Financial leverage

1. Financial and Operating
Leverage

2.  Explain the concept of financial leverage.
 Discuss the alternative measures of
financial leverage.
 Understand the risk and return
implications of financial leverage.
 Analyse the combined effect of financial
and operating leverage.
 Highlight the difference between operating
risk and financial risk.
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3.  The term capital structure is used to
represent the proportionate relationship
between debt and equity.
 The various means of financing represent
the financial structure of an enterprise. The
left-hand side of the balance sheet
(liabilities plus equity) represents the
financial structure of a company.
Traditionally, short-term borrowings are
excluded from the list of methods of
financing the firm’s capital expenditure.
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4.  How should the investment project be financed?
 Does the way in which the investment projects
are financed matter?
 How does financing affect the shareholders’
risk, return and value?
 Does there exist an optimum financing mix in
terms of the maximum value to the firm’s
shareholders?
 Can the optimum financing mix be determined
in practice for a company?
 What factors in practice should a company
consider in designing its financing policy?
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5.  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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6.  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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7. Company Capital Gearing Income Gearing
Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio
1. Indian Oil 0.556 1.25:1 4.00 0.250
2. HPCL 0.350 0.54:1 5.15 0.194
3. BPCL 0.490 0.96:1 5.38 0.186
4. SAIL 0.858 6.00:1 - ve - ve
5. ONGC 0.106 0.12:1 53.49 0.019
6. TELCO 0.484 0.94:1 0.99 1.007
7. TISCO 0.577 1.37:1 1.62 0.616
8. BHEL 0.132 0.15:1 8.36 0.120
9. Reliance 0.430 0.75:1 3.46 0.289
10. L&T 0.522 1.09:1 2.31 0.433
11. HLL 0.027 0.03:1 264.92 0.004
12. Infosys 0.000 0.00:1 NA* NA*
13. Voltas 0.430 0.72:1 2.64 0.378
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8.  The primary motive of a company in using
financial leverage is to magnify the
shareholders’ return under favourable economic
conditions. The role of financial leverage in
magnifying the return of the shareholders’ is
based on the assumptions that the fixed-
charges funds (such as the loan from financial
institutions and banks or debentures) can be
obtained at a cost lower than the firm’s rate of
return on net assets (RONA or ROI).
 EPS, ROE and ROI are the important figures for
analysing the impact of financial leverage.
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9.  For calculating ROE either the book value
or the market value equity may be used.
9
N
)
T
1
)(
INT
EBIT
(
N
PAT
=
EPS
shares
of
Number
after tax
Profit
=
share
per
Earnings



S
)
T
INT)(1
(EBIT
=
ROE
equity
of
Value
after tax
P rofit
=
equity
on
Return



10.  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.
Financial Plan
Debt-equity
(Rs)
All-equity
(Rs)
1. Earnings before interest and taxes,
EBIT
120,000 120,000
2. Less: interest, INT 0 37,500
3. Profit before taxes, PBT = EBIT –
INT
120,000 82,500
4. Less: Taxes, T (EBIT – INT) 60,000 41,250
5. Profit after taxes, PAT = (EBIT –
INT) (1 – T)
60,000 41,250
6. Total earnings of investors, PAT +
INT
60,000 78,750
7. Number of ordinary shares, N 50,000 25,000
8. EPS = (EBIT – INT) (1 – T)/N 1.20 1.65
9. ROE = (EBIT – INT) (1 – T)/S 12.0% 16.5%
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11. Favourable ROI > i
Unfavourable ROI < i
Neutral ROI = i
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12. Economic Conditions
Very poor Poor Normal Good
Probability 0.05
0.10 0.15 0.35 0.30 0.05
Sales (Rs) 510 660 710 800 880 1,160
Costs:
Variable (Rs) 255 330 355 400 440 580
Fixed (Rs) 280 280 280 280 280 280
Total Costs (Rs) 535 610 635 680 720 860
EBIT (Rs) –25 50 75 120 160 300
ROI (r) –5% 10% 15% 24% 32% 60%
Plan I: No debt
EBIT –25.00 50.00 75.00 120.00 160.00 300.00
Less: Interest 0.00 0.00 0.00 0.00 0.00 0.00
PBT –25.00 50.00 75.00 120.00 160.00 300.00
Less: tax, 50% –12.50* 25.00 37.50 60.00 80.00 150.00
PAT –12.50 25.00 37.50 60.00 80.00 150.00
No. of shares (000) 50.00 50.00 50.00 50.00 50.00 50.00
EPS (Rs) –0.25 0.50 0.75 1.20 1.60 3.00
ROE (%) –2.50 5.00 7.50 12.00 16.00 30.00
Plan II: 25% debt
EBIT –25.00 50.00 75.00 120.00 160.00 300.00
Less: Interest 18.75 18.75 18.75 18.75 18.75 18.75
PBT –43.75 31.25 56.25 101.25 141.25 281.25
Less: tax, 50% –21.88* 15.63 28.13 50.63 70.63 140.63
PAT –21.87 15.62 28.12 50.62 70.62 140.62
No. of share (000) 37.50 37.50 37.50 37.50 37.50 37.50
EPS (Rs) –0.58 0.42 0.75 1.35 1.88 3.75
ROE (%) –5.80 4.20 7.50 13.50 18.80 37.50
Plan III: 50% debt
EBIT –25.00 50.00 75.00 120.00 160.00 300.00
Less: Interest 37.50 37.50 37.50 37.50 37.50 37.50
PBT –62.50 12.50 37.50 82.50 122.50 262.50
Less: tax, 50% –31.25* 6.25 18.75 41.25 61.25 131.25
PAT –31.25 6.25 18.75 41.25 61.25 131.25
No. of shares (000) 25.00 25.00 25.00 25.00 25.00 25.00
EPS (Rs) –1.25 0.25 0.75 1.65 2.45 5.25
ROE (%) –12.50 2.50 7.50 16.50 24.50 52.50
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13.  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





14.  Operating leverage affects a firm’s
operating profit (EBIT), while financial
leverage affects profit after tax or the
earnings per share.
 The degrees of operating and financial
leverages is combined to see the effect of
total leverage on EPS associated with a
given change in sales.
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15.  The degree of combined leverage (DCL) is
given by the following equation:
 another way of expressing the degree of
combined leverage is as follows:
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% Change in EBIT % Change in EPS % Change in EPS
% Change in Sales % Change in EBIT % Change in Sales
  
( ) ( ) ( )
DCL
( ) ( ) INT ( ) INT
Q s v Q s v F Q s v
Q s v F Q s v F Q s v F
   
  
       

16.  The variability of EBIT and EPS distinguish
between two types of risk—operating risk and
financial risk.
 Operating risk can be defined as the variability
of EBIT (or return on total assets). The
environment—internal and external—in which a
firm operates determines the variability of EBIT
◦ The variability of EBIT has two components:
◦ variability of sales
◦ variability of expenses
 The variability of EPS caused by the use of
financial leverage is called financial risk.
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17.  We can use two measures of risk:
◦ Standard deviation and
◦ Coefficient of variation.
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2 2 2 2
1 1 2 2
2
1
1 1 2 2
1
(EPS) [EPS (EPS)] [EPS (EPS)] [EPS (EPS)]
[EPS (EPS)]
(EPS) EPS EPS EPS EPS
j j
n
j j
j
n
j j j j
j
E P E P E P
E P
E P P P P



      
 
      

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