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18 - 18 - 11

Chapter 18Chapter 18

Operating, Financial And Operating, Financial And Combined LeverageCombined Leverage


18 - 18 - 22

OPERATING, FINANCIAL AND COMBINED LEVERAGE

Operating Leverage

Financial Leverage

Combined Leverage : Total Risk

Solved Problem

Mini Case


18 - 18 - 33

Leverage refers to the use of an asset or source of funds which involves fixed costs or fixed returns. As a result, the earnings available to the shareholders/owners are affected as also their risk. There are three types of leverage, namely,

1) Operating

2) Financial

3) Combined


18 - 18 - 44

Operating LeverageOperating Leverage

Leverage associated with asset acquisition or investment activities is referred to as the operating leverage. It refers to the firm’s ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits (EBIT) and results in more than a proportionate change (±) in EBIT with change in the sales revenue.

Degree of operating leverage (DOL) is computed in two ways:

1) Percentage change in EBIT/Percentage change in sales and

2) (Sales – Variable costs)/EBIT.


18 - 18 - 55

The operating leverage is favourable when increase in sales volume has a positive magnifying effect on EBIT. It is unfavourable when a decrease in sales volume has a negative magnifying effect on EBIT. Therefore, high DOL is good when sales revenues are rising and bad when they are falling.

The DOL is a measure of the business/operating risk of the firm. Operating risk is the risk of the firm not being able to cover its fixed operating costs. The larger is the magnitude of such costs, the larger is the volume of sales required to recover them. Thus, the DOL depends on fixed operating costs.


18 - 18 - 66

Example 1

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

Solution

If sales level of 2,000 units are used as a base for comparison, the operating leverage is illustrated in Table 1

Table 1 EBIT for Various Sales Levels

Case 2

– 50%

Base Case 1

+ 50%

1. Sales in units 1,000 2,000 3,000

2. Sales revenue Rs 1,00,000 Rs 2,00,000 Rs 3,00,000

3. Less: Variable operating cost 50,000 1,00,000 1,50,000

4. Contribution 50,000 1,00,000 1,50,000

5. Less: Fixed operating cost 50,000 50,000 50,000

6. EBIT Zero 50,000 1,00,000

–100% +100%


18 - 18 - 77

From the results contained in Table 1, certain generalisations

follow:

1) Case 1: A 50 per cent increase in sales (from 2,000 to 3,000

units) results in a 100 per cent increase in EBIT (from Rs 50,000

to Rs 1,00,000).

2) Case 2: A 50 per cent decrease in sales (from 2,000 to 1,000

units) results in a 100 per cent decrease in EBIT (from Rs

50,000 to zero).


18 - 18 - 88

Example 2

A firm sells its products for Rs 50 per unit, has variable operating costs of Rs 30 per unit and fixed operating costs of Rs 5,000 per year. Its current level of sales is 300 units. Determine the degree of operationg leverage. What will happen to EBIT if sales change: (a) rise to 350 units, and (b) decrease to 250 units?

Solution: The EBIT for various sales levels is computed in Table 2.

Table 2: EBIT at Various Sales Levels

Case 2–16.7%

Base Case 1+16.7%

1. Sales in units 250 300 350

2. Sales revenue Rs 12,500 Rs 15,000 Rs 17,500

3. Less: Variable cost 7,500 9,000 10,500

4. Contribution 5,000 6,000 7,000

5. Less: Fixed operating cost

5,000 5,000 5,000

6. EBIT Zero 1,000 2,000

– 100% + 100%


18 - 18 - 99

Interpretation

In case 2, 16.7 per cent decrease in sales volume (from 300 units to 250 units)

leads to 100 per cent decline in the EBIT (from Rs 1,000 to zero). On the other

hand, a 16.7 per cent increase in the sales level in case 1 (from 300 units to

350 units) results in 100 per cent increase in EBIT (from Rs 1,000 to Rs 2,000).

The two illustrations (Tables 1 and 2) clearly show that when a firm has fixed

operating costs, an increase in sales volume results in a more than

proportionate increase in EBIT. Similarly, a decrease in the level of sales has

an exactly opposite effect. This is operating leverage; the former being

favourable leverage, while the latter is unfavourable. Leverage, thus, works in

both directions.


