The Use of Leverage &
Financial structure
The Use of Leverage &
Financial structure
Financial Management-II
Department of Commerce
University of North Bengal
Topics in the Syllabus
Operating and Financial Leverage:
1. Effects of operating and financial
leverage on profit
2. Measu...
LEVERAGE
Leverage factor is defined as the ratio of total debt
to total assets.
Let us suppose that a firm’s total asset i...
RISK
Business Risk:
It means the inherent
uncertainty or variability
of expected returns on
the firm’s assets (EBIT).
Fina...
CAPITAL STRUCTURE OF FOUR
DIFFERENT FIRMS
Debt
Equity
25% Leverage factor=20%=
Debt
Equity
0 Leverage factor=0=
FIRM-A
LIA...
CAPITAL STRUCTURE OF FOUR DIFFERENT
FIRMS
Debt
Equity
4
4 or 400% Leverage factor= or 80%
5
=
Debt 1
Equity 2
1 or 100% Le...
Additional Information
• The Rate of Interest on debt = 10 percent
• The Tax Rate is = 50 percent
• Variable Costs = 40 pe...
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 ...
FIRM-A          
EBIT   -2000 1600 4000 10000
  Less Interest 0 0 0 0
  Less Tax -1000 800 2000 5000
Net Profit after
Taxe...
FIRM- B
EBIT   -2000 1600 4000 10000
 
Less Interest
(10% of 2000) 200 200 200 200
 
Earnings before
Taxes -2200 1400 3800...
FIRM-C          
EBIT   -2000 1600 4000 10000
 
Less Interest
(10% of 5000) 500 500 500 500
 
Earnings before
Taxes -2500 ...
FIRM-D          
EBIT   -2000 1600 4000 10000
 
Less Interest (10% 
of 8000) 800 800 800 800
 
Earnings before 
Taxes -280...
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 ...
Return on Stockholders Equity
EBIT -2000 1600 4000 10000
Return on Stockholders Equity A -10 8 20 50
Return on Stockholder...
END
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Leverage & financial structure

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Effects of operating and financial leverage on profit, Measurement of leverages, Analyzing alternate financial plans, combined financial and operating leverage.

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Leverage & financial structure

  1. 1. The Use of Leverage & Financial structure
  2. 2. The Use of Leverage & Financial structure Financial Management-II Department of Commerce University of North Bengal
  3. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 16. END

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