A general meaning of the term leverage refers

to an increased means of accomplishing some

purpose.
In the financial point of view, leverage refers to
firms ability to use fixed cost assets or funds
to increase the return to its shareholders.
The employment of an asset or
fund for which the firm pays a
fixed cost or fixed return.

- James Horne
 Benefits of Leverage
The primary benefit of leverage is that it frees up
your capital, as you only have to commit a
fraction of the value of the assets you are
interested in.
With leverage you can take a much larger
position than you could with a direct physical
holding.
 Effect of Leverage

A hypothetical income statement for a firm :

Sales 2000
Less: Variable costs 800
------
Contribution 1200
Less: Fixed costs 500
------
Profits 700
------
 Sales 2500 (increase of 25%)
Less: Variable costs 1000 (increase of 25%)
------
Contribution 1500 (increase of 25%)
Less: Fixed costs 500 (No change)
--------
Profits 1000 (increase of 43%)
---------

It is fixed costs that introduce leverage into the firm

higher the fixed cost, higher is the leverage.
 Risk
Leverage is a double-edged sword
It magnifies profits as well as losses
An aggressive or highly leveraged firm
has high fixed costs (and a relatively high
break-even point)
A conservative or non-leveraged firm has
low fixed costs (and a relatively low
break-even point)
 BUSINESS RISKS
Business Risk, sometimes called operating
risk, is risk associated with the normal day
to day operations of the firm

Examples : Rentals, Salaries, Electricity

expenses etc.
 FINANCIAL RISKS

Financial Risk is created by use of fixed

cost securities( i.e. debt and preference
shares)

Examples: Interest on Debt, Preference

Dividend.
TYPES OF LEVERAGES

OPERATING
LEVERAGES

FINANCIAL
LEVERAGES

COMPOSITE
LEVERAGES
 FINANCIAL LEVERAGE
The use of long term fixed interest
bearing debt and preference share capital
along with equity share capital is called
Financial leverage or Trading on equity.
 Sources of
Funds

Owners Creditors
equity equity
 IMPACT OF FINANCIAL LEVERAGE
Q. A firm is considering two financial plans with a view to examining their
impact on Earnings Per Share (EPS). The total funds required for
investment in assets are Rs. 5,00,000.

Financial Plans
Plan I Plan II
Debt (Interest @ 10% p.a.) 4,00,000 1,00,000
Equity Shares (Rs. 10 each) 1,00,000 4,00,000
Total finances required 5,00,000 5,00,000

The earnings before interest and tax are assumed as Rs. 50,000, Rs.
75,000 and Rs. 1,25,000.
 No. of equity shares = Total value of shares
Face value of each share

EPS = EAIT
No. of equity shares

EAIT = EBIT - Interest - Tax

EAIT = Earnings after Interest and Tax

EBIT = Earnings before Interest and Tax
 Solution.
1. When EBIT is Rs. 50,000
Plan I Plan II
Earnings before interest and tax (EBIT) 50,000 50,000
Less : Interest on debt 40,000 10,000
Earnings before tax (EBT) 10,000 40,000
Less : Tax @50% 5,000 20,000
Earninngs after interst and tax 5,000 20,000

No. of equity shares 10,000 40,000

5,000/10,000 20,000/40,000
Earnings per share (EPS) = 0.50 P = 0.50 P
 2. When EBIT is Rs. 75,000
Plan I Plan II
Earnings before interest and tax (EBIT) 75,000 75,000
Less : Interest on debt 40,000 10,000
Earnings before tax (EBT) 35,000 65,000
Less : Tax @50% 17,500 32,500
Earninngs after interst and tax 17,500 32,500
No. of equity shares 10,000 40,000

Earnings per share (EPS) Rs. 1.75 Rs. 0.81

 3. When EBIT is Rs. 1,25,000
Plan I Plan II
Earnings before interest and tax (EBIT) 1,25,000 1,25,000
Less : Interest on debt 40,000 10,000
Earnings before tax (EBT) 85,000 1,15,000
Less : Tax @50% 42,500 57,500
Earninngs after interst and
tax 42,500 57,500
No. of equity shares 10,000 40,000

Earnings per share (EPS) Rs. 4.25 Rs. 1.438

Plan I is leveraged financial plan.

 IMPACT OF LEVERAGE ON LOSS
Q. A firm is considering two financial plans with a view to examining their
impact on Earnings Per Share (EPS). The total funds required for
investment in assets are Rs. 5,00,000. The firm suffers a loss of Rs. 70,000.