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Alternative definition of Operating LeverageWhen proportionate change in EBIT as a result of a given change in sales is more than the proportionate change in sales, operating leverage exists. The greater the DOL, the higher is the operating leverage. Symbolically,

2)level) base (at EBIT

level) base (at onContributi Total

FV)Q(S

V)Q(S

ΔQ

Q

F-V)-Q(S

V)-Q(S ΔDOL

costs. fixed Total F

unit per cost VariableV

unit per price Selling S

units inquantity Sales Q

Where

V)-Q(S ΔEBIT ΔF,V)Q(SEBITQΔQ

EBIT ΔEBIT DOL ely,Alternativ

1)1sales in change Percentage

EBIT in change PercentageDOL

(

(


18 - 18 - 1111

Since the DOL exceeds 1 in both the illustrations, operating leverage exists. However, the degree of operating leverage is higher (3 times) in the case of the firm in Example 2 as compared to the firm in Example 1, the respective quotients being 6 and 2. The quotients mean that for every 1 per cent change in sales, there will be 6 per cent (Examples 2) and 2 per cent (Example 1) change in EBIT in the direction the sales change.

250,000 Rs

1,00,000 Rs

2) (Case 250%

100%1), (Case 2

50%

100%DOL

get, we1 Example to 2 and 1 Equations Applying

61,000 Rs

6,000 Rs

2) (Case 616.7%-

100%- 1), (Case6

16.7%

100%DOL

2, Example in Similarly,


18 - 18 - 1212

Operating leverage exists only when there are fixed operating costs. If there are no fixed operating costs, there will be no operating leverage. Consider Example 3.

Example 3

Particulars Base Level New Level

1. Units sold 1,000 1,100

2. Sales price per unit Rs 10 Rs 10

3. Variable cost per unit 6 6

4. Fixed operating cost Nil Nil

Solution The relevant computations are given in Table 3.

TABLE 3 EBIT for Various Sales Volume

Particulars Base Level New Level

1. Sales revenues Rs 10,000 Rs 11,000

2. Less: Variable costs 6,000 6,600

3. Less: Fixed costs — —

4. EBIT 4,000 4,400

Applying Equation 1, DOL = 1. Since the quotient is 1, there is no operating leverage.


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Financial LeverageFinancial Leverage

Financial leverage is related to the financing activities of a firm. It results from the presence of fixed financial charges (such as interest on debt and dividend on preference shares). Since such financial expenses do not vary with the operating profits, financial leverage is concerned with the effect of changes in EBIT on the earnings available to equity-holders. It is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share (EPS).


18 - 18 - 1414

Example 4

The financial manager of the Hypothetical Ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs 10,000. The firm has 5 per cent bonds aggregating Rs 40,000, while the 10 per cent preference shares amount to Rs 20,000. What would be the earnings per share (EPS)? Assuming the EBIT being (i) Rs 6,000, and (ii) Rs 14,000, how would the EPS be affected? The firm can be assumed to be in the 35 per cent tax bracket. The number of outstanding ordinary shares is 1,000.

Solution

TABLE 4 EPS for Various EBIT Levels

Case 2 Base Case 1

–40% +40%

EBIT Less: Interest on bondsEarnings before taxes (EBT) Less: Taxes (35%)Earning after taxes (EAT) Less: Preference dividendEarnings available for ordinary shareholdersEarnings per share (EPS)

Rs 6,0002,0004,0001,4002,6002,000

6000.6

Rs 10,0002,0008,0002,8005,2002,0003,200

3.2

Rs 14,0002,000

12,0004,2007,8002,0005,800

5.8

– 81.25% +81.25%


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The interpretation of Table 4 is as follows:

Case 1:

A 40 per cent increase in EBIT (from Rs 10,000 to Rs 14,000) results in 81.25 per cent increase in EPS (from Rs 3.2 to Rs 5.8).

Case 2:

A 40 per cent decrease in EBIT (from Rs 10,000 to Rs 6,000) leads to 81.25 per cent decrease in EPS (from Rs 3.2 to Re 0.6).


18 - 18 - 1616

Example 5

A company has Rs 1,00,000, 10% debentures and 5,000 equity shares outstanding. It is in the 35 per cent tax-bracket. Assuming three levels of EBIT (i) Rs 50,000, (ii) Rs 30,000, and (iii) Rs 70,000, calculate the change in EPS (base level of EBIT = Rs 50,000).

Solution

TABLE 5 EPS at Various EBIT Levels

Case 2 Base Case 1

–40% +40%

EBIT Less: interestEarnings before taxes Less: TaxesEarning after taxesEarnings per share (EPS)

Rs 30,00010,00020,000

7,00013,000

2.6

Rs 50,00010,00040,00014,00026,000

5.2

Rs 70,00010,00060,00021,00039,000

7.8

– 50% +50%

Thus, a 40 per cent increase in EBIT in case 2 from the base level of EBIT has led to 50 per cent increase in EPS. And a decrease of 40 per cent in EBIT has decreased the EPS by 50 per cent.


