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leverage in terms of finance


  2. 2. Introduction • Leverage provides the Framework for Financing Décisions of a Firm. • It May Be définie as the Employment of an Assest or Source of Funds for which the Firm has to pay a Fixed Cost , or Fixed Return. • Deleveraging is the action of reducing borrowings. • A key measure of leverage is the debt to GDP ratio.
  3. 3. Break-Even (BE) Point • Quantity where Total Revenue equals Total Cost • Company has no Profit or Loss • BE = FC / P – VC • A leveraged firm has a high BE point • A non-leveraged firm has a low BE point
  4. 4. Risk in the Context of Leverage • Leverage influences stock price Alters the risk/return relationship in an equity investment • Measures of performance Operating income (EBIT or Earnings Before Interest and Taxes) • Unaf f ect ed by leverage because it is calculat ed prior t o t he deduct ion f or int erest Return on Equity (ROE) is Earnings after Taxes ÷ Stockholders’ Equity Earnings per Share (EPS) is Earnings after Taxes ÷ number of shares • I nvest ors regard EPS as an import ant indicat or of f ut ure prof it abilit y
  5. 5. Risk in the Context of Leverage • Redefining Risk for Leverage-Related Issues • Leverage-related risk is variation in ROE and EPS: 1. Business risk—variation in EBIT 2. Financial risk—additional variation in ROE and EPS brought about by financial leverage. • An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point) • A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)
  6. 6. Business and Financial Risk
  7. 7. Operating Leverage • It is associated with asset acquisition or investment activities. • It may be defined as the ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits(EBIT). • Refers to the amount of fixed costs in the cost structure. • Fixed and Variable Costs and Cost Structure. • Fixed costs don’t change with the level of sales, while variable costs do – Fixed costs include rent, depreciation, utilities, salaries – Variable costs include direct labor, direct materials, sales commissions • The mix of fixed and variable costs in a firm’s operations is its cost structure
  8. 8. The Effect of Operating Leverage • As volume moves away from Breakeven(Used t o det ermine t he level of act ivit y a f irm must achieve t o st ay in business in t he long run), profit or loss increases faster with more operating leverage • The Risk Effect More operating leverage leads to larger variations in EBIT, or business risk • The Effect on Expected EBIT • Thus, when a firm is operating above breakeven, more operating leverage implies higher operating profit  I f a f irm is relat ively sure of it s operat ing level, it is in t he f irm’s best int erest s t o t rade variable cost s f or f ixed cost (assuming t he f irm is operat ing above
  9. 9. Breakeven Diagram at High and Low Operating Leverage
  10. 10. The Degree of Operating Leverage (DOL)—A Measurement • Operating leverage amplifies changes in sales volume into larger changes in EBIT • DOL relates relative changes in volume (Q) to relative changes in EBIT. DOL = %change in EBT %change in Sales DOL = Sales – Variable Costs EBIT
  11. 11. example A company is perfectly selling 5000 units of a product @ Rs 20 per unit. If variable cost is Rs 6 per unit & fixed operational cost are Rs 80000. Find DOL sol :- sales = 20*5000 = 100000 VC = 30000 contribution = 70000 (-) FC = 80000 EBIT = 10000 therefore, DOL = 70000/10000 = 7%
  12. 12. Financial Leverage • Measure of the amount of debt used by a firm. • a  in EBIT (or OI) → a larger  in EPS. • Financial Leverage measures the sensitivity of a firm’s earnings per share to a  in operating income. • Used as a means of increasing the return to common shareholders. • Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS • The degree of financial leverage (DFL) relates relative changes in EBIT to relative changes in EPS. • An easier method of calculating DFL is:- EBIT DFL = EBIT - Interest
  13. 13. Degree of Financial Leverage (DFL) • Degree of Financial Leverage -- The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in operating profit. DFLDFL = Percentage change in earnings per share (EPS) Percentage change in operating profit (EBIT) % EPS DFL = or % EPS = DFL % EBIT % EBIT ∆ ∆ × ∆ ∆
  14. 14. Financial Risk • Financial Risk ---- The added variability in earnings per share (EPS) -- plus the risk of possible insolvency -- that is induced by the use of financial leverage. • Debt increases the probability of cash insolvency over an all-equity-financed firm.
  15. 15. Total Firm Risk
  16. 16. The Compounding Effect of Operating Leverage and Financial Leverage
  17. 17. example Ques :- a company’s EBIT= 10000 & it has 5% bonds for Rs 40000 & preference shares = 20000. Calculate DFL Sol:- EBIT = 10000 (-) Interest = 2000 EBT = 8000 Therefore DFL = 10000/8000 = 1.25
  18. 18. Example Ques :-A co. having a total capital of Rs 10 lacs with 60% as bonds @10% as equity. The expected sales of firm = 20000 units @20 per unit, VC = 10 per period, fixed operational cost = Rs 50000, calcualte DOL, DFL & DCL Sol:- Sales = 400000 VC = 200000 Contri = 200000 (-) FC = 50000
  19. 19. Example contd.... EBIT = 150000 (-) Int =60000 EBT = 90000 Therefore, DOL = 200000/150000 = 1.33 DFL = 150000/90000 = 1.67 DCl = DFL*DOL = 2.22