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

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