18 - 18 - 1717

Alternative Definition of Financial Leverage

The procedure outlined above is merely indicative of the presence or absence of financial leverage. Financial leverage can be more precisely expressed in terms of the degree of financial leverage (DFL). The DFL can be calculated by Eq. (3)

)4(

t1/DIEBIT

EBIT

t1/DIFVSQ

FVSQ

VSQ

FVSQ

t1/DIFVSQ

VSΔQDFL

t1/DIFVSQ

VSΔQ

t1by rdenominato and numerator Dividing

Dt1IFVSQ

t1VSΔQ

EPS

ΔEPS

/Nt1VSΔQΔEPS

ts,areconstanD and IF,Since,N

Dt1IFVSQN

Dt1IEBITEPS

EBITΔEBIT

EPSΔEPSDFL ely,Alternativ

(3)1EBIT in change Percentage

EPS in change PercentageDFL

pP

P

p

P

p

P

p


18 - 18 - 1818

As a rule, when a percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. In other words, financial leverage occurs when the quotient in Equation 3 is more than one.

In both the examples, the relevant quotient is larger than one. Therefore, financial leverage exists. But the degree of financial leverage is higher in Example 4 (2.03) than in Example 5 (1.25). The higher the quotient of percentage change in EPS due to percentage change in EBIT, the greater is the degree of financial leverage. The quotient of 2.03 implies that 1 per cent change in EBIT will cause 2.03 per cent change in EPS in the same direction (± increase/decrease) in which the EBIT changes. With 1.25 quotient the proportionate change in EPS as a result of 1 per cent change in EBIT will be comparatively less, that is, 1.25 per cent in either direction.

1.2510,000 Rs50,000 Rs

50,000 Rs

1.25 40%

50% 2 Case 1.25,

40%

50% 1 Case :5 e(ii)Exampl

2.030.3512,000/ RsRs2,00010,000 Rs

10,000Rs

2.03 40%-

81.25 2 Case 2.03,

40%

81.25% 1 Case :4 Example (i)For

5, and 4 Examples in 2 Case and 1 Case to 3 Equations Applying


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Degree of financial leverage (DFL): Applying Eq. (3)

(i) Case 1 = (+40% / + 40%) = 1

(ii) Case 2 = (-40% / -40%) = 1

Thus, the quotient is 1. Its implication is that 1 per cent change in EBIT will result in 1 per cent change in EPS, that is, proportionate. There is, therefore, no magnification in the EPS.

There will be, however, no financial leverage, if there is no fixed-charged financing. (Table 6).

TABLE 6 EPS at Various EBIT Levels

Case 2 Base Case 1

– 40% +40%

EBIT Rs 30,000 Rs 50,000 Rs 70,000

Less: Taxes (0.35) 10,500 17,500 24,500

Earnings available for equity-holders

19,500 32,500 45,500

Number of shares 10,000 10,000 10,000

EPS 1.95 3.25 4.55

– 40% +40%


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Financial leverage involves the use of funds obtained at a

fixed cost in the hope of increasing the return to the equity-

holders. When a firm earns more on the assets purchased

with the funds than the fixed cost of their use, the financial

leverage is favourable. Unfavourable leverage occurs when

the firm does not earn as much as the funds cost.

High fixed financial costs increase the financial leverage

and, thus, financial risk. The financial risk refers to the risk

of the firm not being able to cover its fixed financial costs.

In case of default, the firm can be technically forced into

liquidation. The larger is the amount of fixed financial costs,

the larger is EBIT required to recover them. Thus, the DFL

depends on fixed financial costs.


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EBIT-EPS Analysis

To devise an appropriate capital structure, the amount of EBIT under various financing plans should be related to EPS. The EBIT-EPS analysis is a widely-used method of examining the effect of financial leverage/use of debt. A financial alternative that ensures the largest EPS is preferred, given the level of EBIT.

Example 6

Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to Rs 10,00,000. The firm now wishes to raise additional Rs 10,00,000 for expansion. The firm has four alternative financial plans:

(A) It can raise the entire amount in the form of equity capital.

(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.

(C) It can raise the entire amount as 6% debentures.

(D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital.

Further assume that the existing EBIT are Rs 1,20,000, the tax rate is 35 per cent, outstanding ordinary shares 10,000 and the market price per share is Rs 100 under all the four alternatives.

Which financing plan should the firm select?