Financial Plans
Plan I Plan II
Debt (Interest @ 10% p.a.) 4,00,000 1,00,000
Equity Shares (Rs. 10 each) 1,00,000 4,00,000
Total finances required 5,00,000 5,00,000
 Solution.
Plan I Plan II
Loss before interest and tax (EBIT) -70,000 -70,000
Less : Interest on debt 40,000 10,000
Loss after interest -1,10,000 -80,000

No. of equity shares 10,000 40,000

1,10,000/10,000 80,000/40,000
Loss per share = Rs. 11 = Rs. 2

Plan I is leveraged financial plan.

 How Financial Leverage works
When the difference between the assets financed by fixed cost
funds and the cost of these funds are distributed to the equity
stockholders , they will get additional earnings without
increasing their own investment .
Consequently , the Earning per share (EPS) and the rate of
return on equity share capital will go up .
The situation in which Earning per share (EPS) and the rate of
return on equity share capital will go up , may also be reverse
sometimes.
if the firm acquires fixed cost funds at a higher cost than the
Earnings from those assets .
PAYMENT OF SAVINGS IN
INTEREST TAX

INCREASE IN
DIVIDENT
EARNING PER
INCREASE
SHARE

VALUATION OF
FIRM
When is financial leverage not
favorable ?
If the firm is incurring losses.

If the cost of raising debt is

higher than the rate of return or
rate of earnings of company.
 A ratio that measures the sensitivity of a companys
earnings per share (EPS) to fluctuations in its operating
income, as a result of changes in its capital structure.

% in EPS
DFL =
% in EBIT

DFL = EBIT
(EBIT I)
 Importance of financial leverage

Magnification of Shareholder Profits

Improvement in Credit Rating
Capturing Economies of Scale
Increased Free Cash
Profit Planning
Planning of capital structure
Limitations of financial leverage
Double edged weapon
Beneficial to companies having stable
earnings
Restrictions from financial institutions
High Risk
Liquidity
Investment life cycle
Company is too leveraged
 OPERATING LEVERAGE

The Fixed cost remaining the same, the

%change in operating income will be more
than the % change in sales. This occurrence
is known as Operating leverage.

A firm with relatively high fixed operating

costs will experience more variable
operating income if sales change.
Disadvantages of operating leverage
Beneficial Only To Some Extent .

Higher degree of operating leverage

indicates lower margin of safety .

Higher operating leverage situation is

also risky.
 Operating leverage

operating leverage = C
OP

Contribution = Sales Variable cost

Operating Profit = Sales- variable cost
fixed cost.
Or Contribution - Fixed Cost.
 Calculation of operating leverage

RS.
Sales 10,50,000
Variable cost 7,67,000
Fixed cost 75,000
EBIT 2,08,000
Interest 1,10,000
Taxes(30%) 29400
Net Income 68600
 Operating Leverage = Contribution
EBIT

= 2,83,000
2,08,000

= 1.36
Contribution =Sales- Variable cost
=10,50,000 - 7,67,000
EBIT= Given
1% Change in sales is likely to results 1.365 change in
EBIT.
 Degree of Operating Leverage (DOL)

Operating leverage: by using fixed

operating costs, a small change in sales
revenue is magnified into a larger
change in operating income.

This multiplier effect is called the

degree of operating leverage.
Degree of Operating Leverage
from Sales Level (S)

DOLs = % change in EBIT

% change in sales

change in EBIT
EBIT
=
change in sales
sales
EXAMPLE :

Fixed Cost= Rs. 50000

Variable cost= 70% of sales

Sales= Rs. 200000 in the previous year and

250000 in the current year. Find out Percentage
change in sales and operating profits when:

1. Fixed costs are not there

2. Fixed costs are there

1. Previous year Current year %age change

Sales 200000 250000 25 %

Less: Variable 140000 175000 25 %
cost
Profit from 60000 75000 25 %
operations

2. Previous year Current year %age change

Sales 200000 250000 25 %

Less: Variable 140000 175000 25 %
cost

Contribution 60000 75000 25 %

Less Fixed cost 50000 50000

Profit from 10000 25000 150%

operations
 Breakeven Calculations

Breakeven point (units of output)

F
QB =
P-V
QB = breakeven level of Q.
F = total anticipated fixed costs.
P = sales price per unit.
V = variable cost per unit.
 Total Revenue

$ Total Cost
} EBIT
+

-
FC {
Break- Q1 Quantity
even
point
 Total Revenue

+ } EBIT
Total Cost

{
FC
- = Fixed

Break-even Q1 Quantity
point
 What does this tell us?
If DOL = 2, then a 1% increase in sales
will result in a 2% increase in operating
income (EBIT).

