Leverage

Learning Outcomes
• After studying this topic, the student will be able to:
• Understand the concept of leverage
• Differentiate between different types of leverages
Case analysis
• A company believes that increase in sales and promotion expenses will
result in increase in its’ sales.
• As a result, the company increased its sales and promotion expenses from
5000$ to 6000$ (an increase of 20%) and this resulted in increase in
number of units sold from 200 to 300 (an increase of 50%).
• The relationship b/w number of units sold and promotional expenses may
be defined as:
= % change in units sold
% change in promotional expenses
• This means that % increase in number of units sold is 2.5 times that of %
increase in sales promotion expenses.
Leverage – concept
• Percentage change in one dependent variable divided by percentage
change in independent variable.
• Reflects as to how responsiveness is the dependent variable to the
change in independent variable.
Sales Revenue
Less:- variable costs
= Contribution (A)
Less :- Fixed costs
= EBIT(B)
Less:- Interest
= EBT (C)
Operating Leverage – CASE ANALYSIS
• A company sells 1000 units @ Rs. 10 per unit. The cost of production is Rs.
7 per unit (the whole cost being variable in nature).
• The profit for the firm is 1000 * (Rs.10 – Rs.7) = Rs. 3000.
• The firm is able to increase its sales level by 40% resulting in total sales of
1400 units. (Total sales in (amount) Rs. 14000)
• The profit for the firm would be now 1400 * (Rs.10 – Rs.7) = Rs. 4200
• The operating leverage of the firm will be:-
Operating Leverage = % increase in EBIT
% increase in sales
Or
Operating Leverage = Increase in EBIT / EBIT
Increase in sales / sales
 Operating leverage = 1200/3000
4000/10000
• OL = 1
• OL of 1 shows EBIT level increases or decreases in direct proportion to
increase or decrease in sales level.
• This is because there are no fixed costs and all the costs are variable
in nature.
Situation – II
• The company has fixed costs of Rs. 1000 in addition to variable costs
of Rs. 7 per unit.
• The present and expected cost and profit structure (in Rs.) is as
follows:-
PRESENT EXPECTED
Sales @ Rs. 10 per unit 10000 14000
Less :- variable costs @ Rs. 7 per unit 7000 9800
Contribution 3000 4200
Less:- fixed costs 1000 1000
EBIT 2000 3200
 Operating leverage = 1200/2000
4000/10000
• OL = 1.5
• OL of 1.5 shows that % increase in EBIT level is 1.5 times that of %
increase in sales level.
• This is due to existence of fixed costs.
• OL > 1 in case of any firm having fixed costs in its’ costs structure.
News Analysis
• Star signs 11 IPL sponsors, sells Rs 500 crore inventory
• Trump slams India over import duty on Harley-Davidson bikes
• Paytm head accuses Whatsapp for unfair play, wants Govt. to step in
• Samsung India aims for Sales of over $10 billion this year
CASE ANALYSIS - MICROSOFT
• The bulk of this company's cost structure is fixed and limited to
upfront development and marketing costs.
• Whether it sells one copy or 10 million copies of its latest Windows
software, Microsoft's costs remain basically unchanged.
• So, once the company has sold enough copies to cover its fixed costs,
every additional dollar of sales revenue generates more EBIT.
• In other words, Microsoft possesses remarkably high operating
leverage.
CASE ANALYSIS – WALMART
• The company has fairly low levels of fixed costs, while its variable
costs are large.
• Merchandise inventory represents Wal-Mart's biggest cost.
• For each product sale that Wal-Mart rings in, the company has to pay
for the supply of that product.
• As a result, Wal-Mart's cost of goods sold (COGS) continues to rise as
sales revenues rise.
SIGNIFICANCE – OPERATING LEVERAGE
• Essentially, operating leverage boils down to an analysis of fixed costs
and variable costs.
• Operating leverage is highest in companies that have a high
proportion of fixed operating costs in relation to variable operating
costs.
• These kind of companies uses more fixed assets in the operation of
the company.
• Conversely, operating leverage is lowest in companies that have a low
proportion of fixed operating costs in relation to variable operating
costs.
SIGNIFICANCE – OPERATING LEVERAGE
• OL arises as a result of fixed costs in the cost structure of the firm.
• If there are no fixed costs, there will be no OL and % change in EBIT
will be same as % change in sales.
• If the firm has high fixed costs as compared to variable costs, the firm
will have high operating leverage.
• If a firm has high operating leverage, a small change in sales volume
results in a large change in EBIT.
Degree of operating leverage
DOL = % increase in EBIT
% increase in sales

