Chapter 2 Leverages ll Try to make at least two persons happy in a day; but make sure that one of them is yourself. Meaning — Definition - Types of Leverages — Distinction - Importance of Leverage ~ Margin of Safety - Break Even Analysis - Solved Problems - Questions for Self- Practice. Meaning: Capital structure decisions has an impact of the firms objective of wealth maximisation of shareholders. The sources of finance are classified into those which carry a fixed rate of return and those on which returns varies. In case of debt it involves the payment of a stated rate of interest which is fixed and therefore the return to the equity shareholders is affected by the magnitude of debt in the capital structure ofa firm. / The employment of an asset or source of funds for which the firm has to pay a fixed rate of return is termed as leverage. In case of a higher leverage outside borrowings are higher therefore the risk is more and thereby the profits are also more and vice versa. ; It is to be noted that, for the purpose of calculation of leverages fixed costs are divided into two parts: (a) fixed operating cost, which excludes interest on borrowed funds; and (b) fixed financial cost which pertains to interest on borrowed funds. ; The dictionary meaning of the term leverage refers to “an increased means for accomplishing some In general terms, leverage helps us in lifting heavy objects, may not be otherwise possible. In ‘the area of finance the term leverage is used to describe the firm’s ability assets or funds to magnify the returns to its owners. ooVan 55 2 are three types of leverage: “Operating Leverage: It is concerned with operation of the firm. perating leverage relates to the sales and profit variations. perating leverage is determined by the relationship between sales fevenuie and earnings before interest and tax,Operating leverage is the firms ability to use the fixed operating costs to magnify the “effects of changes in sales on its earnings before interest and taxes. Degree of Operating Leverage ~ Sonuebation financial Leverage: Financial leverage indicates the effect on arnings due to rise of fixed cost eee | leverage arises fixed Financial \¢ firm employs debt funds verage represents the relationship jeen earnings ore in and taxes and the earnings available for equity shareholders.) Financial leverage is the ability of the firm to use financial charges to magnify the effect of change in earnings interest and tax on the earnings per share. There will be no leverage if there is no fixed charge financing.uuw Financial Management (FM - 11) (BaF) multiplying the degree of operating leverage by the degree of financial leverage. ee Costs are dlassified into variable cost and fixed costs. Further fixed costs are divided into fixed operating cost and fixed financial cost. If a firm is not required to pay fixed cost or fixed return on its funds then there will be no leverage. In case of a high degree of leverage it indicates there will be a large change in profits due to a relatively small change in sales and a low-degree of leverage indicates that there will be a small change in profits due to a relatively large change in sales. Thus it indicates that higher the leverage, higher is the risk and higher is the return and vice versa. Distinction between Operating Leverage and Financial Leverage: [- Operating Leverage Financial Leverage (i) The objective of operating]() The objective of financial] leverage is to magnify the leverage is to magnify effect of changes in sales on effect of changes in EBIT on | BPS 3 EBIT. ( It is known as first stage|(2) It is known as second- ~_ leverage. leverage. 3) It affects earnings .