This document discusses financial and operating leverage. It defines key terms like capital structure, financial leverage, and operating leverage. It explains how to measure financial leverage using ratios like debt ratio, debt-equity ratio, and interest coverage. It discusses how financial leverage can impact return on equity and earnings per share. The document also distinguishes between operating risk and financial risk and how financial leverage can increase risk for shareholders through increased variability of earnings per share.
Risk and Return: An Overview of Capital Market Theory PANKAJ PANDEY
Discuss the concepts of average and expected rates of return.
Define and measure risk for individual assets.
Show the steps in the calculation of standard deviation and variance of returns.
Explain the concept of normal distribution and the importance of standard deviation.
Compute historical average return of securities and market premium.
Determine the relationship between risk and return.
Highlight the difference between relevant and irrelevant risks.
Risk and Return: An Overview of Capital Market Theory PANKAJ PANDEY
Discuss the concepts of average and expected rates of return.
Define and measure risk for individual assets.
Show the steps in the calculation of standard deviation and variance of returns.
Explain the concept of normal distribution and the importance of standard deviation.
Compute historical average return of securities and market premium.
Determine the relationship between risk and return.
Highlight the difference between relevant and irrelevant risks.
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.
Definition of leverage, Types of Leverages, meaning of operating leverage, financial leverage, combined leverage, Formulas for Operating and financial leverage, variable cost, fixed cost, EBIT, Contribution, EPS-EBIT Analysis, Income statement, practical problems on leverages, etc.
This PPT contains the full detail of topic leverage in financial management
it covers following topics :-
Meaning of Leverage
Types of Leverage
Operating Leverage
Financial Leverage
Difference between Operating & Financial Leverage
Combined Leverage
Illustrations
Exercise
Leverages one of the most difficult to understand and interpret in financial management.. Here's a short explanation with calculation of financial and operating leverages..
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.
Definition of leverage, Types of Leverages, meaning of operating leverage, financial leverage, combined leverage, Formulas for Operating and financial leverage, variable cost, fixed cost, EBIT, Contribution, EPS-EBIT Analysis, Income statement, practical problems on leverages, etc.
This PPT contains the full detail of topic leverage in financial management
it covers following topics :-
Meaning of Leverage
Types of Leverage
Operating Leverage
Financial Leverage
Difference between Operating & Financial Leverage
Combined Leverage
Illustrations
Exercise
Leverages one of the most difficult to understand and interpret in financial management.. Here's a short explanation with calculation of financial and operating leverages..
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2. LEARNING OBJECTIVES
Explain the concept of financial leverage
Discuss the alternative measures of financial leverage
Understand the risk and return implications of
financial leverage
Analyze the combined effect of financial and operating
leverage
Highlight the difference between operating risk and
financial risk
2
3. Capital Structure Defined
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.
3
5. While making the Financing Decision...
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?
5
6. 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.
6
7. 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.
7
10. Financial Leverage and the Shareholders’
Return
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.
10
11. EPS and ROE Calculations
For calculating ROE either the book value or the market
value equity may be used.
11
12. Analyzing Alternative Financial Plans:
Constant EBIT
Management is expecting return of 24 % on Total
inveatment of Rs 5,00,000
EBIT=500000*0.24=120,000
12
13. 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.
13
Effect of Financial Plan on EPS and ROE:
Constant EBIT
14. Interest Tax Shield
The interest charges are tax deductible and,
therefore, provide tax shield, which increases the
earnings of the shareholders.
=0.5*37500=Rs 18750
In this example effect of leverage is favourable
As ROI > i
14
15. Effect of Leverage on ROE and EPS
Favourable ROI > i
Unfavourable ROI < i
Neutral ROI = i
15
18. EPS INCREASES in all plans with improves EBIT.
The imp. Thing is as financial leverage is increased
Eps is further magnified.
When EBIT increase from 120 to 160-an increase
of 33 %,EPS under no financial leverage increase
same at rate (33%)
But EPS increases faster under high leverage plans
18
20. Calculation of indifference point
The EPS formula under all-equity plan is
The EPS formula under debt–equity plan is:
Setting the two formulae equal, we have:
20
21. Sometimes a firm may like to make a choice between two
levels of debt. Then, the indifference point formula will be:
The firm may compare between an all-equity plan and an
equity-and-preference share plan. Then the indifference point
formula will be:
21
Calculation of indifference point
22. 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.
22
% Change in EBIT
DOL
% Change in Sales
EBIT/EBIT
DOL
Sales/Sales
=
∆
=
∆
24. 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:
24
26. Combining Financial and Operating Leverages
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.
26
27. Combining Financial and Operating Leverages
The degree of combined leverage (DCL) is given
by the following equation:
another way of expressing the degree of combined
leverage is as follows:
27
% 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
− − − −
= × =
− − − − − − − −
28. If dcl=4.85
Means combined effect of leverage is to increase
EPS BY 4.85 times for one unit increase in sales.
28
29. Financial Leverage and the Shareholders’
Risk
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. Financial risk is an
avoidable risk if the firm decides not to use any debt in its
capital structure.
29
30. Measuring Operating and Financial Risk
We can use two measures of risk:
Standard deviation and
Coefficient of variation.
30
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
σ
=
=
= − + − + + −
= −
= × + × + + =
∑
∑
L
L
31. 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.
31