Definition of leverage, Types of Leverages, meaning of operating leverage, financial leverage, combined leverage, Formulas for Operating and financial leverage, variable cost, fixed cost, EBIT, Contribution, EPS-EBIT Analysis, Income statement, practical problems on leverages, etc.

2. LeveragesLeverages
 It refers to “an increased means of
accomplishing some purpose.”
 In Physics, a multiplication of a
force into even larger forces.
 In finance, a multiplication of %
change in sales into even larger
change in profitability measures.
 It refers to “an increased means of
accomplishing some purpose.”
 In Physics, a multiplication of a
force into even larger forces.
 In finance, a multiplication of %
change in sales into even larger
change in profitability measures.

5. A hypothetical income statementA hypothetical income statement
for a firm is as follows:for a firm is as follows:
Sales 4000
Less:Variable costs 1600
--------
Contribution 2400
Less: Fixed costs 1000
--------
Profit 1400
--------
Sales 4000
Less:Variable costs 1600
--------
Contribution 2400
Less: Fixed costs 1000
--------
Profit 1400
--------

6. If sales andVC are increasedIf sales andVC are increased
by 25% ...by 25% ...
Sales 5000 (increase of 25%)
Less:Variable costs 2000 (increase of 25%)
--------
Contribution 3000 (increase of 25%)
Less: Fixed costs 1000 (No change)
--------
Profit 2000 (6/14*100 = 43%)
--------
Sales 5000 (increase of 25%)
Less:Variable costs 2000 (increase of 25%)
--------
Contribution 3000 (increase of 25%)
Less: Fixed costs 1000 (No change)
--------
Profit 2000 (6/14*100 = 43%)
--------

7. LeverageLeverage
 A 25% increase in sales from 4,000 to 5,000, profits
have increased from 1400 to 2000, an increase of
43%.
 This is the effect of leverage.
 If there are not fixed costs and all its costs were
variable, there would have been no leverage and the
percentage change in sales would have been the same
as the percentage change in profits.
 It is fixed costs that introduce leverage into the
firm and higher the fixed cost, higher is the
leverage.
 A 25% increase in sales from 4,000 to 5,000, profits
have increased from 1400 to 2000, an increase of
43%.
 This is the effect of leverage.
 If there are not fixed costs and all its costs were
variable, there would have been no leverage and the
percentage change in sales would have been the same
as the percentage change in profits.
 It is fixed costs that introduce leverage into the
firm and higher the fixed cost, higher is the
leverage.

8. Types ofTypes of LeveragesLeverages
 Operating Leverage
 Financial Leverage
 Combined Leverage
 Operating Leverage
 Financial Leverage
 Combined Leverage

9. Sales xxx
Less:Variable Cost xx
Contribution xxx
Less: fixed Operating expenses xx
EBIT xxx
Less: Interest xx
EBT xxx
Less:Tax xx
PAT xxx
Less: Preference Dividend xx
Earnings available to Equity Share holders xxx
Operating
Leverage
Types ofTypes of LeveragesLeverages
Sales xxx
Less:Variable Cost xx
Contribution xxx
Less: fixed Operating expenses xx
EBIT xxx
Less: Interest xx
EBT xxx
Less:Tax xx
PAT xxx
Less: Preference Dividend xx
Earnings available to Equity Share holders xxx
Financial
Leverage

10. Operating LeverageOperating Leverage
 The firm’s ability to use fixed
operating costs and magnify the
effects of changes in sales on its
earnings before interest and taxes.
 The relationship between sales and
earnings before interest and tax.
 The firm’s ability to use fixed
operating costs and magnify the
effects of changes in sales on its
earnings before interest and taxes.
 The relationship between sales and
earnings before interest and tax.