\before /(3) It affects __earni =_ interest and tax. interest and tax. _ (@) It relates to the “Assets” side|(4) It relates to the __ of the Balance Sheet. side of the Balance SI (5) It relates with investment}(5) It relates with decisions. decisions. a It deals with operating risk of | (6) It deals with financial ri being unable to cover fixed operating cost Importance of Leverage a) Leverages indicates the ability of the firm to use fixed cost fixed cost funds to magnify the returns to its shareholders (2) Leverages helps in examining a relative change in the change in the sales, "2 @) Revesaees helps in determining the increase occurs on account ating financial cost. oa Leverages helps in bi fs; cit Se ang a Profits of the firm at differently. Leverages helps in det company, © @ (5)Leverages 57 Margin of Safety (MOS) Sale wu MR Atal Gees in Ro.” BRP Sle Rs 8s.) = MOS Sales Units x Selling Price Per Unit ts) = Actual Sales Units — BEP Sales Units Sales = Actual Sales — Break Even Sales 6) Margin Safety Sates (in Rs) = =-P#ofit_ ry Margin Safety Sales ()) =Matsin of Safety Sales oy (u) Net Profit = Margin of Safety Sales x P/V Ratio Margin of Safety: Margin of Safety Sales is the excess sales over the Break-even sales. It isthe difference between actual Sales and Break - even sales. Formulae: _ _ Profit ® = D7V Ratio (ii) = Actual Sales minus Break Even Sales The more the margin of safety sales it is better because: (i) Ttindicates a higher profit. cio (i) Itacts as a cushion even if the sales drops drastically. ; (iii) It indicates recovery of the full costs and profit earned above that. (iv) Higher the MOS sales the more sa i Break~Even (BEP) Sales: At Bre Cost or Sales = Marginal Cost + Fixed loss at the Break-even sales. iFormulaes for Calculati @ ing Leverages: Degree of Operating Leverage (DOL) = “Satsibution © G@ Degree of Financial Leverage (DFL) = ST EBT Gi) Degree of Combined Leverage (DCL) = DOL x DEL — Contribution . Be — Contribution EBT Therefore; Degree of Combined Leverage (DCI) = Seutsibation ‘ =VED PROBLEMS _ illustration 1: Find the Operating leverage from the following data: Sales Rs. 50,000 60% Rs, 12,000SS (it) Combined Leverage = Contbuton _4, Financial Management (FM - 1 (BAF) 400,000 _ “EBT = 1,00,000 =4 OR Combined Leverage = Operating Leverage x Financial Leverage a : i. x16 fstation 4: Calculate degree of operating leverage, degree of financial leverage and combined leverage from the following date: Sales 1,00,000 units at Rs. 2 Per unit is Rs, 2,00,000. ‘ Variable cost per unit at Re. 0.70, Fixed Costs: Rs. 1,00,000. Interest Charges: Rs. 3,668, (b) Which combination: of operating and financial leverages constitute: (0) fishy situation and (ii) ideal situation Solution: (a) Income Statement p Pa Per Unit | For 7,00,000) Sales Less: Variable Cost Contribution Less: Fixed Cost excluding interest Eamings Before interest and Tax (EBIT) Less: Interest Eamings Before Tax Contribution 4, ODO, = =e 55 EBIT _ 30,000 _ (DAL =FBy =O ss Contbuiion 1.30000 CH) Do, = ET 180000 og (6) High operating leverageLeverages 61 Solution: With increase in sales volume from 2,500 units to 3,000 units Le by 20%, increased from Rs. 2,500 to Rs. 5,000 i. by 100%. Thus with increase in sales Units operating profit, led. Illustration 6: Pee ~ Calculate operating leverage and financial leverage under situations 1 and 2 andSe management (FM - Il) (BAF) Situation fl Plan A Plan B For 1,000 | PU Units 3S | Rs. Less: Variable Cost y ; : 10 Contribution 10 Less: Fixed Cost excluding | ear ing Interest = 1.66 = 1.66 = = EBT m @ pnt 8.000 6,000 5000 5 EBT aS 4500 5,500 3500 aon =133 =1.09 = 1.42 =111 __ Contribution “10,000 10,000 10,000 10,000 EBT 4500 5500 3,500 4500 =222 =181 3285 «-[ics oaliges wr ‘ustration 7: Calculate the operating leverage, financial leverage and combined