•Leverage is the effect on earnings available to the
shareholders due to the use of fixed cost capital
•Higher is the leve...
Types of leverages
1. Operating leverage
2. Financial leverage
3. Composite leverage
1. Operating leverage
 It is defined as the tendency of the operating profit to vary
disproportionately with sales.
 The...
1. Operating leverage (cont…d)
Degree of operating leverage= % change in profit
% change in sales
 A small drop in sales ...
1. Operating leverage (cont..d)
 Statement showing operating leverage
Situation 1 Situation 2 Situation 3
(i) Sales 4000 ...
2. Financial leverage
 The use of fixed source of funds such as debt and preference
capital along with equity capital in ...
2. Financial leverage(cont…d)
 Solution Situation I Situation II Situation III
EBIT 100000 60000 140000
Less Interest 200...
3. Composite Leverage
Composite leverage= Operating leverage x Financial leverage
 It is the combined effect of operating...
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Leverages

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Leverages

  1. 1. •Leverage is the effect on earnings available to the shareholders due to the use of fixed cost capital •Higher is the leverage, higher is the risk and higher is the expected return
  2. 2. Types of leverages 1. Operating leverage 2. Financial leverage 3. Composite leverage
  3. 3. 1. Operating leverage  It is defined as the tendency of the operating profit to vary disproportionately with sales.  The firm is said to have high degree of operating leverage if it employs a greater amount of fixed cost and a small amount of variable cost.  On the other hand, a firm will have a low operating leverage when it employs a greater amount of variable costs and a smaller amount of fixed cost  There will be no operating leverage, if there is no fixed operating costs. Operating leverage = Contribution Operating profit Note: Operating profit means earnings before interest and tax(EBIT)  Operating leverage may be favorable or unfavorable. Incase contribution (ie, sales less variable cost) exceeds fixed cost, there is favorable operating leverage. In the reverse case, the operating leverage will be termed as unfavorable.
  4. 4. 1. Operating leverage (cont…d) Degree of operating leverage= % change in profit % change in sales  A small drop in sales can be excessively damaging to the firm’s efforts to achieve profitability, if a firm has a high degree of operating leverage  Eg: The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling price per unit is Rs 10. Variable cost is Rs 6/unit. Calculate the operating leverage in each of the following three solutions. a) When fixed cost are Rs 400 b) When fixed cost are Rs 1000 c) When fixed cost are Rs 1200
  5. 5. 1. Operating leverage (cont..d)  Statement showing operating leverage Situation 1 Situation 2 Situation 3 (i) Sales 4000 4000 4000 (ii) Variable cost 2400 2400 2400 (iii) Contribution (S-V) 1600 1600 1600 (iv) Fixed cost 400 1000 1200 (v) Operating profit(C-F) 1200 600 400 (vi) Operating leverage(C :- OP) 1.33 2.67 4.00 The above example shows that the degree of operating leverage increases with every increase in share of fixed cost in the total capital structure. In situation 3 it shows that if sales increases by one rupee, the profit would increase by Rs 4
  6. 6. 2. Financial leverage  The use of fixed source of funds such as debt and preference capital along with equity capital in the capital structure is described as financial leverage or gearing or trading on equity Degree of financial leverage= % change in EPS % change in EBIT Eg: A co. has the following capital structure 10000 equity shares of Rs 10 each 100000 2000, 10% preference shares of Rs 100 each 200000 2000, 10% debentures of Rs 100 each 200000 Calculate the EPS for each of the following levels of EBIT(i)Rs 100000 (ii) Rs 60000 (iii) 140000 .The co. is in 50% tax bracket Calculate the financial leverage taking EBIT level under each base
  7. 7. 2. Financial leverage(cont…d)  Solution Situation I Situation II Situation III EBIT 100000 60000 140000 Less Interest 20000 20000 20000 EBT 80000 40000 120000 Less Tax 40000 20000 60000 PAT 40000 20000 60000 Less preference dividend 20000 20000 20000 Earnings available for equity shareholders 20000 Nil 40000 EPS 2 --- 4 a) In case (ii) if the EBIT has decreased by 40% ((ie, from 100000 to 60000) EPS has decreased by 1000% (ie, from 2/share to Nil b) In case (iii) if the EBIT has increased by 40% (from 100000 to 140000) as compared to case (i) EPS has increased by 100% (from Rs 2 to Rs 4/share)
  8. 8. 3. Composite Leverage Composite leverage= Operating leverage x Financial leverage  It is the combined effect of operating and financial leverage.

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