Leverage allows an investor to make an investment larger than what they could with just their own money by borrowing funds and taking on debt. This can increase potential returns but also increases potential losses if the investment declines in value, as the debt still needs to be repaid. There are different types of leverage including operating leverage, which measures fixed vs variable costs, and financial leverage, which measures how net income varies with operating profit due to financing with debt. When analyzing leverage, metrics like degree of financial leverage, degree of operating leverage, and degree of combined leverage are used to understand risk. A case study example compares how different capital structures using equity, debt, or preference shares would impact earnings per share for a firm.

1. Leverages

2. Meaning
Leverage is an investment
technique in which you use a small
amount of your own money to make
an investment of much larger value.
In that way, leverage gives you
significant financial power.

3. The amount of
debt used to
finance a firm's
assets.
A firm with
significantly
more debt than
equity is
considered to
be highly
leveraged.
The amount of
debt used to
finance a firm's
assets.
A firm with
significantly
more debt than
equity is
considered to
be highly
leveraged.
Debt is that which is owed;
usually referencing assets
owed, but the term can
cover other obligations.
Debt is that which is owed;
usually referencing assets
owed, but the term can
cover other obligations.
Equity
The difference between
the market value of a
property & the claims held
against it .
The difference between
the market value of a
property & the claims held
against it .

4. Leverage allows
greater potential
returns to the investor
than otherwise would
have been available
but the potential for
loss is also greater
because if the
investment becomes
worthless, the loan
principal and all
accrued interest on the
loan still need to be
repaid.
Leverage allows
greater potential
returns to the investor
than otherwise would
have been available
but the potential for
loss is also greater
because if the
investment becomes
worthless, the loan
principal and all
accrued interest on the
loan still need to be
repaid.

5. Risk associated
• The most obvious and apparent risk of leverage
is that if price changes unexpectedly, the
leveraged position can end up leading to severe
losses.
• Another limitation of trading on equity is on
account of the fact that every rupee of extra debt
increases the risk and hence the rate of interest
on increasing. it becomes difficult for the
company to obtain further debt without offering
extra securities and higher rate of interest
reducing their earnings

6. Types of Leverages
• Operating leverage
• Financial leverage

7. Operating leverage
• A measurement of the degree to which a
firm or project incurs a combination of
fixed and variable costs.

8. Financial leverage
• Financial leverage may b defined as the
tendency of the residual net income to
vary disproportionately with the operating
profit.
• It indicates the change that takes place in
the taxable income as the result of the
change in the operating profit.
• FL = OP(EBIT)/ PBT

9. Degree of leverage
• Degree of financial leverage
• Degree of operating leverage
• Degree of combined leverage

10. Degree of financial leverage
• DFL= EBIT/PBT
OR
DFL= %change in EPS
%change in EBIT

11. Degree of operating leverage
• DOL = Contribution/PBT
OR
DOL = %change in EBIT
%change in SALES

12. Degree of combined leverage
• DCL= DFL * DOL
OR
%change in EPS
%change in sales

13. Case study
• XYZ ltd. Firm has a capital structure exclusively comprising of
ordinary shares amounting to Rs. 1000000 . The firm now wishes to
raise additional Rs 1000000 for expansion . The firm has 4
alternative financial plans :
• It can raise the entire amount in the form of equity capital
• It can raise 50% as equity capital and 50% as 5% debentures
• It can raise the entire amount as 6% debentures
• It can raise 50% as equity capital and 5% preference capital.
• Further assume that the existing EBIT is Rs. 120000.
The tax rate is 50%,outstanding ordinary shares 10000
And the market price per share is 100 under all the 4
alternatives.

14. • Which financial plan should the firm
select?????

15. Solution
Financial
plans
A B C D
EBIT 120000 120000 120000 120000
Less: Interest -- 25000 60000 --
EBT 120000 95000 60000 120000
Taxes(50%) 60000 47500 30000 60000
PAT 60000 47500 30000 60000
Less: pref.
div.(5%)
-- -- -- 25000
Earning to
ordinary
sh.holders
60000 47500 30000 35000
No. of shares 20000 15000 10000 15000
EPS 3.0 3.17 3 2.33

16. Thank you