leverag following ~ data under Situation | and Il and Financial Plan A and B. sea Installed capacity 4,000 units Actual production and sales 75% of the capacity Selling price Rs. 30 per unit Variable Cost Rs. 15 per unit Fixed Cost: Under Situation! — Rs. 15,000 Under Situation Il Rs. 20,000 Structure: Debt (Rate of interest at 20%) Solution: , 75, Actual Production and Sales = 709 * Installed Capacity 75 = 709 * 4,000 = 3,000 units= a ie ie Co San ae Cee © 1 LOA Soltion: Income Statement Firms a B Particulars PU] ‘Totalfor | PU] Totalfor | PU 60,000 Units 15,000 Units Rs. | Rs. Rs. | Rs. Rs. a 060] 98,000 6.00 75,000 | 0.10 Less: Variable Cost 020 | 12,000 _| 1.50} 22,500 __| 0.02 Contribution 040 [24,000 [-350| 52,500 | 008 Less: Fixed Cost exclucing interest 7,200 14,000 Pal 16,800 38,500 Less: interest 4,000 8,000 Eamings Before Tax 12,800 30,500 = Contribution, 24,000 52500 OO EST 16,800 38,500 = 142 | =1.96 fa 16,800 13,500) aes ES 12,800 30,500 =131 =126 = Cention 24000 52500, e! oe EST 12,800 30,500 | y bg = 187 =172 yw tration 9: F VY Compute different leverages from the following information: — ine > | Sales (2,200 Units Variable Cost Fixed Cost Solution: Sales Less: Variable Cost Contribution Less: Fixed Cost excluding interest Eamings Betore Interest and Tax (EBIT) Less:Ifthe retum on investment is 18% and the tax rate is 40%. Calculate: (@). Financial leverage.PIVRatio = SOME Contribution = PIV Ratio x Sales = 0:33 x 18,60,000 Contribution = Rs. 6,20,000 aa Contribution _ 620,000 _ Do. = “Far 558000 = 1! Contribution _ 620,000 _ , 94 DCL =""epT 470,000 EBIT 5,58,000 _ DFL = Egr =470000 = "18 Illustration 11: Calculate Eamings per share (EPS) of Solid Ltd. and Sound Ltd. assuming: (@) 20% before tax rate of retum on assets. (b) 10% before tax rate of retum on assets based on the following data: Solid Ltd. ‘Sound Ltd. (Rs. in lakhs) (Rs. in takhs)_ Assels 100 100 Debt vs Equity 100 (Share of Fis. 10 each) (Share of Rs. 10 ea ‘Assume a 50% income tax rate in both the cases. Give your comments on the financial leverage. Solution: Particulars Eamings Before Interest and Tax (EBIT) Less: Interest Eamings Before Tax Less: Tax @ 50% Eamings After Tax — Amount Available to Equity Shareholders. Re Number of Equity Shares EBit (@ DFL=far Comments: (2) _ 1f 20% is the retum on assets then Sound Preferred based ruin on atts dps to 10% Sold Li peed €amings are high a company with high debt in its Uc.) but when the eamings drops down a co : Structure is preferred (i. in this case Solid Ld.tee wag 8 In case of Solid Ltd. there is no debt and therefore the financial leverage is 1; whereas in () ase of Sound Lid. there exss a ancl leverage and enc dating ir Rok by SOM i followed by a decline in EPS by 71.42% (Le, from Rs, 1.40 to Re 0.40), z Note: ie cane Before a re Oo oe s ist jon 12; by ‘ ‘Affirm has sales of RS: 150 lakhs, variable cost of Rs. 84 lakhs and fixed cost of Rs. 12 lakhs. It as a debt of Rs. 90 lakhs at 9% and equity of Rs. 110 lakhs. PF ‘What is the firm’s ROI? Does it have favourable financial leverage? Ihe fm belongs 0 an Ins Wis ais oes ets ll aes leverage’ ‘What is the operating, financial and combined leverage of the firm? Ifthe sales drop to Rs. 125 lakhs, what will be the new EBIT? Atwhat level the EBT of the firm will be equal to zero? ~~”Financial Management (FM - I!) (BAF) 44 __» Ans.: Sales = Rs. 45.68 Lakhs (approx.) RD AMlustration 13; Yy ‘The selected financial data for A, B and C companies for the year ended 31st March, 2002 a. were as follows: A B Variable Cost as a Percentage of Sales 66% Interest Expenses (Rs.) 200 Degree of Operating Leverage 5 Degree of Financial Leverage 3 Income Tax Rate % 40 Prepare an income statement for each of the 3 companies. Solution: : Income