The document discusses the concept of leverage, specifically financial leverage and operational leverage. It provides examples to illustrate how financial leverage can increase earnings per share through the use of debt financing compared to equity financing alone. Operational leverage is also explained as the use of fixed costs that can magnify changes in operating income from small fluctuations in sales revenue. The degree of financial leverage and operational leverage are defined as the percentage change in earnings per share and operating income from a percentage change in operating factors like interest expense and sales.
The document discusses the concept of leverage, specifically financial leverage and operational leverage. It provides examples to illustrate how financial leverage can increase earnings per share through the use of debt financing compared to equity financing alone. Operational leverage is also explained as the use of fixed costs that can magnify changes in operating income from small fluctuations in sales revenue. The degree of financial leverage and operational leverage are defined as the percentage change in earnings per share and operating income from a percentage change in operating factors like interest expense and sales.
The document discusses the concept of leverage, specifically financial leverage and operational leverage. It provides examples to illustrate how financial leverage can increase earnings per share through the use of debt financing compared to equity financing alone. Operational leverage is also explained as the use of fixed costs that can magnify changes in operating income from small fluctuations in sales revenue. The degree of financial leverage and operational leverage are defined as the percentage change in earnings per share and operating income from a percentage change in operating factors like interest expense and sales.
The document discusses the concept of leverage, specifically financial leverage and operational leverage. It provides examples to illustrate how financial leverage can increase earnings per share through the use of debt financing compared to equity financing alone. Operational leverage is also explained as the use of fixed costs that can magnify changes in operating income from small fluctuations in sales revenue. The degree of financial leverage and operational leverage are defined as the percentage change in earnings per share and operating income from a percentage change in operating factors like interest expense and sales.
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LEVERAGES
MEANING The term leverage is used to describe the firms ability to use fixed cost assets or funds to increase the return to its owners (equity shareholder).
TYPES 1. FINANCIAL LEVERAGE 2. OPERATIONAL LEVERAGE 1. FINANCIAL LEVERAGE OR TRADING ON EQUITY • 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. • 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.
Illustration 1. 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 Z 5,00,000. Plan I When EBIT is Rs. 50,000
EBIT 50,000 - Interest 40,000 EBT 10,000 - Tax 5,000 EAT 5,000 - Dp 0 EAESH 5,000 / No. of Equity Share 10, 000 EPS 0.5 Plan II When EBIT is Rs. 50,000
EBIT 50,000 Interest 10,000 EBT 40,000 Tax 20,000 EAT 20,000 Dp 0 EAESH 20,000 / No. of Eq. Share 40,000 EPS 0.5 Rs. Illustration 2. A Ltd. Company has equity share capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion cum modernization plans. The company plans the following financing schemes. a. All common stock b. Rs. One lakh in common stock and Rs. Two lakh in 10% debentures c. All debt at 10% p.a. d. Rs. One lakh in common stock and Rs. Two lakhs in preference capital with the rate of dividend at 8% The company’s expected earnings before interest and tax (EBIT) are Rs. 1,50,000. The corporate rate of tax is 50%. You are required to determine the earning per share(EPS) under each plan and comment on the implications of financial leverage. 1. When Equity increase - No. of shares increase – but no interest
2. When Debentures, Loans, and Bonds
increase – Interest increase
3. When Preference shares increase -
Preference dividends increase Solution - PLAN 1 PLAN 2 PLAN3 PLAN4
% Change = F2 – F1 * 100 F1 Where, F2 = Final Value, F1 = Initial Value DEGREE OF FINANCIAL LEVERAGE • The degree of financial leverage measures the impact of a change in operating income (EBIT) on change in earning on equity capital or on equity share(EPS). Degree of financial leverage DFL can be calculated as:- DFL = Percentage Change in EPS Percentage Change in EBIT = ( EPS / EPS) ( EBIT / EBIT DFL = EBIT EBT - Dp 1-t
Where, Dp = Dividend for Preference Shares
and t = tax rate in decimals 4 1.11 Operating Leverage • It results from the presence of fixed costs that help in magnifying net operating income fluctuations flowing from small variation in revenue.
