ANSWER :

(a)

Capital structure refers to the mix of debt, preference share and equity capital. Capital structure is a
composition or makeup of the long term financing.

Leveraged finance is funding of a company with more debt than would be considered normal for that
company.

Financial Leverage(FL) : It is the degree to which a company is utilizing the borrowed money rather
than the equity fund.

Operating Leverage (OL): The firms ability to use fixed operating cost to magnify the effect of changes in
sales on its earnings before interest and taxes.

Combined Leverage(CL) : It is the product of FL and OL, in indicates the effect of change in sales on EPS.

Use of leverage in the capital structure of the firm has the potential to increase its return and risk.
Leverage and capital structure are closely related concepts that are linked on capital budgeting decision
through cost of capital. The concepts can be used to minimize the firm’s cost of capital and maximize
owner’s wealth.

Increases in leverage result in increased return and risk, whereas decreases in leverage result in
decreased return and risk.

Leverage is linked with capital structure since an organization having a optimal capital ( where weighted
average cost of capital is minimum) structure is a great leverage /advantage both the company as well
as investor.

Example:

The following figures are related to MNC M/s ABC Co.

Contribution (C) : Rs. 10 Lacs

Fixed cost (F) : Rs. 2.5 Lacs

Debt (D) : Rs. 4 Lacs

Interest (I) : Rs. 3.5 Lacs

EBIT = (C-F) = Rs. 7.5 Lacs

EBT = (EBIT – I)= Rs. 4.0 Lacs

Operating leverage = Contribution/ EBIT = 10/7.5 = 1.33

Financial Leverage = EBIT/EBT = 7.5/4 = 1.87

It is always desirable to have low operating risk and high financial risk(subject to ROCE > interest cost on
debt).

We can say that ABC Co. is having a optimal capital structure and can manage the risk.

(b)

Particular P Ltd Q Ltd

Sales 500 1000
Variable costs 200 300
Contribution 300 700
Fixed cost 150 400
PBIT 150 300
Interest 50 100
PBT 100 200
Computation of Leverage :
1. Operating Leverage(OL) 2.0 2.3
= Contibution/PBIT

2. Financial Leverage(FL) 1.5 1.5

= PBIT/PBT

3. Combined Leverage (CL) 3.0 3.5

= OL x FL= Contribution/PBT
Comments : Operating risk is higher (i,e fixed Operating risk is higher than ‘P’
Costs are high) Ltd(i,e fixed costs are high)

Financial risk looks low Financial risk looks low

Overall risk is low as compared Overall risk is high as compare to

to ‘Q’ Ltd. ‘P’ Ltd.
It is always advisable to have low operating leverage and high financial leverage (provided,
ROCE>interest of debt.