This document discusses different types of leverage used in business - operating, financial, and combined leverage. Operating leverage is related to fixed operating costs and how they magnify changes in sales on earnings. Financial leverage uses fixed financing costs to magnify the effect on earnings per share. Combined leverage is the product of operating and financial leverage. Degrees of leverage are defined to quantify the effects. Indifference points are discussed as the earnings level where leveraged vs unleveraged financing plans yield equal shareholder returns. Analysis of earnings-per-share for different financing options is based on expected earnings levels relative to the indifference point.

1. OPERATING, FINANCIAL &
COMBINED LEVERAGE
PRESENTED BY
SIMRAN KAUR

2. LEVERAGE
 Leverage is the employment of an
asset/source of finance for which firm
pays fixed cost/fixed return
 If earnings available to shareholders
less than variable cost exceed the
fixed cost, or earnings before interest
and taxes exceed the fixed return
requirement, the leverage is called
favourable

3. TYPES OF LEVERAGE
 OPERATING LEVERAGE : leverage
associated with investment (asset
acquisition) activities
 FINANCING LEVERAGE : leverage
associated with financing activities

4. OPERATING LEVERAGE
 Operating leverage may be defined as
the firm’s ability to use fixed operating
costs to magnify the effects of
changes in sales on its earning before
interest and taxes.
 It is determined by the relationship
between the firm’s sales revenues and
its earning before interest and taxes.
 It is caused due to fixed operating
expenses in a firm.

5. OPERATING LEVERAGE
The operating costs of a firm fall into
three categories:
1. Fixed costs : which don’t vary with
sales volume
2. Variable costs : which vary directly
with sales
3. Semi-variable or Semi-fixed costs :
which are partly fixed and partly
variable

6. DEGREE OF OPERATING
LEVERAGE (DOL)
 DOL measures in quantitative terms the
extent or degree of operating leverage
 The greater the DOL, the higher is the
operating leverage
 DOL =
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
∗ 100
 EBIT = Q(S-V)-F
Where Q = sales quantity in units
S = selling price per unit
V = variable cost per unit
F = total fixed cost

7. DEGREE OF OPERATING
LEVERAGE (DOL)
 Since DOL depends on fixed
operating costs, it largely follows that
the larger the fixed operating costs,
the higher is the degree of operating
leverage of the firm.
 Higher operating leverage is good
when revenues are rising and bad
when they are falling.

8. FINANCIAL LEVERAGE
 Financial leverage is defined as the
ability of a firm to use fixed financial
charges to magnify the effect of
changes in EBIT on EPS
 It is caused due to fixed financial costs
(interests) to the firm
 It represents the relationship between
the firm’s earnings before interest and
taxes (operating profits) and the
earnings available for ordinary
shareholders

9. FINANCIAL LEVERAGE
 Use of fixed interest source of funds
provides increased return on equity
investment without additional
requirements of funds from
shareholders. Thus, it is also called
“trading on equity”
 It measures the degree of the use of
debt and other fixed cost sources of
fund to finance the assets of the firm
has required
 It can be expressed in “Stock terms”
and “Flow terms”

10. STOCK TERMS OF FINANCIAL
LEVERAGE
 The financial leverage can be
measured either by (a) a simple ratio
of debt to equity, or (b) by the ratio of
long-term debt plus preference share
to total capitalization
 Each of these measures indicates the
relative proportion of the funds to total
funds of the firm on which it is to pay
fixed financial charges

11. FLOW TERMS OF FINANCIAL
LEVERAGE
 The financial leverage can be
measured either by (a) the ratio of
EBIT to interest payments or (b) the
ratio of cash flows to interest payment,
popularly called debt service
capacity/coverage.
 These coverage ratios are useful to
the suppliers of the funds as they
assess the degree of risk associated
with lending to the firm

12. DEGREE OF FINANCIAL
LEVERAGE (DFL)
 DFL =
%𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
> 1
 DFL =
𝐸𝐵𝐼𝑇
(𝐸𝐵𝐼𝑇−𝐼)
, when debt is used
 DFL =
𝐸𝐵𝐼𝑇
(𝐸𝐵𝐼𝑇−𝐼−𝐷 𝑝) (1−𝑡)
, when debt
and preference capital is used
 DFL =
𝐸𝐵𝐼𝑇
[𝐸𝐵𝐼𝑇−𝐼−(𝐷 𝑝+𝐷𝑡) (1−𝑡)]
, when
dividends paid on preference share
capital are subject to dividend tax