Cost Break Even Point = Fixed Cost P/V ratio P/V ratio = Contribution Sales Margin of Safety = EBIT 100 Contribution DOL or Operating Leverage % Change in EBIT (Op. P.) % Change in Sales
=% in EBIT = EBIT / EBIT
% in Sales Sales / Sales Solution : A B C Sales 8000 8000 8000
Less: Variable Cost 5600 5600 5600
Contribution 2400 2400 2400
Less: Fixed Cost 800 1200 1500
Operating Profit = EBIT 1600 1200 900 Solution : A B C Sales 8000 8000 8000
Less: Variable Cost 5600 5600 5600
Contribution 2400 2400 2400
Less: Fixed Cost 800 1200 1500
Operating Profit = EBIT 1600 1200 900 Solution : A B C Sales 8000 8000 8000
Less: Variable Cost 5600 5600 5600
Contribution 2400 2400 2400
Less: Fixed Cost 800 1200 1500
Operating Profit = EBIT 1600 1200 900 Solution : A B C Sales 8000 8000 8000
Less: Variable Cost 5600 5600 5600
Contribution 2400 2400 2400
Less: Fixed Cost 800 1200 1500
Operating Profit = EBIT 1600 1200 900 Margin of Safety • The Margin of safety is a financial ratio that measures the amount of sales that exceed the break-even point. In other words, this is the revenue earned after the company or department pays all of its fixed and variable costs associated with producing the goods or services. • Calculate BEP, Margin of Safety, and % of Sales at BEP ( = BEP Sales/ Sales) * 100 in the above question. COMPOSITE LEVERAGE OR COMBINED LEVERAGE • DCL or Composite Leverage = Percentage change in EPS Percentage change in Sales = EPS/EPS Sales/Sales
Sales Sales -VC 0.667 Sales Contribution 0.333 Sales 1200 = 0.333 * Sales 1200/0.333 = Sales Sales = 3600 Sales 3600 -VC 2400 Contribution 1200 -FC 900 EBIT 300 -I 200 EBT 100 -T 45 EAT 55 PART || % Change in x to make it 0 % Change in x = (Change /Original) * 100 = ((F2-F1)/F1)*100
= ((0-x)/x)*100 = (-x/x)*100 = -100%
% Change in EBIT to make it 0
*Note • % Change in EBIT = (Change/Original) * 100 = ((F2-F1)/F1) * 100 • F2 = 0 • F1 = EBIT • % Change in EBIT = ((0-EBIT)/EBIT) * 100 = (-EBIT/EBIT)*100 = -100% • DOL = % Change in EBIT % Change in Sales
2 = % Change in EBIT => 2 = -100*(Note) % Change in Sales % Change in Sales
% Change in Sales = -100/2 = -50%
Note • The ratio of Sales with Variable Cost will remain the same for a considerable range of level of output. INDIFFERENCE POINT • Indifference point refers to that level of EBIT (Earnings Before Interest and Tax) at which EPS (Earnings Per Share) would be same irrespective of the method of financing the new funds requirement. Direct Formula Approach (EBIT – I1) (1 – t) – Preference Dividend = ES1 = (EBIT – I2) (1 – t) – Preference Dividend ES2 Where, I1 represents Interest on Debt under alternative 1 ES1 represents Number of Equity Shares under alternative 1 I2 represents Interest on Debt under alternative 2 ES2 represents Number of Equity Shares under alternative 2 * * Note: Preference Dividend is an appropriation out of profits and not charge against profits Practice Question • Do the above question using Direct formula approach.
• Hint: The answer would be the same.
INDIFFERENCE POINT UNDER UNCOMMITTED EPS APPROACH
EAT -Dp - Transfer to DRR UEAESH /n_____ UEPS 10. * P/E Ratio = Market Price / EPS