Stock-
Sales EBIT EPS holders
With high operating leverage,
an increase in sales produces
a relatively larger increase in
operating income.
 Levered Company
Sales (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Common shares outstanding 100,000
 Levered Company
10% increase in sales
Sales (1,10,000 units) 15,40,000
Variable Costs (8,80,000)
Fixed Costs (2,50,000)
EBIT 4,10,000 ( +17.14%)
Interest (1,25,000)
EBT 2,85,000
Taxes (34%) (96,900)
Net Income 1,88,100
EPS $1.881 ( +26.67%)
 Levered Company

17.14%
10%

Operating
Sales Income EPS

Operating
leverage
 Levered Company

26.67%
10%

Operating EPS
Sales Income

Operating Financial
leverage leverage
 WORKING CAPITAL LEVERAGE
WORKING CAPITAL LEVERAGE MEASURES
THE SESITIVITY OF RETURN ON
INVESTMENT (ROI) OF CHANGES IN THE
LEVEL OF CURRENT ASSETS (CA) ,
SYMBOLICALLY :
WCL = PERCENTAGE CHANGE IN ROI
PERCENTAGE CHANGE IN CA
WHERE , WCL = WORKING CAPITAL LEVERAGE
ROI = RETURN ON INVESTMENT
CA = CURRENT ASSETS
In Case The Earnings Are Not Affected By The
Change In Current Assets, Then Working
Capital Leverage Can Be Calculated As:-

WCL= CA
TA + DCA
WHERE, CA = CURRENT ASSETS
TA = TOTAL ASSESTS
DCA= CHANGE IN THE LEVEL OF CURRENT ASSETS
ILLUSTRATION : THE FOLLOWING
INFORMATION IS AVAILABLE FOR TWO
COMPANIES.
A. Ltd. B Ltd.

FIXED ASSESTS 2,00,000 8,00,000

CURRENT ASSETS 8,00,000 2,00,000

TOTAL ASSETS 10,00,000 10,00,000

EARNINGS BEFORE 1,00,000 1,00,000

INTEREST AND TAX
You Are Required To Compare The Sensitivity
Of Earnings Of The Two Companies For A 25%
Change In The Level Of Their Current Assets .
Solution:-
Let Us Calculate The WCL Of The Two
Companies, For A 25% Reduction In Ca
WCL(A . Ltd) = 8,00,000 =1.0
10,00,000-2,00,000

WCL(B. Ltd)= 2,00,000 =0.21

10,00,000-50,000
LOOKING AT THE WCL OF THE TWO COMPANIES,
WE CAN SAY THAT THE SENSITIVITY OF EARNINGS
FOR CHANGES IN THE LEVEL OF CURRENT ASSETS
OF A. Ltd FOR GREATER THAN THAT OF B .Ltd
 Relationship of Operating, Financial,
and Total Leverage

Total leverage reflects the combined impact of

operating and financial leverage on the firm.
High operating leverage and high financial
leverage will cause total leverage to be high. The
opposite will also be true.
 The relationship between operating leverage
and financial leverage is multiplicative rather
than additive.
DTL = DOL DFL
Substituting the values when calculated for
both DOL and DFL into the previous
equation yields:
DTL = 1.2 (OL) 5.0 (FL) =6.0
 Leverage results from the use of fixed costs to magnify returns to a
firms owners. Capital structure, the firms mix of long-term debt and
equity, affects leverage and therefore the firms value. Breakeven
analysis measures the level of sales necessary to cover total operating
costs. The operating breakeven point increases with increased fixed and
variable operating costs and decreases with an increase in sale price,
and vice versa.
Operating leverage is the use of fixed operating costs by the firm to
magnify the effects of changes in sales on EBIT. The higher the fixed
operating costs, the greater the operating leverage. Financial leverage is
the use of fixed financial costs by the firm to magnify the effects of
changes in EBIT on EPS. The higher the fixed financial costs, the greater
the financial leverage. The total leverage of the firm is the use of total
fixed costsboth operating and financialto magnify the effects of
changes in sales on EPS.
Debt capital and equity capital make up a firms capital structure.
Capital structure can be externally assessed by using financial ratios
debt ratio, times interest earned ratio, and fixed-payment coverage
ratio. The major benefit of debt financing is the tax shield. However, an
increase in the cost of debt financing may due to the increased
probability of bankruptcy, agency costs imposed by lenders, and
asymmetric information.