Statement for the year ended 31.03.2002 Particulars A B i Rs. Rs. Sales 100 4,500 100 9,600 100: Less: Variable Cost 66% 3,000 75 7,200 50 Contribution 33% 1,500 25 2,400 50 Less: Fixed Cost excluding Interest 4,200 2/000 EBIT 300 400 Less: Interest 200 300 Eamings Before Tax 100 100. ee Less: Tax @ 40% | 0 Eamings Afier Tax 60 60 EBIT @) DFL=ERr Let the EBIT =x +. EBT = x~ Interest amount ny A x a = 200) =x 3x- 600 =x 3K- fx =600 & =600 600 ee x =300C =6x 409 aT Let the = 100 5 c 33 1,500 33% 1,500 wo X [4 10 % [J Sales = 9,600 ‘Sales = 8,000 From the following information of S Ltd. and G. Lid. compute Operating Leverage, Financial erage and combined leverage and comment on the impact on the shareholder's wealth, S.Lid (Rs) Equiy Share of Ris, 10 Each ia 70,000 10% Debentures Total Capital Employed Sales 90, 1,80,000Financial Management (FM - 11) (BAF) Rs. Crore ol) 152.31 Borrowing 165.47 EBIT 43.17 Interest 34.39 jing interes!) You are required to calculate (a) debt - equity ratio (b) interest covefage (6) Operating Leverage (d) financial Leverage (@) Combined Leverage Intereprete your results and comment on debt policy. Solution: Rs. In Crores Sales ‘980.20 Less: Variable cost 818.80 161.40 Less: Fixed Costs (Excl Interest) |_ 118.23 EST 43.17 Less: Interest EBT j_*—_ Debt ‘ ESL = Equity ~ 152.31 =1.08: 4 (approx.) E EBIT 43.17 {b) Interest Coverage Ratio = Tpierest =34.39 = 1.25 Times (approx.) . Contribution _ 161.40 DEERE ad =~ EBT ~ 43.17 = 3.73:1 (approx.) 5 EBIT 43.17 {@) Financial leverage EBT =4.91:1 (approx.) {e) Combined leverage cer = 878 = 18.38:1 (approx.) ad tion 16: Calculate operating leverage and Financial Leverage under situations A, B and C ior Plans |, II and lll respectively from the following information relating to the operation > structure of Rani Lid. Also find out the combinations of operating and financial es value and the least value. How are these calculations useful to fi Installed Capacity (No. of Units) ‘Actual Production and Sales (No. of Units) ‘Seling Price Per Unit (Rs. Variable Cost Per Unit (Rs.) Fined Cost ~ Situation A (Rs.) Fixed Cost - Situation B (Rs) Fixed Cost ~ Situation C (Rsuuu (Actual Production and Sales: 600 Units) Statement (Rs. p IFinancial Management (FM - I) (BAF) ad gag Interest burden on Debt (Rs.) 120,005 One baa of bee da cont (2) Operating Leverage. () Financial Leverage () Combined Leverage. Solution:LeveragesWorking Note: (8) _ Interest on Debentures = 10% x Debenture Amount A ,000 x 1 tion 21: 8 wn Caloulate the degree of operating leverage, degree of financial leverage and the degreed * ‘combined leverage for the following firms: Firms Total for 6,000 Unitsert ve ee Global Sue Deas 100°| Sabo 100 -vc oy | -Vve 75 Contribution 3% Contribution 25 ~~ 33% 1,50,000 By 2,40,000 ye 100 > 7=450,000 100 23 8,00,000 Illustration 23: 5,00,000. Variable costs Rs. 3,00,000. Fixed Pere Given information for Sales Rs. ope Sa Reston 000. Calculate Operating leverage and rating Cost Rs. 1,00,000. Interest on borrowings Rs. 20, Financial Leverage. Solution: Income Statement Particulars ‘Amount —_ | (Rs. pa.) Sales i 5,00,000, Less: Variable Cost 3,00,000 Contribution 2,00,000 Less: Fixed Operating Cost 1,00,000 Eamings Before interest and Taxes 1,00,000 Less: Interest on Borrowings ___— 20,000 Eamings Before Tax 80,000, Contribution @ DOL =~“Esir = 200,000. ~ 1,00,000 DOL =2 EBIT (i) OFL EBT — 1:00,000. ~ 80,000 i u DFL = 1.25 {O° Llustration 24: x The following details of A Ltd for the year ended 3st March, 2014 are fuished. Operating Leverage Financial Leverage Interest charged p.a. Comporate tax Variable Cost as per Sales Prepare the income statement of the comy Solution: ad Less: Variable Cost (0,6 Sales) Contribution (0.4 Sales) Less: Operating