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Business Finance Assignment

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0% found this document useful (0 votes)
33 views13 pages

Business Finance Assignment

Uploaded by

janimubarkob23
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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FINANCIAL

AND
OPERATING
LEVERAGES

Principles of Business
Finance

Prepared by:
Name: Abdul Rehman
Roll No: 2K21/BBAE/6
Assignment by: Dr. Maria Sheikh
Contents
Meaning of Leverage .......................................................................................................................................... 3
Degree of Operating Leverage (DOL) ............................................................................................................... 3
Break-Even Analysis and Operating Leverage................................................................................................... 4
Margin of Safety and Operating Leverage ......................................................................................................... 5
Degree of Financial Leverage (DFL) ............................................................................................................... 10
Financial Leverage as ‘Trading on Equity’ ...................................................................................................... 12
Financial Leverage as a ‘Double edged Sword’ ........................................................................................... 13
OPERATING AND FINANCIAL LEVERAGE
Meaning of Leverage

The term leverage represents influence or power. In financial analysis leverage, represents the influence of one
financial variable over some other related financial Variable. These financial variables may be costs, output,
sales revenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we want to
Calculate impact of change in variable X on variable Y, it is termed as Leverage of Y With X, and it is
calculated as follows:

Measurement of Leverage= Change in Y÷Y/Change in X ÷X

Types of Leverage
There are three commonly used measures of leverage in financial analysis. These are:

(i) Operating Leverage: It is the relationship between Sales and EBIT and indicates Business risk.

(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates Financial risk.

OPERATING LEVERAGE
Operating Leverage means tendency of operating income (EBIT) to change disproportionately with change in
sale volume. This disproportionate change is Caused by operating fixed cost, which does not change with
change in sales volume. In other words, operating leverage (OL) maybe defined as the employment of an Asset
with a fixed cost so that enough revenue can be generated to cover all the
Fixed and variable costs.

The use of assets for which a company pays a fixed cost is called operating leverage. Operating leverage is a
function of three factors:

(i) Amount of fixed cost,


(ii) Variable contribution margin, and
(iii) Volume of sales.

Degree of Operating Leverage (DOL)

When we measure magnitude of disproportionate change it is termed as degree of Leverage. Degree of


Operating Leverage may be defined as percentage change in EBIT With respect to percentage change in sales
quantity.

Degree of Operating Leverage= Percentage Change in EBIT/Percentage Change in Sales

Mathematically:

DOL= ∆EBIT÷EBIT/ ∆Q÷Q

Here, EBIT = Q (S-V) – F


Q = sales quantity
S = selling price per unit
V = variable cost per unit
∆ Denotes change

DOL= ∆ [Q (S-V)-F] / [Q (S-V)-F] /∆Q / Q

Now ∆F is nil because change in fixed cost is nil. Therefore:

DOL= ∆ Q (S-V)÷Q (S-V)-F / ∆ Q÷Q = ∆ Q (S-V)÷Q (S-V)-F × Q÷∆ Q = Q (S-V)÷Q (S-V)-F

DOL= Contribution ÷ Contribution-Fixed Cost= Contribution ÷ EBIT

Break-Even Analysis and Operating Leverage

Break-even analysis is a generally used to study the Cost Volume Profit analysis. It Is concerned with
computing the break-even point. At this point of production level And sales there will be no profit and loss i.e.
total cost is equal to total sales revenue.

Break-even point in units = Fixed Cost ÷ Contribution per unit

Let us Understand through the following example:

PARTICULARS PRODUCT X PRODUCT Y

SELLING PRICE
20
40

VARIABLE COST 12
20

CONTRIBUTION 8
20

TOTAL CONTRIBUTION OF
8,000
1000 UNITS 20,000

FIXED COST 5,000


15,000

PROFIT (EBIT) 3,000


5,000

BREAK-EVEN POINT
(FIXED 15,000/20=750 units 5000/8=625 units
COST/CONTRIBUTION)
OPERATING LEVERAGE
8000/3000=2.67
( CONTRIBUTION/EBIT) 20,000/5,000=4

There is a relationship between leverage and Break-even point. Both are used for Profit planning. In brief the
relationship between leverage, break-even point and Fixed cost as under:

Leverage Break-even Point

1. Firm with high leverage 2. Higher Break-even point

3. Firm with low leverage 4. 1. Higher Break-even point

Fixed cost Operating Leverage

1. High fixed cost 1. High degree of operating leverage

2. Lower fixed cost 2. Lower degree of operating leverage

Margin of Safety and Operating Leverage

In cost accounting, one studies that margin of safety (MOS) may be calculated as Follows:

Higher margin of safety indicates lower business risk and higher profit and vice Versa. If we both multiply and
divide above formula with profit volume (PV) ratio Then:
We know that:

PV ratio= Contribution ÷ Sales or Sales ×PV ratio=Contribution

Further, BEP=Fixed Cost ÷ PV ratio or BEP×PV ratio=Fixed Cost

We know that:

DOL=Contribution ÷ EBIT

Hence:

Let us Understand through the following example:


When DOL is more than one (1), operating leverage exists. More is the DOL higher Is operating leverage. A
positive DOL/ OL means that the firm is operating at higher level than the break-Even level and both sales and
EBIT moves in the same direction. In case of negative DOL/ OL firm operates at lower than the break-even
sales and EBIT is negative.

