CA. CS.CMA.
MBA: Naveen Rohatgi
NMIMS School of Economics Corporate finance
1 MEANING OF LEVERAGE
Leverage refers to the ability of a firm in employing long term funds having fixed cost to
enhance returns to the owners. In other words, leverage is the employment of fixed assets or
funds for which a firm has to meet fixed costs and fixed obligation irrespective of the level of
activities attained or level of operating profit earned. The higher leverage means higher profit
and vice versa. But a higher leverage implies means outside borrowing is higher and hence
higher risk if the business suddenly dips. But a low leverage does not necessary means a
prudent financial management, as the firm might be incurring an opportunity cost for not
having borrowed funds at a fixed cost to earn higher profits. Leverage are classified into
following types (1) operating leverage (2) Financial leverage (3) combined leverage
2 MEANING OF OPERATING LEEVRAGE
Operating Leverage
Definition: Operating Leverage is defined as employment of an asset with a fixed cost
with a hope that sufficient revenue would be generated to be cover all the fixed and variable
cost
When sales changes, Variable Cost will change in proportion to Sales while Fixed Cost
will remain constant. So, a change in Sales will lead to a more than proportional change in
EBIT. The effect of change in sales on EBIT is measured by Operating Leverage.
When Sales increase, Fixed Cost will remain the same irrespective of level of output, and
so, the percentage increase in EBIT will be higher than increase in Sales. This is the favourable
effect of Operating Leverage.
When Sales decreases the reverse process will be applicable and hence, the percentage
decrease in EBIT will be higher than decrease in Sales. This is the adverse effect of Operating
Leverage.
Measurement:
The degree of Operating Leverage (DOL) is measured as under - (expressed in time)
DO L
% Change in EBIT Contribution
DOL = (or)
% Change in Sales EBIT
Significance:
Effect on EBIT: DOL measures the impact of change in sales on operating income.
Suppose DOL of a firm is 1.67 times, it implies that 1% change in sales will lead to 1.67%
change in EBIT. Hence, if sales increase by 20%, EBIT increase by 20% x 1.67 = 33%. Also,
if Sales decrease by say 40%, EBIT falls by 40% x 1.67 = 67%.
Impact of Fixed cost: DOL depends on the amount of Fixed Costs. If Fixed Cost are
higher, DOL is higher and vice versa.
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CA. CS.CMA.MBA: Naveen Rohatgi
NMIMS School of Economics Corporate finance
Effect of high DOL: If DOL is high, it implies that Fixed Costs are high. Hence the Break
Even Point (BEP) would be reached at a higher level of sales. Due to the high BEP, the Margin
of Safety and profits would be low. This means that the Operating Risks are higher. Hence, the
lower the DOL, the better it is for the business.
Above BEP: A High DOL means that profits (EBIT) may be wiped off, even for a
marginal reduction in Sales. Hence, a Firm should operate sufficiently above the BEP, to avoid
the danger of fluctuations in sales and profits.
3 MEANING OF FINANCIAL LEVERAGE
Financial Leverage
Meaning: Financial Leverage is defined as the ability of a firm to use fixed financial
charges (interest) to increase EPS.
Explanation:
Financial Leverage occurs when a company has debt content in its capital structure and
fixed financial charges, e.g. interest on debentures. These fixed financial charges do not vary
the EBIT. They are fixed and are to be paid irrespective of level of EBIT.
When EBIT increase, the interest payable on debt remains constant, and hence, Residual
Earning available to Equity Shareholders will also increase more than proportionately.
Hence an increase in EBIT will lead to a higher percentage increase in Earning per Share
(EPS). This is measured by the Financial Leverage.
Measurement:
The degree of Financial Leverage (DFL) is measured as under – (expressed in times)
% Change in EPS EBIT
DFL = (or)
% Change in EBIT EBT
Significance:
Effect on EPS: DFL measures the impact of change in EBIT (Operating Income) on EPS.
Suppose DFL of a Firm is 4 times, it implies that 1% change in EBIT will lead to 4% change
in EPS, hence, if EBIT increase by 10%, EPS increase by 10% x 4 = 40%. Also, if EBIT
decreases by say 5%, EPS falls by 5% x 4 = 20%.
Impact on Fixed Financial Charges: DFL depends on the magnitude of interest and
fixed financial charges. If these costs are higher, DFL is higher and vice-versa.
Effect on High DFL: If DFL is high, it implies that fixed interest charges are high. This
means that the financial risks are higher. In such a case, the Firm is justified in borrowing /
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CA. CS.CMA.MBA: Naveen Rohatgi
NMIMS School of Economics Corporate finance
using Debt Funds, only when it is able to earn at a rate higher than what it has to pay towards
interest on debt.
ROCE vs Interest Rate: DFL is considered to be favourable or advantageous to the Firm,
only if Return on Capital Employed (ROCE) is greater than Rate of Interest on Debt. In such a
case, the use of debt funds is justified, thus magnifying the Residual Earning available to Equity
Shareholders.