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Solution

TABLE 7 EPS Under Various Financial Plans

Particulars Financing plans

A B C D

EBIT Less: InterestEarnings before taxesTaxesEarnings after taxes Less: Preference dividendEarnings available to ordinary shareholdersNumber of sharesEarnings per share (EPS)

Rs 1,20,000—

1,20,00042,00078,000

—

78,00020,000

3.9

Rs 1,20,00025,00095,00033,25061,750

—

61,75015,000

4.1

Rs 1,20,00060,00060,00021,00039,000

—

39,00010,000

3.9

Rs 1,20,000—

1,20,00042,00078,00025,000

53,00015,000

3.5

The calculations in Table 7 reveal that given a level of EBIT of Rs 1,20,000, the financing alternative B, which involves 50 per cent ordinary shares and 50 per cent debt, is the most favourable with respect to EPS. Another disclosure of the table is that although the proportion of ordinary shares in the total capitalisation under the financing plan D is also 50 per cent, that is, equal to plan B, EPS is considerably different (lowest). The difference in the plans B and D is due to the fact that interest on debt is tax-deductible while the dividend on preference shares is not. With 35 per cent income tax, the explicit cost of preference shares would be higher than the cost of debt.


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Financial Break-even Point (BEP)

Financial break-even point (BEP) represents a point at which before-tax earnings are equal to the firm’s fixed financial obligations. Symbolically, it is computed as follows:

[I + Dp + Dt)/(1 – t)] (5)

In other words, at financial BEP, EPS is zero.

Equation 5 gives before-tax earnings necessary to cover the firm’s fixed financial obligations.

As fixed financial charges are added, the break-even point for zero EPS is increased by the amount of the additional fixed cost. Beyond the financial break-even point, increase in EPS is more than the proportionate increase in EBIT. This is illustrated in Table 8, which presents the EBIT-EPS relationship for the data in Example 6 under the various EBIT assumptions given in the box:

1) Rs 80,000 (4 per cent return on total assets)2) 1,00,000 (5 per cent return on total assets)3) 1,30,000 (6.5 per cent return on total assets)4) 1,60,000 (8 per cent return on total assets)5) 2,00,000 (10 per cent return on total assets)


18 - 18 - 2424

TABLE 8 EBIT-EPS Analysis under Various EBIT Assumptions for the Four Financing Plans of Example 6

(i) EBIT = Rs 80,000 (4 per cent return on investments)

Particulars Financing Plans

A B C D

EBIT

Less: Interest

EBT

Less: Taxes

EAT

Less: Preference dividend

EAT for equity-holders

EPS

80,000 80,000 80,000 80,000

— 25,000 60,000 —

80,000 55,000 20,000 80,000

28,000 19,250 7,000 28,000

52,000 35,750 13,000 52,000

— — — 25,000

52,000 35,750 13,000 27,000

2.6 2.38 1.3 1.8

(ii) EBIT = Rs 1,00,000 (5 per cent return)

EBIT 1,00,000 1,00,000 1,00,000 1,00,000

Less: Interest — 25,000 60,000 —

EBT 1,00,000 75,000 40,000 1,00,000

Less: Taxes 35,000 26,250 14,000 35,000

EAT 65,000 48,750 26,000 65,000

Less: Preference dividend — — — 25,000

EAT for equity-holders 65,000 48,750 26,000 40,000

EPS 3.25 3.25 2.6 2.67


18 - 18 - 2525

(iii) EBIT = Rs 1,30,000 (6.5 per cent return)

EBIT 1,30,000 1,30,000 1,30,000 1,30,000

Less: Interest — 25,000 60,000 —

EBT 1,30,000 1,05,000 70,000 1,30,000

Less: Taxes 45,500 36,750 24,500 45,500

EAT 84,500 68,250 45,500 84,500


EAT for equity-holders 84,500 68,250 45,500 59,500

EPS 4.22 4.55 4.55 3.97

(iv) EBIT = Rs 1,60,000 (8 per cent return)

EBIT 1,60,000 1,60,000 1,60,000 1,60,000

Less: Interest — 25,000 60,000 —

EBT 1,60,000 1,35,000 1,00,000 1,60,000

Less: Taxes 56,000 47,250 35,000 56,000

EAT 1,04,000 87,750 65,000 1,04,000


EAT for equity-holders 1,04,000 87,750 65,000 79,000

EPS 5.2 5.8 6.5 5.3

Contd.