13. COMBINED LEVERAGE
Combined leverage is the product of
operating leverage and financial
leverage
CL = OL * FL

14. DEGREE OF COMBINED
LEVERAGE
 DCL = DOL * DFL
 DCL =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐸𝐵𝐼𝑇−𝐼
 DCL measures the percentage
change in EPS due to percentage
change in sales

15. IMPORTANT TERMS
 FINANCIAL RISK : risk of not being able
to cover fixed financial costs by a firm
 FINANCIAL BREAK-EVEN POINT : level
of EBIT which is equal to firm’s fixed
financial costs
 INDIFFERENCE POINT : EBIT level
beyond which benefits of financial
leverage accrue with respect to EPS
 EBIT-EPS ANALYSIS : comparison of
alternative methods of financing at
various levels of EBIT

16. INDIFFERENCE POINT FOR A
NEW COMPANY
 Equity shares versus Debentures
𝑋(1 − 𝑡)
𝑁1
=
(𝑋 − 𝐼)(1 − 𝑡)
𝑁2
 Equity shares versus Preference
shares
𝑋(1 − 𝑡)
𝑁1
=
𝑋 1 − 𝑡 − 𝐷 𝑝
𝑁3
 Equity shares versus Preference
shares with tax on Preference
dividend
𝑋(1 − 𝑡) 𝑋 1 − 𝑡 − 𝐷 𝑝(1 + 𝐷𝑡)

17. INDIFFERENCE POINT FOR A
NEW COMPANY
 Equity shares versus Preference
shares and Debentures
𝑋(1 − 𝑡)
𝑁1
=
𝑋 − 𝐼 1 − 𝑡 − 𝐷 𝑝
𝑁3

18. INDIFFERENCE POINT FOR AN
EXISTING COMPANY
If the debentures are already
outstanding, let us assume 𝐼1 =
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 𝑜𝑛 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑑𝑒𝑏𝑡 𝑎𝑛𝑑
𝐼2
= 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑑𝑒𝑏𝑡,
Then indifference point would be
determined by
(𝑋 − 𝐼1)(1 − 𝑡)
𝑁1
=
(𝑋 − 𝐼1 − 𝐼2)(1 − 𝑡)
𝑁2

19. NOTATIONS IN INDIFFERENCE
POINT
 X = EBIT at indifference point
 𝑁1 = Number of equity shares
outstanding if only equity shares are
issued
 𝑁2 = Number of equity shares
outstanding if both debentures and
equity shares are issued
 𝑁3 = Number of equity shares
outstanding if both preference and
equity shares are issued

20. NOTATIONS IN INDIFFERENCE
POINT
 𝑁4 = Number of equity shares
outstanding if both preference shares
and debentures are issued
 I = Amount of interest on debentures
 𝐷 𝑝 = Amount of dividend on preference
shares
 t = Corporate income tax rate
 Dt = tax on preference dividend

21. EBIT-EPS ANALYSIS
 If the expected level is to exceed the
indifference level of EBIT, the use of
fixed-charge source of funds (debt)
would be advantageous from the
viewpoint of EPS, that is, financial
leverage will be favourable and lead to
an increase in EPS available to
shareholders
 If the expected level of EBIT is less
than the indifference point, the
advantage of EPS would be available
from the use of equity capital

22. EBIT-EPS ANALYSIS
 The greater the likely level of EBIT
than the indifference point, the
stronger is the case for using levered
financial plans to maximize EPS
 The lower the likely level of EBIT in
relation to the indifference point, the
more useful the unlevered financial
plan would be from the viewpoint of
EPS

23. EBIT-EPS ANALYSIS
On the basis of level of EBIT which
ensures identical market price for
alternative financial plans, the
indifference point can be symbolically
computed by
𝑃 𝐸1
𝑋 1−𝑡
𝑁1
= 𝑃 𝐸2[
𝑋−𝐼 1−𝑡 −𝐷 𝑝
𝑁2
]
Where
𝑃 𝐸1= 𝑃 𝐸 ratio of unlevered plan
𝑃 𝐸2 = 𝑃 𝐸 ratio of levered plan

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