock terms” and “Flow terms”

10. STOCK TERMS OF FINANCIAL LEVERAGE The financial leverage can be measured either by (a) a simple ratio of debt to equity, or (b) by the ratio of long-term debt plus preference share to total capitalization Each of these measures indicates the relative proportion of the funds to total funds of the firm on which it is to pay fixed financial charges

11. FLOW TERMS OF FINANCIAL LEVERAGE The financial leverage can be measured either by (a) the ratio of EBIT to interest payments or (b) the ratio of cash flows to interest payment, popularly called debt service capacity/coverage. These coverage ratios are useful to the suppliers of the funds as they assess the degree of risk associated with lending to the firm

12. DEGREE OF FINANCIAL LEVERAGE (DFL) DFL = > 1 DFL = , when debt is used DFL = , when debt and preference capital is used DFL = , when dividends paid on preference share capital are subject to dividend tax  

13. COMBINED LEVERAGE Combined leverage is the product of operating leverage and financial leverage CL = OL * FL

14. DEGREE OF COMBINED LEVERAGE DCL = DOL * DFL DCL = DCL measures the percentage change in EPS due to percentage change in sales  

15. IMPORTANT TERMS FINANCIAL RISK : risk of not being able to cover fixed financial costs by a firm FINANCIAL BREAK-EVEN POINT : level of EBIT which is equal to firm’s fixed financial costs INDIFFERENCE POINT : EBIT level beyond which benefits of financial leverage accrue with respect to EPS EBIT-EPS ANALYSIS : comparison of alternative methods of financing at various levels of EBIT

16. INDIFFERENCE POINT FOR A NEW COMPANY Equity shares versus Debentures Equity shares versus Preference shares Equity shares versus Preference shares with tax on Preference dividend  

17. INDIFFERENCE POINT FOR A NEW COMPANY Equity shares versus Preference shares and Debentures  

18. INDIFFERENCE POINT FOR AN EXISTING COMPANY If the debentures are already outstanding, let us assume Then indifference point would be determined by  

19. NOTATIONS IN INDIFFERENCE POINT X = EBIT at indifference point = Number of equity shares outstanding if only equity shares are issued = Number of equity shares outstanding if both debentures and equity shares are issued = Number of equity shares outstanding if both preference and equity shares are issued  

20. NOTATIONS IN INDIFFERENCE POINT = Number of equity shares outstanding if both preference shares and debentures are issued I = Amount of interest on debentures = Amount of dividend on preference shares t = Corporate income tax rate Dt = tax on preference dividend  

21. EBIT-EPS ANALYSIS If the expected level is to exceed the indifference level of EBIT, the use of fixed-charge source of funds (debt) would be advantageous from the viewpoint of EPS, that is, financial leverage will be favourable and lead to an increase in EPS available to shareholders If the expected level of EBIT is less than the indifference point, the advantage of EPS would be available from the use of equity capital

22. EBIT-EPS ANALYSIS The greater the likely level of EBIT than the indifference point, the stronger is the case for using levered financial plans to maximize EPS 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

23. EBIT-EPS ANALYSIS On the basis of level of EBIT which ensures identical market price for alternative financial plans, the indifference point can be symbolically computed by Where = ratio of unlevered plan = ratio of levered plan  

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