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(v) EBIT = Rs 2,00,000 (10 per cent return)

EBIT 2,00,000 2,00,000 2,00,000 2,00,000

Less: Interest — 25,000 60,000 —

EBT 2,00,000 1,75,000 1,40,000 2,00,000

Less: Taxes 70,000 61,250 49,000 70,000

EAT 1,30,000 1,13,750 91,000 1,30,000


EAT for equity-holders 1,30,000 1,13,750 91,000 1,05,000

EPS 6.5 7.6 9.1 7

It can be seen from Table 8 that when the EBIT level exceeds the financial break-even level (Rs 25,000, Rs 60,000 and Rs 38,462 for financing alternatives, B, C and D respectively) EPS increases. The percentage increase in EPS is the greatest when EBIT is nearest the break-even point. Thus, in Plan C, an increase of 25 per cent in EBIT (from Rs 80,000 to Rs 1,00,000) results in a 100 per cent increase in EPS (from Re 1.3 to Rs 2.6), whereas the percentage increase in EPS is only 40 per cent (from Rs 6.5 to Rs 9.1) as a result of the change in EBIT at higher levels from Rs 1,60,000 to Rs 2,00,000 (i.e. 25 per cent increase).

Contd.


18 - 18 - 2727

Indifference point EBIT level beyond which benefits of financial leverage accrue with respect to EPS.

The indifference point between two methods of financing can be obtained mathematically (algebraic approach) as well as graphically.

Algebraic Approach

Mathematically, the indifference point can be obtained by using the following symbols:

X = earnings before interest and taxes (EBIT) at the indifference point

N1 = number of equity shares outstanding if only equity shares are issued

N2 = number of equity shares outstanding if both debentures and equity shares are issued

N3 = number of equity shares outstanding if both preference and equity shares are issued

N4 = number of equity shares outstanding if both preference shares and debentures are issued

I = the amount of interest on debentures

DP = the amount of dividend on preference shares

t = corporate income tax rate

Dt = tax on preference dividend


18 - 18 - 2828

For a New Company

The indifference point can be determined by using the following equations:

(8)

N

Dt1IX

N

t1X:Debentures and shares Preference versus sharesy (iii)Equit

(7A)N

Dt1Dt1X

N

t1X

:dividend Preference ontax withshares Preference versus sharesEquity (ii)(b)

(7)N

Dt1X

N

t1X:shares Preference versus sharesEquity (ii)(a)

(6)N

t1IX

N

t1X:Debentures versus shares(i)Equity

4

p

1

3

p

1

3

p

1

21

For an Existing Company

If the debentures are already outstanding, let us assume I1 = interest paid on existing debt, and I2 = interest payable on additional debt, then the indifference point would be determined by Equation 9.

)9(

N

t1IIX

N

t1IX

2

21

1

1


18 - 18 - 2929

Example 7

The financial manager of a company has formulated various financial plans

to finance Rs 30,00,000 required to implement various capital budgeting

projects:

1) Either equity capital of Rs 30,00,000 or Rs 15,00,000 10% debentures

and Rs 15,00,000 equity;

2) Either equity capital of Rs 30,00,000 or 13% preference shares of Rs

10,00,000 and Rs 20,00,000 equity;

3) Either equity capital of Rs 30,00,000 or 13% preference capital of Rs

10,00,000, (subject to dividend tax of 10 per cent), Rs 10,00,000 10%

debentures and Rs 10,00,000 equity; and

4) Either equity share capital of Rs 20,00,000 and 10% debentures of Rs

10,00,000 or 13% preference capital of Rs 10,00,000, 10% debentures of

Rs 8,00,000 and Rs 12,00,000 equity.

You are required to determine the indifference point for each financial plan,

assuming 35 per cent corporate tax rate and the face value of equity shares

as Rs 100.


18 - 18 - 3030

Solution

Confirmation Table

Particulars Equity financing Equity + debt financing

EBIT Rs 3,00,000 Rs 3,00,000

Less: Interest — 1,50,000

Earning before taxes 3,00,000 1,50,000

Less: Taxes 1,05,000 52,500

Earnings for equity-holders 1,95,000 97,500

Number of equity shares 30,000 15,000

EPS 6.5 6.5

3,00,000 Rs /0.651,95,000 Rs X

1,95,000 Rs - 0.65X -Or

1,95,000 Rs - 1.3X 0.65XOr

15,000

97,500Rs0.65X

30,000

0.65XOr

15,000

0.3511,50,000 RsX

30,000

0.351XOr

N

t1IX

N

t1X (i)

21


18 - 18 - 3131

Confirmation Table

Particulars Equity financing Equity + Preference financing

EBIT Rs 6,00,000 Rs 6,00,000

Less: Taxes 2,10,000 2,10,000

Earning after taxes 3,90,000 3,90,000

Less: Dividends on preference shares

— 1,30,000

Earnings for equity-holders 3,90,000 2,60,000


EPS 13 13

6,00,000 RsX20,000

1,30,000Rs0.65X30,0000.65XOr

20,0001,30,000 Rs0.351

30,0000.351XOr

3N

pDIX

1N

t1X (ii)