Fixed Cost Earmings Before Interest and Tax (earnrages teva Gag n Les: Interest ; / Profit Before Tax Less Income Tax @ 60% éamings/ Net Proft Alter Tax Workings: BIT @ OF. = esr Let the EBIT be equal fo x a 1 *x=20,00,000 2(x~20,00,000) =x 2x-40,00,000 = 1x 2x-1x = 40,00,000 EBIT=x = 40,00,000 () DOL = 3 _ Contribution 1 =" 40,00,000 3 x 40,00,000 Contribution "= 120 Lakhs Points to Rememberit ag Financial Management (FM - I!) (BAF) (Mt) True oF False: (8) Contribution margin letra expenseon Debt (4) rating Level ing & Pract verge: {(Sales minus Variable Cost) / Sales] X 100 () a) a) to be hi 4 (A firm with signiticantty moro debt than equity is considered ighly leveraged. @ Ieret on loan ea fied cot, erage comes without any risk. bankruptcy. , itis considered to be near ® Daeany iri istorortoed ot might be able to secure new capital even, if itis incapable of meoting its current obligations. [Ans.: (1 True) (2- True) (3 - False) (4 - True) (5 - False). Match the Columns: No Profit - No Loss (2) Break even point Fixed costs Income Tax TAns.:(1- 0) (2- 3) (3-6) (4-b) (5-o)] THEORY QUESTIONS Answer the following questions: What is Operating Leverage? Explain the importance of leverage. Distinguish between operating leverage and financial leverage. Write a note on various types of leverages. Distinguish between operating leverage and financial leverage. What do leverage ratios indicate? What is the relevance of operating leverage and financial leverage in . business decisions? (8) Whatis ‘Margin of Safety’? (9) What is meant by financial break even point? (10) What is meant by financial leverage? Write short notes on: (1) Financial Leverage. (2) Operating Leverage. (3) Combined Leverage. PRACTICAL PROBLEMS Calculate operating leverage and financial mee 9 an epcil om heels eres la Ste PPE Sa rae nd tthe conbiaton of operating and ancl ast value, How are these calculations useful to Intald capacty 1200 uns nancial manager in ‘Actual production and sales 800 units Seling price per unit Rs, 15 Variable cost per unit Ris, 10 Fixed Cost: Situation A Rs. 1,000 Sityation B Rs, 2,000 Situation © Rs. 3,000©) — The capital Corporation consists of an ordina oa Rs. 10,00,000 (shares of Fs, 100 face vale) and Fi. 10,00,000 of 10% Debentures, salow ncsoasod BY 20% from 1,00,000 units to 1,20,000 unt, the selfing price fs Re, 10 Por unt variabe costs amount 10 Rs. 6 por unt and fixed expenses amount 10 Rs. '2,00,000. Tho income-tax rate is assumed to be 50%: {a) You aro required to calculate te following (©) Comment on the behaviour [production from 1,00,000 units to 1,20,000 fAns.:P EPS. © The wolExtbishod Conpary/s est ent balance shea slows Com | ol | 000 Equity Capital (Rs. 10 per share) £60,000 | Net Fixed Assets 30,000 | Current Assets 20,000 | 2,00,000 | Rs. “The Company’ toll assets tumover ratio is 8.0; ts fixed operating costs are Rs. 1,00,000 and its ‘variable operating costs ratio is 40%. The Income Tax Rate is 50%, ® ‘Calculate for the company all the three types of leverages. Determine the likely evel of EBIT if EPS is (Re 1. (i) Rs. 3. (il) Zero {Ans.: (a) DOL = 1.38, DFL = 1.08, DCL = 1.42, (b)() Rs. 6,000 (i) Fs. 18,000 (i) Fs. 0) A ay ee ee ea deena topics ‘projected year. With the existing capital equipment and the producto ‘capacity the total fixed costs are estimated at Rs, 6 lakhs; the variable costs being placed at 25% o the ‘sles price. The seling price per unit is Rs. 50. The total capital employed includes a borrowing of Rs.5 lakhs at 12% interest. ‘The finance manager proposes 10 pay of the existing suggested the |Jaypee Ltd. need Rs, 100 Lacs for the installation of a new manufacturing unit. The ‘expocted to yiold an annual EBIT of Rs, 16 Lacs. In choosing a financial plan, Jaypoo