leverage explanation with explanation

1. BY ROLL NO ;- 25

2. MEANING OF FINANCIAL LEVERAGE
 The use of the fixed-charges sources of funds, such as debt
and preference capital along with the owners’ equity in the
capital structure, is described as financial leverage or
gearing or trading on equity.
 The financial leverage employed by a company is intended
to earn more return on the fixed-charge funds than their
costs. The surplus (or deficit) will increase (or decrease) the
return on the owners’ equity. The rate of return on the
owners’ equity is levered above or below the rate of return
on total assets.
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3. MEASURES OF FINANCIAL LEVERAGE
 Debt ratio
 Debt–equity ratio
 Interest coverage
 The first two measures of financial leverage can be
expressed either in terms of book values or market
values. These two measures are also known as
measures of capital gearing.
 The third measure of financial leverage, commonly
known as coverage ratio. The reciprocal of interest
coverage is a measure of the firm’s income gearing.
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4. DEGREE OF FINANCIAL LEVERAGE
 The degree of financial leverage (DFL) is defined as the
percentage change in EPS due to a given percentage
change in EBIT:
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5. EPS AND ROE CALCULATIONS
 For calculating ROE either the book value or the market value
equity may be used.
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6. EXAMPLE SHOWING IMPACT OF FINANCIAL
LEVERAGES ON THE EARNINGS PER SHARE
All - equity Debt - equity
1 Investment 5,00,000 5,00,000
2 Equity capital 500000 250000
3 Debt capital @ 15 % 0 250000
4 Earning before interest and tax 120000 120000
5 Less: interest 0 37500
Profit before tax 120000 82500
6 Less: taxes@50% 60000 41250
Profit after tax 60000 41250
7 No. of equity shares 50000 25000
8 Earning per share(5 -:- 6) 1.20 1.65
This indicates that EPS increases as debt is introduced in capital
structure.

7. 7
FINANCIAL LEVERAGE OF TEN LARGEST INDIAN
COMPANIES, 2008

8. ANALYZING ALTERNATIVE FINANCIAL
PLANS:
CONSTANT EBIT
 The firm is considering two
alternative financial plans:
 (i) either to raise the entire
funds by issuing 50,000
ordinary shares at Rs 10 per
share, or
 (ii) to raise Rs 250,000 by
issuing 25,000 ordinary
shares at Rs 10 per share
and borrow Rs 250,000 at 15
per cent rate of interest.
 The tax rate is 50 per cent.
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Effect of Financial Plan on EPS and ROE:
Constant EBIT
Financial plan
All-equity Debt-
equity
1. Earnings before
interest
and tax , EBIT
1,20,000 1,20,000
2. Less : interest
3. Profit before taxes,
PBT = EBIT - INT
1,20,000 82,500
4. Less : taxes
5. Profit after tax 60,000 41,250
6.T otal earning of investor
PAT + INT
60,000 78,750
7. No of ordinary shares 50,000 25,000
8. EPS= (EBIT - INT) (1-
T)/N
1.20 1.65
9. ROE = (EBIT - INT)(1-
T)/E
12.0 16.5%

9. ANALYZING ALTERNATIVE FINANCIAL
PLANS:
CONSTANT EBIT
 The firm is considering
two alternative financial
plans:
 (i) either to raise the entire
funds by issuing 50,000
ordinary shares at Rs 10
per share, or
 (ii) to raise Rs 250,000 by
issuing 25,000 ordinary
shares at Rs 10 per share
and borrow Rs 250,000 at
15 per cent rate of interest.
 The tax rate is 50 per
cent. 9
Effect of Financial Plan on EPS and ROE:
Constant EBIT

10. INTEREST TAX SHIELD
 The interest charges are tax deductible and, therefore,
provide tax shield, which increases the earnings of the
shareholders.
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11. EFFECT OF LEVERAGE ON ROE AND EPS
Favourable ROI > i
Unfavourable ROI < i
Neutral ROI = i
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ROE- Return on equity ;, EPS- Earnings' per share ;, ROI - Return
on investment

12. OPERATING LEVERAGE
 Operating leverage
affects a firm’s operating
profit (EBIT).
 The degree of
operating leverage
(DOL) is defined as the
percentage change in
the earnings before
interest and taxes
relative to a given
percentage change in
sales.
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% Change in EBIT
DOL
% Change in Sales
EBIT/EBIT
DOL
Sales/Sales





13. OPERATING LEVERAGE
 One potential “effect” caused by the
presence of operating leverage is that a
change in the volume of sales results in
a “more than proportional” change in
operating profit (or loss).
Operating Leverage -- The use of
fixed operating costs by the firm.

14. IMPACT OF OPERATING LEVERAGE ON
PROFITS
Firm F Firm V Firm 2F
Sales $10 $11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit $ 1 $ 2 $ 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72
(in thousands)

15. IMPACT OF OPERATING LEVERAGE ON
PROFITS
 Now, subject each firm to a 50% increase
in sales for next year.
 Which firm do you think will be more
“sensitive” to the change in sales (i.e.,
show the largest percentage change in
operating profit, EBIT)?
[ ] Firm F; [ ] Firm V; [ ] Firm 2F.

16. IMPACT OF OPERATING LEVERAGE ON
PROFITS
Firm F Firm V Firm 2F
Sales $15 $16.5 $29.25
Operating Costs
Fixed 7 2 14
Variable 3 10.5 4.5
Operating Profit $ 5 $ 4 $10.75
Percentage Change
in EBIT* 400% 100% 330%
(in thousands)
* (EBITt - EBIT t-1) / EBIT t-1

17. IMPACT OF OPERATING LEVERAGE ON
PROFITS
 Firm F is the most “sensitive” firm -- for it, a 50%
increase in sales leads to a 400% increase in EBIT.
 Our example reveals that it is a mistake to assume
that the firm with the largest absolute or relative
amount of fixed costs automatically shows the most
dramatic effects of operating leverage.
 Later, we will come up with an easy way to spot the
firm that is most sensitive to the presence of
operating leverage.

18. RISK-RETURN TRADE-OFF
 If the firm wants higher return (EPS or ROE) for the
shareholders for a given level of EBIT, it will have to
employ more debt and will also be exposed to greater
risk (as measured by standard deviation or coefficient of
variation).
 In fact, the firm faces a trade-off between risk and return.
 Financial leverage increases the chance or probability of
insolvency.
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19. THE END