18 - 18 - 3232

Confirmation Table

Particulars Equity financing

Equity + Preference + Debentures financing

EBIT Rs 4,80,000 Rs 4,80,000

Less: Interest — 1,00,000

Earnings after interest 4,80,000 3,80,000

Less: Taxes 1,68,000 1,33,000


Less: Dividends including dividend tax

on preference shares — 1,43,000

Earnings available for equity holders 3,12,000 1,04,000


EPS 18.4 18.4

000,80,4 RsX

000,10

000,43,1Rs000,65RsX65.0

000,30

X65.0Or

000,10

1.011,30,000 Rs35.01000,00,1RsX

000,30

35.01XOr

N

Dt1DIX

N

t1X )iii(

4

p

1


18 - 18 - 3333

Confirmation Table

Particulars Equity financing

Equity + Debt + Preference financing

EBIT Rs 5,50,000 Rs 5,50,000

Less: Interest 1,00,000 80,000

Earnings before taxes 4,50,000 4,70,000

Less: Taxes 1,57,500 1,64,500


Less: Dividends on preference shares

— 1,30,000

Earnings for equity-holders 2,92,500 1,75,500


EPS 14.625 14.625

000,50,5RsX

000,12

000,30,135.01000,80X

000,20

35.01000,00,1RsXOr

N

Dt1IX

N

t11X )iv(

4

p

2


18 - 18 - 3434

Graphic ApproachGraphic Approach

The indifference point can also be determined graphically. In order to graph the financial plan, two sets of EBIT-EPS coordinates are required for each financial plan. The point at which the two lines intersect is the IP.


18 - 18 - 3535

In order to graph the financial plan, two sets of EBIT-EPS coordinates are required. The EPS values associated with EBIT values of Rs 2,00,000 and Rs 6,00,000 are calculated and plotted on the graph paper under each financial plan in case of Figure 1. It may noted that 100 per cent equity financing plan starts from origin (O) because EPS would be zero if EBIT is zero.

However, EBIT required to have the value of the EPS as zero is Rs 1,50,000, that is, the interest charges payable on 10% debentures of Rs 15,00,000. Therefore, the starting point of 50 per cent equity financing plan is away from the point of the origin (i.e. it starts from Rs 1.5 lakh). The point at which the two lines intersect is the indifference point (IP). When we draw a perpendicular to the X-axis from the point of intersection, we have EBIT required for the IP. A line drawn from the point of intersection and joined with the Y-axis determines the EPS at the indifference point of EBIT.

An important point to be remembered in relation to the drawing of 33 per cent preference share financial plan (Fig. 2), is that EPS would not be zero if the firm’s EBIT is Rs 1,30,000, because dividend payable on preference share is not tax-deductible. The firm must earn so much more than Rs 1,30,000 that it is left with Rs 1,30,000 after paying taxes. This amount can be calculated dividing Rs 1,30,000 by (1 – t). The required amount is Rs 2,00,000 [Rs 1,30,000) ÷ (1 – 0.35)]. Thus, the starting point of preference share financial plan would be Rs 2 lakh.


18 - 18 - 3636

0 1 2 3 4 5 6 7

6.5

13

19.5

EBIT (Rs in lakhs)

Figure 1: EBIT-EPS Analysis

Debt Advantage

Debt + EquityAlternative

Equity Alternative

Indifference PointEquity Advantage

EP

S (

Rs

)


18 - 18 - 3737

The indifference points of Figs. 1 and 2 correspond to what we have determined through the algebraic approach. But the utility of the EBIT-EPS chart lies in its being more informative regarding the EBIT-EPS relationship. It gives a bird’s eye view of EPS at various levels of EBIT. The EPS value at the estimated level of EBIT can be promptly ascertained. Moreover, it more easily explains why an equity financing plan is better than other plans requiring debenture and/or preference shares for the EBIT level below the IP. For instance, Fig. 2 indicates that for all EBIT levels below Rs 6 lakh, the EPS under equity alternative is greater than 33 per cent preference share financing plan and for all EBIT levels above Rs 6 lakh, the EPS is greater under 33 per cent financing plan than 100 per cent equity financing. The IP can be compared with the most likely level of EBIT. If the likely level of EBIT is more than the IP, the use of fixed cost financing plan may be recommended, otherwise equity plan would be more suitable. To sum up, the greater the likely level of EBIT than the indifference point, the stronger is the case for using levered financial plans to maximise the EPS. Conversely, the lower the likely level of EBIT in relation to the indifference point, the more useful the unlevered financial plan would be from the view point of EPS. In other words, financial leverage will be favourable and shareholders will get higher EPS if the return on total investment is more than the fixed cost (interest and preference dividend). If the return is less than the fixed financial charge, the EPS will decline with the use of debt and the leverage will be unfavourable. The financial leverage will have no effect on EPS in case the return on investment is exactly equal to the fixed financial costs.


