Leverage

Costs
Fixed Costs & Variable Costs.
Two types of Fixed Charges:
(i) Stems from the cost structure.
(ii) Originates from financing structure.
The impact of both these fixed charges on the
earnings of the share holders of the firm is
referred to as leverage.

Income Statement
Amount

Sales Revenue
Less: Variable Costs
Contribution

***
*
**

Less: Fixed Costs

EBIT
Less: Interest

**
*

PBT
Less: Tax
PAT

**
*
**

Less: Preference Dividend

Earnings for Equity Shareholders

*
**

Operating Leverage
Operating leverage can be defined as change in EBIT due to
change in sales.
If all the costs of production are variable, the expected
percentage change in EBIT will be equal to the percentage change
in sales.
Operating leverage measures the sensitivity of firms profit (EBIT)
to the change in sales.
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.
% Change in EBIT
% Change in Sales
EBIT/EBIT
DOL
Sales/Sales
DOL

DOL = [Q(S-V)]/ [Q(S-V)-F]

Example:
Quantity Produced = 5000 units
Selling price per unit = Rs.500
Variable costs per units = Rs.200
Fixed cost = Rs.9,00,000
Calculate DOL.

Implications of DOL
DOL answer the following question: If output
(quantity produced & sold) is increased by 10
percent by what percentage will the operating
income increase?
DOL measures the Business Risk: Business risk refers
to the uncertainty or variability of the firms EBIT.
Other things being equal, the higher the DOL means
higher the business risk & vice-versa.
Production Planning (Introduction of labor Saving
Machine): The method of production which
increases DOL is justified only if there is a very high
probability that sales will be high so that, the firm
can enjoy the increased earnings of increased DOL.

Financial Leverage
While operating leverage measures the change in
the EBIT to a particular change in the output
sold, the financial leverage measures the effect
of the change in EBIT on EPS of the company.

Financial leverage also refers to the debt-equity

ratio in the capital structure of the company.
The degree of financial leverage (DFL) is defined
as the percentage change in EPS due to a given
percentage change in EBIT.

 Example:
Capital Structure

Amount

5,00,000 equity shares of Rs.10 each

50,00,000

12% Preference Shares

5,00,000

10% Debenture

5,00,000

Total

60,00,000

The corporate tax rate is 40%. Calculate DFL when

EBIT is Rs.4,00,000.

 Impact of Financial Leverage on Investors

Rate of Return.
Financial Leverage and Risk.
(i) Increased fluctuation of RoE
(ii) Increased the interest on debts.

Total Leverage
The degree of combined leverage (DCL) is
given by the following equation:
DCL = DOL DFL

% Change in EBIT % Change in EPS

% Change in EPS

% Change in Sales % Change in EBIT % Change in Sales

DCL

Q( s v)
Q( s v) F
Q(s v)

Q ( s v ) F Q ( s v ) F INT Q ( s v ) F INT