11. Operating LeverageOperating Leverage
Degree of
Operating
Leverage
=
% change in EBIT
--------------------------
% change in Sales
=
Contribution
--------------------------
EBIT
Degree of
Operating
Leverage
(at base level)

12. ExampleExample –– 11
A firm sells products for 100 per unit,
has variable operating costs of 50 per
unit and fixed operating cost of
50,000 per year. Show the various
levels of EBIT that would result from
sale of
(i) 1,000 units
(ii) 2,000 units
(iii) 3,000 units
A firm sells products for 100 per unit,
has variable operating costs of 50 per
unit and fixed operating cost of
50,000 per year. Show the various
levels of EBIT that would result from
sale of
(i) 1,000 units
(ii) 2,000 units
(iii) 3,000 units

13. Degree of Operating Leverage of 2
indicates that a 1% change in sales
leads to 2% change in EBIT.
Degree of Operating Leverage of 2
indicates that a 1% change in sales
leads to 2% change in EBIT.

14. ExampleExample –– 22
A firm sells products for 50 per unit,
has variable operating costs of 30 per
unit and fixed operating cost of 5,000
per year. Its current level of sales are
300 units. Determine the degree of
operating leverage. What will happen
to EBIT if sales change
(a) rise to 350 unit
(b) decrease to 250 units
A firm sells products for 50 per unit,
has variable operating costs of 30 per
unit and fixed operating cost of 5,000
per year. Its current level of sales are
300 units. Determine the degree of
operating leverage. What will happen
to EBIT if sales change
(a) rise to 350 unit
(b) decrease to 250 units

15. Financial LeverageFinancial Leverage
 It studies the impact of change in
EBIT on EPS.
 The degree of financial leverage
measures the financial risk
associated with the firm.
 It is also known as trading on
equity.
 It studies the impact of change in
EBIT on EPS.
 The degree of financial leverage
measures the financial risk
associated with the firm.
 It is also known as trading on
equity.

17. Financial LeverageFinancial Leverage
Degree of
Financial
Leverage
=
% change in EPS
--------------------------
% change in EBIT
Degree of
Financial
Leverage
=
% change in EPS
--------------------------
% change in EBIT

18. Financial LeverageFinancial Leverage
=
EBIT
--------------------------
EBIT – I –
Degree of
Financial
Leverage
(at base level)
Dp
-------
(1-T)
Degree of
Financial
Leverage
(at base level)
Dp
-------
(1-T)
I Interest
Dp Preference Dividend
T Tax Rate

19. ExampleExample –– 33
The EBIT of a firm is 60,000. The firm’s
capital structure is as follows:
10% Debt of 1,00,000; 8% Preference
shares of face value 100 amounting to
2,00,000 and Equity shares of face value
100 amounting to 4,00,000. The company
fall in 35% tax bracket. Compute Degree of
Financial Leverage.
The EBIT of a firm is 60,000. The firm’s
capital structure is as follows:
10% Debt of 1,00,000; 8% Preference
shares of face value 100 amounting to
2,00,000 and Equity shares of face value
100 amounting to 4,00,000. The company
fall in 35% tax bracket. Compute Degree of
Financial Leverage.

20. Degree of Financial Leverage of
___ indicates that a 1% change in
EBIT leads to ____% change in
EPS.
Degree of Financial Leverage of
___ indicates that a 1% change in
EBIT leads to ____% change in
EPS.

21. Combined LeverageCombined Leverage
 It studies the impact of change in
sales on Earnings Per Share (EPS).
 It quantifies the relationship
between sales and EPS.
 It measures the total risk
associated with the firm.
 It studies the impact of change in
sales on Earnings Per Share (EPS).
 It quantifies the relationship
between sales and EPS.
 It measures the total risk
associated with the firm.