18 - 18 - 3838

0 1

6.5

13

19.5

EBIT (Rs in lakhs)

Figure 2: EBIT-EPS Analysis

Equity + PreferenceAdvantage

Equity + PreferenceAlternative

Equity Alternative

Indifference PointEquity Advantage

EP

S (

Rs

)

2 3 4 5 6 7 8 9 10 11 12 13

26

32.5


18 - 18 - 3939

The indifference point may be computed in another way using market value as the basis. Since the operational objective of financial management is the maximisation of share prices, the market price of shares of a firm with two different financial plans should be identical. Thus, on the basis of level of EBIT which ensures identical market price for alternative financial plans, the indifference point can be symbolically computed by Equation 10.

where PE1 = P/E ratio of unlevered plan and P/E2 = P/E ratio of levered plan.

)10(

N

Dt1IXE/P

N

t1XE/P

2

p

2

1

1

Example 8

Determine the indifference point at which market price of equity shares of a corporate firm will be the same from the following data:

1. Funds required, Rs 50,000.2. Existing number of equity shares outstanding, 5,000 @ Rs 10 per share.3. Existing 10% debt, Rs 20,0004. Funds required can be raised either by (a) issue of 2,000 equity shares,

netting Rs 25 per share or (b) new 15 per cent debt.5. The P/E ratio will be 7 times in equity alternative and 6 times in debt

alternative.6. Corporate tax rate, 35 per cent.


18 - 18 - 4040

Confirmation Table

Particulars 15% Debt issue Equity issue

EBIT Rs 47,000 Rs 47,000

Less: Interest 9,500 2,000

Earning before taxes 37,500 45,000

Less: Taxes 13,125 15,750

Earning after taxes 24,375 29,250


Earnings per share 4.875 4.18

P/E ratio (times) 6 7

Market price of the share 29.25 29.25

47,000 Rs xi.e. 2,13,850, Rs or4.55x

37,050) Rs 7(3.9x 9,100) Rs or5(4.55x

5,000

6,175Rs0.65x

7,000

1,300Rs0.65x

5,000

0.659,500Rsx6

7,000

0.652,000Rsx7Or

N

t1IIxP/E

N

t1IxP/E

2

212

1

11


18 - 18 - 4141

Measures of Financial Leverages

Financial leverage measures the degree of the use of debt and other fixed-cost sources of fund to finance the assets the firm has acquired. As shown above, the use of debt has a magnifying effect on the earnings per share. It can be said that the higher the proportion of debt in the capital structure, the higher is the financial leverage and vice-versa. Broadly speaking, financial leverage can be measured in two ways: (i) stock terms, and (ii) flow terms.

1) Stock Terms

It can be measured either by (a) a simple ratio of debt to equity, or (b) by the ratio of long-term debt plus preference share to total capitalisation. Each of these measures indicates the relative proportion of the funds to the total funds of the firm on which it is to pay fixed financial charges.

2) Flow Terms

The financial leverage can be measured either by (a) the ratio of EBIT to interest payments or (b) the ratio of cash flows to interest payment, popularly called the debt service capacity/coverage. These coverage ratios are useful to the suppliers of the funds as they assess the degree of risk associated with lending to the firm.

In general, the higher the ‘stock’ ratios and the lower the ‘flow’ ratios, the greater is the risk and vice-versa.


18 - 18 - 4242

COMBINED LEVERAGE: TOTAL RISK

Combined leverage is the product of operating leverage and financial leverage.

Total risk is the risk associated with combined leverage.

DCL = DOL X DFL (11)

Thus, the DCL measures the percentage change in EPS due to percentage change in sales. If the degree of operating leverage of a firm is 6 and its financial leverage is 2.5, the combined leverage of this firm would be 15(6 x 2.5). That is, 1 per cent change in sales would bring about 15 per cent change in EPS in the direction of the change in sales. The combined leverage can work in either direction. It will be favourable if sales increase and unfavourable when sales decrease because changes in sales will result in more than proportionate returns in the form of EPS.

)13(IEBIT

onContributi

IEBIT

EBIT

EIBT

onContributiDCL

)12(sales in change %

EPS in change %

EBIT in change %

EPS in change %

sales in change %

EBIT in change %DCL


18 - 18 - 4343

SOLVED PROBLEMSOLVED PROBLEM


18 - 18 - 4444

A plastic manufacturing company is planning to expand its assets by 50 per cent. All financing for this expansion will come from external sources. The expansion will generate additional sales of Rs 3 lakh with a return of 25 per cent on sales before interest and taxes. The finance department of the company has submitted the following plans for the consideration of the Board.