OR

Sales – variable cost

Sales – variable cost – fixed cost
CASE ANALYSIS
• Brightways Textiles Ltd. Is having the sales of 100,000 units (selling
price/unit = Rs. 8). The company appoints a technical expert and this
expert is of opinion that the company need to opt for more
automated production process.
• It is believed that such automated production process will reduce the
variable cost to Rs. 2 but will increase the fixed costs to Rs. 480,000.
• Is the opinion of the technical expert correct? Should the
management go for making an investment in automated production
process? Analyse with help of suitable workings
 CASE ANALYSIS – CAR MANUFACTUING COMPANY
• BMW is German automobile manufacturing company engaged in manufacturing
of luxury cars
• This company is classified in the nature of capital intensive business.
• The company is having huge amount of equipment that is required to
manufacture their product - automobiles.
• The company generates 40% of their revenue by selling their cars in Chinese
markets.
• During the year 2016, Chinese economy slowed down and there were left fewer
people buying new BMW cars.
• With regard to Chinese markets, the company still have to pay their fixed costs
such as overhead on the plants that house the equipment, depreciation on the
equipment, and other fixed costs associated in the nature of capital intensive
firms.
• An economic slowdown in China hurted a capital intensive company much more
than a company not quite so capital intensive.
Problem solving
• From the following information, determine the degree of operating
leverage
Company A Company B
Sales 25,00,000 30,00,000
Fixed costs 7,50,000 15,00,000
Variable expenses 50% of sales 25% of sales

• Which company has the greater amount of business risk?

MCQ
• Operating Leverage helps in analysis of:
a) Business risk
b) Financing risk
c) Production risk
d) Credit risk
MCQ
• Combined leverage is obtained from OL and FL, by their:
a) Addition
b) Subtraction
c) Multiplication
d) Any of these
MCQ
• Operating Leverage is calculated as:
a) Contribution/EBIT
b) EBIT/EBT
c) EBIT/Interest
d) EBIT/Interest
MCQ
• Operating leverage works on:
a) Sales increases
b) Sales decreases
c) Both (a) and (b)
d) Use of variable cost
FINANCIAL LEVERAGE – CASE ANALYSIS
• A Company borrows Rs. 100 at 8 percent interest per annum.
• The company invests Rs. 100 to earn return at 12 percent interest per
annum.
• 12 – 8 = 4 percent (after payment of interest) will belong to equity
shareholders.
• It reflects profits from financial leverage.
Financial Leverage – MEANING
• Use of fixed charges sources of funds such as debt and preference
capital along with equity share capital in capital structure
• Also known as trading on equity
• Acts as double - edged sword.
• It may increase the shareholder earnings
• It may create the risks of loss to them (if company earns only 6%
return on Rs. 100; the loss to shareholders will be Rs. 2)
Definition – Financial leverage
• Ability of the firm to use fixed financial charges to magnify the effects
of changes in EBIT on EPS.
Measures of Financial Leverage
1. Debt ratio = debt
total capital

2. Debt equity ratio = debt

equity

3. Interest coverage ratio = EBIT

Interest
(Measures the ability of the firm to meet fixed interest charges; also known
as coverage ratio)
Degree of Financial Leverage
DFL = % change in EPS
% change in EBIT