NUMERICALS
Q1Annual sales of a company is Rs 60,00,000. Variable costs are 2/3 of sales and Fixed
cost other than interest is Rs 5,00,000 per annum. Company has 11% debentures
of Rs 30,00,000.
You are required to calculate the operating financial and combined leverages of the
company.
Q2 Mahesh has estimated that for a new product its break-even is 2000 units if the
item is sold for Rs 14 per unit: the cost accounting department has currently
identified variable cost Rs 9 per unit. Calculate the degree of operating leverage
for sales volume 2,500 units and 3,000 units.
Q.3 Compute the financial leverage from the following data:
Net worth = Rs 25,00,000
Debt/equity = 3:1
Interest rate = 12 per cent
Operating profit =Rs 20,00,000
Q4 The operating income of Hypothetical Ltd amounts to Rs 1,86,000. It pays 35 per cent
tax on its income. Its capital structure consists of the following:
14% Debentures Rs 5,00,000
15% Preference shares Rs 1,00,000
Equity shares (Rs 100 each) Rs 4,00,000
i. Determine the firm’s EPS. Rs
ii. Determine the percentage change in EPS associated with 30 per cent change (both
increase and decrease) in EBIT.
iii. Determine the degree of financial leverage at the current level of EBIT.
iv. What additional data do you need to compute operating as well as combined
leverage?
3
CA. CS.CMA.MBA: Naveen Rohatgi
NMIMS School of Economics Corporate finance
Q5 A company operates at a production level of 5000 units. The contribution is Rs 60 per
unit, operating leverage is 6, and combined leverage is 24. If tax rate is 30%, what
would be it's earning after tax?
Q6 The Well Established company’s most recent balance sheet is follows:
Liabilities Amount Assets Amount
Rs Rs
Equity capital (Rs 10 per share) 60,000 Net fixed assets 1,50,000
10% long- term debt 80,000 Current assets 50,000
Retained earnings 20,000
Current liabilities 40,000
Total 2,00,000 Total 2,00,000
The company’s total assets turnover ratio is 3, its fixed operating costs are Rs 1,00,000
and the variable operating costs ratio is 40 per cent. The income tax rate is 35 per cent.
a. Calculate all the three types of leverages.
b. Determine the likely level of EBIT if EPS is (i) Rs 1, (ii) Rs 3, and (iii) Zero
Q7 From the following particulars, prepare income statement of A Ltd. and B. Ltd.
A Ltd. B Ltd.
Degree of Combined Leverage 6 times 15 times
Degree of Operating Leverage 3 times 5 times
Variable Cost as a % of Sales 40% 50%
Rate of Income Tax 35% 35%
Number of Equity Shares 1,00,000 1,00,000
Earnings Per Share 1.30 0.65
Q8: A firm has sales of Rs 75,00,000 variable cost of Rs 42,00,000 and fixed cost of Rs
6,00,000. It has a debt of Rs 45,00,000 at 9%. And equity of Rs 55,00,000
1. What is the firm ROI.
2. Does it have favorable financial leverage.
3. If the firm belongs to an industry whose asset turnover is 3, does it have high or low
asset leverage
4. What are operating, financial and combined leverage of the firm?
5. If sales drop to Rs 50,00,000 what will be the new EBIT?
6. At what level of sales the EBT of the firm will be equal to zero?
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CA. CS.CMA.MBA: Naveen Rohatgi
NMIMS School of Economics Corporate finance
Q9) The ABC Ltd. has the following balance sheet and income statement information:
Balance sheet s on March 31,2015
Liabilities Rs Assets Rs
Equity capital (Rs 10 per share) 8,00,000 Net fixed assets 10,00,000
10% debt Current assets 9,00,000
Retained earnings 6,00,000
Current liabilities 3,50,000
1,50,000
19,00,000 19,00,000
Income statement for the year ending March 31, 2015
Sales Rs 3,40,000
Operating expenses (including Rs 60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: interest 60,000
Earning before tax 1,60,000
Less: Taxes 56,000
Net earnings (EAT) 1,04,000
(a) Determine the degree of operating, financial and combined leverage at the current sales
level, if all operating expenses, other than depreciation, are variable costs.
(b) If total assets remain at the same level, but sales (i) increase by 20 per cent and (ii) decrease
by 20 per cent, what will be the earnings per share in the new situation and percentage
change in EPS.
10) The capital structure of the progression1,00,000 units, the selling price is Rs 15 per
unit, variable costs amount to Rs 10 per unit and fixed expenses amount to Rs
3,00,000. The income tax rate is assumed to be 40 per cent.
a. You are required to calculate the following:
i. The percentage increase in earnings per share.
ii. The degree of financial leverage at 1,00,000 units and 1,25,000 units.
ii. The degree of operating leverage at 1,00,000 units and 1,25,000 units
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