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.

Observations of DOL
Each level of output has a distinct DOL. DOL is undefined at Operating Break-Even Point. If Q is less than the operating break-even point, then the DOL will be negative. If Q is more than the operating break-even point, then the DOL will be positive. However the DOL will start to decline as the level of output increases and will reach to a limit close to 1.

Determining behavior of EBIT

Alpha Ltd. (In Rs.) Beta Ltd. (in Rs.)

Selling Price (per unit) Variable Costs (per unit) Fixed Operating Costs Break-even point (units)

Rs.10 Rs.7 Rs.90,000 30,000

Rs.10 Rs.5 Rs.1,90,000 38,000

Observation
At an output level of 50,000 both the firms have the same EBIT. As sales increases, the EBIT of Alpha Ltd. fluctuate less than the EBIT of Beta Ltd. This bring us a conclusion that DOL of Beta Ltd. would be higher than DOL of Alpha Ltd.

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 5,00,000 equity shares of Rs.10 each 12% Preference Shares Amount 50,00,000 5,00,000

10% Debenture
Total

5,00,000
60,00,000

The corporate tax rate is 40%. Calculate DFL when EBIT is Rs.4,00,000.

Observations of DFL
Each level of output has a distinct DFL. DFL is undefined at Financial Break-Even Point. The DFL will be negative when the EBIT level goes below the financial breakeven point. The DOL will be positive for all values of EBIT that are above the financial breakeven point. However the DFL will start to decline as the EBIT increases and will reach to a limit close to 1.

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

DCL