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- 1. The Use of Leverage & Financial structure
- 2. The Use of Leverage & Financial structure Financial Management-II Department of Commerce University of North Bengal
- 3. Topics in the Syllabus Operating and Financial Leverage: 1. Effects of operating and financial leverage on profit 2. Measurement of leverages 3. Analyzing alternate financial plans 4. Combined financial and operating leverage.
- 4. LEVERAGE Leverage factor is defined as the ratio of total debt to total assets. Let us suppose that a firm’s total asset is Rs. 100.0 which consists of debt Rs. 50.0 and common equity Rs 50.0 Thus Debt Equity Ratio = 1 or 100 percent, and Leverage factor = 0.5 or 50 percent
- 5. RISK Business Risk: It means the inherent uncertainty or variability of expected returns on the firm’s assets (EBIT). Financial Risk: By financial risk we mean the additional risk that is induced by the use of financial leverage.
- 6. CAPITAL STRUCTURE OF FOUR DIFFERENT FIRMS Debt Equity 25% Leverage factor=20%= Debt Equity 0 Leverage factor=0= FIRM-A LIABILITY Rs. Debt 0 Stock 10,000 Total Liability 10,000 ASSETS Rs. Assets- 10,000 Total Assets 10,000 FIRM-B LIABILITY Rs. Debt 2,000 Stock 8,000 Total Liability 10,000 ASSETS Rs. Assets- 10,000 Total Assets 10,000
- 7. CAPITAL STRUCTURE OF FOUR DIFFERENT FIRMS Debt Equity 4 4 or 400% Leverage factor= or 80% 5 = Debt 1 Equity 2 1 or 100% Leverage factor= or 50%= FIRM-C LIABILITY Rs. Debt 5,000 Stock 5,000 Total Liability 10,000 ASSETS Rs. Assets- 10,000 Total Assets 10,000 FIRM-D LIABILITY Rs. Debt 8,000 Stock 2,000 Total Liability 10,000 ASSETS Rs. Assets- 10,000 Total Assets 10,000
- 8. Additional Information • The Rate of Interest on debt = 10 percent • The Tax Rate is = 50 percent • Variable Costs = 40 percent of Sales • Fixed Costs = Rs. 2000 • There are four probable market conditions: Very poor when sales = 0 Poor when sales = Rs. 6,000 Normal when sales = Rs. 10,000 Good when sales = Rs. 20,000 (probability 0.1) (probability 0.3) (probability 0.4) (probability 0.2)
- 9. Probability of Expected Sales 0.1 0.3 0.4 0.2 Sales 0 6000 10000 20000 Fixed Costs 2000 2000 2000 2000 Variable Costs (40 % of Sales) 0 2400 4000 8000 Total Costs 2000 4400 6000 10000 EBIT -2000 1600 4000 10000 EBIT of Each Firm under Four Different Market Conditions
- 10. FIRM-A EBIT -2000 1600 4000 10000 Less Interest 0 0 0 0 Less Tax -1000 800 2000 5000 Net Profit after Taxes -1000 800 2000 5000 Earnings per Share (1000) -1.00 0.80 2.00 5.00 Return on Stockholders Equity (Rs. 10) (percent) -10 8 20 50 EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY
- 11. FIRM- B EBIT -2000 1600 4000 10000 Less Interest (10% of 2000) 200 200 200 200 Earnings before Taxes -2200 1400 3800 9800 Less Tax (50 percent) -1100 700 1900 4900 Net Profit after Taxes -1100 700 1900 4900 Earnings per Share (800) -1.38 0.88 2.38 6.13 Return on Stockholders Equity (Rs. 10) (percent) -13.80 8.80 23.80 61.30 EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY
- 12. FIRM-C EBIT -2000 1600 4000 10000 Less Interest (10% of 5000) 500 500 500 500 Earnings before Taxes -2500 1100 3500 9500 Less Tax (50 percent) -1250 550 1750 4750 Net Profit after Taxes -1250 550 1750 4750 Earnings per Share (500) -2.50 1.10 3.50 9.50 Return on Stockholders Equity (Rs. 10) (percent) -25.00 11.00 35.00 95.00 EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY
- 13. FIRM-D EBIT -2000 1600 4000 10000 Less Interest (10% of 8000) 800 800 800 800 Earnings before Taxes -2800 800 3200 9200 Less Tax (50 percent) -1400 400 1600 4600 Net Profit after Taxes -1400 400 1600 4600 Earnings per Share (200) -7.00 2.00 8.00 23.00 Return on Stockholders Equity (percent) -70.00 20.00 80.00 230.00 EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY
- 14. Expected EPS of four firms Sales Prob A B C D 0 0.1 -1 -1.38 -2.5 -7 6000 0.3 0.8 0.88 1.1 2 10000 0.4 2 2.38 3.5 8 20000 0.2 5 6.13 9.5 23 Expected EPS 1.94 2.304 3.38 7.7 Leverage 0 25 100 400 Var 3.12 4.89 12.51 78.21 sd 1.76 2.21 3.53 8.84
- 15. Return on Stockholders Equity EBIT -2000 1600 4000 10000 Return on Stockholders Equity A -10 8 20 50 Return on Stockholders Equity B -13.8 8.8 23.8 61.3 Return on Stockholders Equity C -25 11 35 95 Return on Stockholders Equity D -70 20 80 230 -100 -50 0 50 100 150 200 250 -2000 1600 4000 10000 Return on Stockholders Equity EBIT B C D A
- 16. END

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