Situation 1: No. Fixed Cost:


Note: DOL can never be between zero and one. It can be zero or less or it can be One or more.

When Sales is much higher than BEP sales, DOL will be slightly more than one. With Decrease in sales DOL
will increase. At BEP, DOL will be infinite. When sales is Slightly less than BEP, DOL will be negative infinite.
With further reduction in sale, DOL will move towards zero. At zero sales, DOL will also be zero.
A Company produces and sells 10,000 shirts. The selling price per shirt is Rs.500. Variable cost is Rs.200 per
shirt and fixed operating cost is Rs.25,00,000.
I) CALCULATE operating leverage.
II) If sales are up by 10%, then COMPUTE the impact on EBIT?

Solution:

Operating Leverage= Contribution ÷ EBIT = 30 lakhs Operating Leverage ÷ EBIT 5 lakhs = 6 times

(b) Operating Leverage (OL) = %Change in EBIT÷%Change in Sales

6 = X / 5,00,000÷5,00,000 / 50,00,000

X = Rs.3,00,000

∴∆EBIT = Rs.3,00,000/5,00,000= 60%


FINANCIAL LEVERAGE
Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in Order to increase earnings per
share.’ In other words, it is the use of company Funds on which it pays a limited return. Financial leverage
involves the use of funds Obtained at a fixed cost in the hope of increasing the return to common Stockholders.

Financial Leverage (FL) = Earnings before interest and tax(EBIT)/Earnings before tax(EBT)

Where, EBIT = Sales – (Variable cost+ Fixed cost)

EBT = EBIT – Interest

Degree of Financial Leverage (DFL)

Degree of financial leverage is the ratio of the percentage increase in earnings per Share (EPS) to the
percentage increase in earnings before interest and taxes (EBIT). Financial Leverage (FL) is also defined as
“the ability of a firm to use fixed Financial charges to magnify the effect of changes in EBIT on EPS.”

DFL = ∆EPS / EPS / ∆EBIT/EBIT

∆ EPS means change in EPS and ∆ EBIT means change in EBIT

Now EPS = [ (EBIT – 1) (1-t)] -D / No. of Shares

Here

T = Tax Rate
D = Dividend on Preference Shares (inclusive of dividend tax if any)

On simplifying the above we get,

DFL = EBIT(1-t) ÷ (EBIT – Int.)(1 – t) – Dp

DFL = EBIT/(EBIT – Int.) – Dp ÷ 1-t

If the company has not issued preference shares, then:

DFL = EBIT ÷ EBIT – Int. = EBIT÷PBT

When DFL is more than one (1), financial leverage exists. More is DFL higher is
financial leverage.
A positive DFL/ FL means firm is operating at a level higher than break-even point
and EBIT and EPS moves in the same direction. Negative DFL/ FL indicates the firm
is operating at lower than break-even point and EPS is negative.
Degree of Finance Leverage – (DFL) = Change in EP/Change in EBIT = 50%/50% = 1

Degree of Finance Leverage – (DFL)= Change in EPS 62.5%/Change in EBIT 50% = 1.25

(2.5/4 ×100) / 50% = 62.5%

Situation 3. When EBT is nil (EBIT = Fixed Interest)

Degree of Finance Leverage = EBIT/Nil = undefined.


Financial Leverage as ‘Trading on Equity’

Financial leverage indicates the use of funds with fixed cost like long term debts And preference share capital
along with equity share capital which is known as Trading on equity. The basic aim of financial leverage is to
increase the earnings Available to equity shareholders using fixed cost fund. A firm is known to have a Positive
leverage when its earnings are more than the cost of debt. If earnings is Equal to or less than cost of debt, it will
be an unfavorable leverage. When the quantity of fixed cost fund is relatively high in comparison to equity
capital it is said that the firm is “trading on equity”.
Financial Leverage as a ‘Double edged Sword’
On one hand when cost of ‘fixed cost fund’ is less than the return on investment Financial leverage will help to
increase return on equity and EPS. The firm will also Benefit from the saving of tax on interest on debts etc.
However, when cost of debt Will be more than the return it will affect return of equity and EPS unfavorably and
As a result firm can be under financial distress. This is why financial leverage is Known as “double edged
sword”.

Effect on EPS and ROE:

When, ROI > Interest – Favourable – Advantage

When, ROI < Interest – Unfavorable – Disadvantage

When, ROI = Interest – Neutral – Neither advantage nor disadvantage.

Note: DFL can never be between zero and one. It can be zero or less or it can be One or more.

Financial BEP is the level of EBIT at which earning per share is zero. If a company Has not issued preference
shares then Financial BEP is simply equal to amount of Interest.

When EBIT is much higher than Financial BEP, DFL will be slightly more than one. With decrease in EBIT,
DFL will increase. At Financial BEP, DFL will be infinite. When EBIT is slightly less than Financial BEP, DFL
will be negative infinite. With further Reduction in EBIT, DFL will move towards zero. At zero EBIT, DFL will
also be zero.

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