objective of maximising eaming per share, It is considering the possibilty of issuing equity shares and raising dabt of Rs. 10 Lacs or Rs. 40 Lacs oF Rs, 60 Lacs. The current markot price per share is Rs. 250 ‘and is expected to drop to Rs, 200 if the funds are borrowed in excess of Rs. 60 lacs, Funds can be ‘borrowed at the rates indicated below: Upto Rs. 10 Lakhs @ 8%, ‘Over Rs. 10 Lakhs to Rs, 50 Lakhs @ 12%, vor Rs, 50 Lakhs @ 18%. ‘Tax rate is 50%. You are required to calculate the EPS, Financial Leverage for the three financing ‘altomatives and number of shares to be issued. Calculate Operating Leverage and Financial Leverage under situations A, B and C and under Financial Plans |, 1! and Ill respectively from the following information relating to the operation and capital ‘structure of Tale-Nitlon Lid, Also find out the combinations of operating and financial leverage which give the highest value and the least value, How are the calculations useful tothe financial manager of7. a (li) Degree of financial leverage. (b) Comment on the financial position and struct ne: eae DOL 6,000 5,000 5 J NPAr ‘which 60,000 units ware sold: (12) The following fs summarised Profit and Loss Ae for 2006 dung re J + Increase in sales required to double nt prot Rs. 1,80,000, .e. 25% 1T industries manufactures one product with selng price is Rs. 20 per unit and variable cost is Rs. 10 per unit. The plant has installed capacy of 2,000 units, but utilisation is only 60%. Fixed cost Rs, 5,000. its capital needs Ris. 20,000 Itconsders following Debt Equity Ratios: Debt 25% - Equity 75% (&) Debt 50% Equity 50% Debt 75% ~ Equity 25%(Nis moro riskier than M,) {19 Pid L. hash capa stucto of Eauiy Shares Copal (Rs 10), 10 Lacs and 15% Dobenturos. (Rs, 100) As, 10. Lacs ‘Tho Sales have increased from 20,000 units to 24,000 units, The sales price is Re. 60 per unt ‘aviblo cost is 60% of sales price. Fited expenses are is, 2 lacs (oxcluding interest). The income tax payable is @ 35%. YYou are required to compute: () E:P.S, at both levels, (1) Operating leverage at both love. Financing leverage at both levels, fans.ial Management (FM - * og Financial a) will eamings per share increase Using ‘of combined leverage, by what percentage i sas ean BY 1 Vority your answer by calculating eamings per share when sales g, Rs, 11,00,000, [Ans.: EPS = 1.69 per share; 30% increase in EPS when sales increases by 1 0x) ‘income statements from the data given below for PO, 0. Remnants Variable Cost as a % of Sales Interest Saeco a en cer Offer your comments on the leverages ‘The sales required to eam profit of Ris. 80,000. ‘The profit made when sales are Rs. 7,00,000, Margin of safety at a profit of Rs, 50,000, Variable cost ofthe two years,ee % ‘Sony Ltd. sell the same type of product in the same type of market. You are fumished with d Revenue Statement for he financial year 2005-06 which is as under: Zee Lid, Sony Lid. Rs. Rs. 6,00,000, 500,000 000. a 8,00,000 2,00,000 to calculate the following in each case: (v8 gn is) From the folowing details (). Prof Volume Ratio (Break Even Point in Units (i)__ Break Even Pointin Sales ‘The company's total assets tumover ratios 3 times. The fixed operating costs are Rs. 4,00,000. ‘The variable operating costs are 40% of sales. ae ee:(26) ‘Gama Lid. has sales of Rs. 18,00,000, variable cost of Rs. 9,60,000 and fixed cost of Rs, 2,40,000,| ‘has a debt of Rs. 20,00,000 at 10% and equity capital of Rs. 20,00,000. ‘You are required to: 0 Calculate operating leverage and find out new eaming before interest and tax level, if. ‘drop to Rs. 12,00,000, by using the value of operating leverage. @ Calculate and find out new sales level, if eamings before tax d ‘of combined leverage. Financial Management (FM - NN) (t