OR

DFL = EBIT
EBIT – Interest – preference dividend
(1 – t)
Problem solving
• Following information is available for Danlaw Ltd. For the year ended
31st March 2016:
• Interest on debt Rs. 400000
• Preference dividend Rs. 200000
• Corporate tax rate 40%
• You are required to calculate the degree of financial leverage:
(i) if EBIT is Rs. 10,00,000
(ii) if EBIT is Rs. 15,00,000
Interpretation of Financial Leverage
• DFL should be greater than 1
• Higher the DFL, higher is the financial leverage and vice versa
• Financial risk refers to ability of the firm to cover its fixed financial
charges due to variation in EBIT
• Greater amount of fixed financial charges, larger EBIT is required to
cover them.
Problem solving
• Compute the financial leverage from the following data given below:
• Net worth = Rs. 25,00,000
• Debt/equity = 3:1
• Interest rate = 12%
• Operating profit = Rs. 20,00,000
 Combined Leverage or Total Leverage
• Studies the combined effect of operating and financial leverage.

Degree of combined leverage (DCL)

% change in EBIT * % change in EPS
% change in sales % change in EBIT

% change in EPS
% change in sales
Degree of combined/total leverage
DTL/DCL = Operating leverage * Financial leverage
OR
DTL/DCL = Contribution * EBIT
EBIT EBT
OR
DTL/DCL = Contribution
EBT
Problem solving
• A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and
fixed cost of Rs. 600,000.
• It has debt of Rs. 45,00,000 at 9% interest and equity of Rs.
55,00,000.
• You are required to calculate the following:-
• Operating leverage
• Financial leverage
• Combined leverage
Problem solving
• Q Ltd. Is having sales of Rs. 1000 lakhs and its’ variable costs
represent 30% of its sales. The fixed costs of the year is Rs. 400 lakhs
and the interest on term loan is Rs. 100 lakhs.
• Calculate the combined leverage of the firm
Problem Solving
• Calculate the degree of operating leverage, financial leverage and
combined leverage for the following firms and interpret the results.
Particulars Firm A Firm B Firm C
Output 60000 15000 100,000
Fixed costs 7000 14000 1500
Variable costs per unit 0.20 1.50 0.02
Interest on borrowed funds 4000 8000 -
Selling price per unit 0.60 5.00 0.10
Problem solving
• A company currently has equity share capital of Rs. 40 lakh, consisting
of 40,000 equity shares of Rs. 100 each. The management is planning
to raise an additional Rs. 30 lakhs to finance a major expansion
program through one of the three possible financing plans.
• Following are the options:-
• Entirely through equity shares
• Rs. 15 lakh in equity shares of Rs. 100 each and balance in 8% debentures.
• Rs. 10 lakh in equity shares of Rs. 100 each and balance through long term
borrowings at 9% interest per annum.
• The expected EBIT will be Rs. 15 lakhs and corporate tax rate is 50%
• You are required to determine the EPS and comment on financial
leverage under each of the above schemes of financing.
Problem solving
• From the following data of X Ltd., as on September 2016, you are
required to calculate the operating leverage, combined leverage and
percentage increase in EPS, if sales are expected to increase by 5%.
• Earnings before interest and tax = Rs. 10 lakhs
• Profit before tax = Rs. 4 lakhs
• Fixed cost = Rs. 6 lakhs
Problem solving
• X enterprises Ltd. Is setting a project with a cost of Rs. 50,00,000. It is
considering the following three options for financing the project:
Capital structure Option A Option B Option C
Equity (Rs. 10) 50,00,000 40,00,000 20,00,000
Debt (15%) Nil 10,00,000 30,00,000
Total 50,00,000 50,00,000 50,00,000

• The estimated earnings of the company per year are Rs. 20,00,000. The
corporate tax rate is 40%.
• You are required to calculate the EPS and financial leverage.
• Also, make the suitable analysis with regard to each option.