22. Combined LeverageCombined Leverage
Degree of
Combined
Leverage
=
% change in EPS
--------------------------
% change in sales
Degree of operating Leverage
x
Degree of Financial Leverage
=
Or

23. Combined LeverageCombined Leverage
=
Contribution
--------------------------
EBIT – I –
Degree of
Combined
Leverage
(at base level)
Dp
-------
(1-T)
I Interest
Dp Preference Dividend
T Tax Rate

24. ExampleExample –– 44
A firm sells 10,000 units at 50 per
unit. The variable costs is 30 per unit
and fixed operating cost of 50,000 per
year. The firm’s capital structure is as :
7% Debt of 2,00,000; 8% preference
shares of face value 100 amounting to
1,00,000 and Equity shares of face value
100 amounting to 5,00,000. Tax rate
is 35%. Compute the degree of
combined leverage.
A firm sells 10,000 units at 50 per
unit. The variable costs is 30 per unit
and fixed operating cost of 50,000 per
year. The firm’s capital structure is as :
7% Debt of 2,00,000; 8% preference
shares of face value 100 amounting to
1,00,000 and Equity shares of face value
100 amounting to 5,00,000. Tax rate
is 35%. Compute the degree of
combined leverage.

25. Degree of Combined Leverage of
___ indicates that a 1% change in
sales leads to ____% change in
EPS.
Degree of Combined Leverage of
___ indicates that a 1% change in
sales leads to ____% change in
EPS.

26. EBITEBIT –– EPS AnalysisEPS Analysis
 It examines the effect of the financial
leverage.
 It involves calculation of EPS of the
firm at each financing alternative at a
given level of EBIT.
 The financing alternative which
maximises the EPS of the firm should
be selected.
 It examines the effect of the financial
leverage.
 It involves calculation of EPS of the
firm at each financing alternative at a
given level of EBIT.
 The financing alternative which
maximises the EPS of the firm should
be selected.

27. A company currently finances its projects with equity of face
value Rs.100 amounting to Rs.20,00,000. The company is
considering to raise additional capital of Rs.10,00,000 to
finance its future expansion projects. The following financing
alternatives are under consideration :
 Plan 1 : Raise the entire amount by issue of equity shares
 Plan 2 : Raise Rs.6,00,000 by issue of 11% debt and the
balance by equity
 Plan 3 : Raise Rs.5,00,000 by issue of 11%preference
shares and the balance by equity
 Plan 4 : Raise Rs.3,00,000 by issue of 10% debt,
Rs.3,00,000 by issue of 11% preference shares
and balance by equity
If the company’s EBIT is Rs.5,00,000 and company falls in 35%
tax bracket, Advise the firm which of the financing alternative
should be selected.
ExampleExample –– 55
A company currently finances its projects with equity of face
value Rs.100 amounting to Rs.20,00,000. The company is
considering to raise additional capital of Rs.10,00,000 to
finance its future expansion projects. The following financing
alternatives are under consideration :
 Plan 1 : Raise the entire amount by issue of equity shares
 Plan 2 : Raise Rs.6,00,000 by issue of 11% debt and the
balance by equity
 Plan 3 : Raise Rs.5,00,000 by issue of 11%preference
shares and the balance by equity
 Plan 4 : Raise Rs.3,00,000 by issue of 10% debt,
Rs.3,00,000 by issue of 11% preference shares
and balance by equity
If the company’s EBIT is Rs.5,00,000 and company falls in 35%
tax bracket, Advise the firm which of the financing alternative
should be selected.

28. DecisionDecision
Which financial alternative have
the highest EPS, the company
should adopt that alternative for
financing its future expansion
projects.
Which financial alternative have
the highest EPS, the company
should adopt that alternative for
financing its future expansion
projects.

29. Financial Break Even PointFinancial Break Even Point
The level of EBIT which is equal to
fixed financial costs.
FBEP = I +
I : Interest
Dp : Preference Dividend
T : Tax Rate
Dp
--------
1-T
The level of EBIT which is equal to
fixed financial costs.
FBEP = I +
I : Interest
Dp : Preference Dividend
T : Tax Rate
Dp
--------
1-T

30. The capital structure of Zenith Ltd. is
as follows.
If the corporate tax rate is 30%,
compute the firm’s financial break
even point.
ExampleExample –– 66
Amount (Rs.)
8% Debt 10,00,000
10% Preference Shares 15,00,000
The capital structure of Zenith Ltd. is
as follows.
If the corporate tax rate is 30%,
compute the firm’s financial break
even point.
10% Preference Shares 15,00,000
Equity Share Capital 20,00,000
Total 45,00,000