Plan 1: Issue of 10% debentures.

Plan 2: Issue of 10% debentures for half the required amount and balance in equity shares to be issued at 25 per cent premium.

Plan 3: Issue equity shares at 25 per cent premium.

Balance sheet of the company as on March 31

Liabilities Amount Assets Amount

Equity capital (Rs 10 per share) Rs 4,00,000 Total assets Rs 12,00,000

8% Debentures 3,00,000

Retained earnings 2,00,000

Current liabilities 3,00,000 ________________

12,00,000 12,00,000


18 - 18 - 4545

Income statement for the year ending March 31

Sales Rs 19,00,000

Operating costs 16,00,000

EBIT 3,00,000

Interest 24,000

Earning after interests 2,76,000

Taxes 96,600

EAT 1,79,400

EPS 4.48

(a) Determine the number of equity shares that will be issued if financial plan 3 is adopted.

(b) Determine indifference point between (i) plans 1 and 2, (ii) plans 1 and 3, and (iii) plans 2 and 3.

(c) Assume that the price earnings ratio is expected to remain unchanged at 8 if plan 3 is adopted, but is likely to drop to 6 if either plan 1 or 2 is used to finance the expansion. Determine the expected market price of the shares in each of the situations.


18 - 18 - 4646

1,34,000 Rs X 88,000

0.6524,000 RsX40,000

0.6554,000 Rs-X

2N

t12I-X

1N2I1I-X

(iii)

1,34,000 Rs X 88,000

0.6524,000 RsX40,000

0.6584,000 Rs-X

2N

t11I-X

1N

t12I1I-X(ii)

1,34,000 Rs X 64,000

0.650,0003 Rs-24,000 Rs-X40,000

0.6560,000 Rs-24,000 Rs-Xor

2N

t12I1I-X

1N

t12I1I-X (i) (b)

12.5 Rs6,00,000 Rs48,000 issued shares ofNumber (a)

Solution


18 - 18 - 4747

Verification table

Particulars Plans

1 2 3

EBS Rs 1,34,000 Rs 1,34,000 Rs 1,34,000

Less: Interest 84,000 54,000 24,000

Earnings before taxes 50,000 80,000 1,10,000

Less: Taxes 17,500 28,000 38,500

EAT 32,500 52,000 71,500

Number of equity shares (N) 40,000 64,000 88,000

EPS 0.812 0.812 0.812


18 - 18 - 4848

(c) Determination of market price per share under various alternative financial plans:

Particulars Plans

1 2 3

EBIT Rs 3,75,000 Rs 3,75,000 Rs 3,75,000

Less: Interest 84,000 54,000 24,000

Earnings before taxes 2,91,000 3,21,000 3,51,000

Less: Taxes 1,01,850 1,12,350 1,22,850

EAT 1,89,150 2,08,650 2,28,150

N 40,000 64,000 88,000

EPS 4.73 3.26 2.59

P/E ratio 6 6 8

Market price 28.38 19.56 20.72


18 - 18 - 4949

MINI CASEMINI CASE


18 - 18 - 5050

G Manufacturing company is an important producer of lawn furniture and decorative objectives for the patio and garden. The last year’s income statement and balance sheet are as follows:

Income statement

SalesVariable costsContributionFixed costsEarnings before interest and tax (EBIT)InterestEarnings before tax (EBT)TaxationNet Income after tax

Rs 75,00,00046,90,00028,10,00014,00,00014,10,0002,00,000

12,10,0006,05,0006,05,000

Balance sheet

Liabilities Amount Assets Amount

Equity capitalReserves and surplusLong-term debt (10%)Current liabilities

Rs 10,00,00042,00,00020,00,0005,00,000

77,00,000

Fixed assetsInventoryReceivablesCash

Rs 60,00,0006,00,0007,00,0004,00,000

77,00,000


18 - 18 - 5151

Figures for industry comparison:

Normal asset turnover 1.2 : 1. Normal profit margin 20 per cent

For the current year, the forecasted sales are Rs 80,00,000 and it is likely that variable costs will remain at approximately the same percentage of sales as was in the last year. (Figures could be rounded off). Fixed costs will rise by 10 per cent.

G has short-listed the following two product lines to be sold through its existing distribution channels:

(1)Production and sale of metal table and chair unit that will be sold for issue around swimming pools. This will require an investment of Rs 20,00,000, which would involve installation of manufacturing and packaging machinery. Sales forecast are Rs 15,00,000 per annum, variable costs account for 2/3rd of sales value, fixed costs are Rs 2,00,000 and no additional working capital is needed.

(2)Hardwood planter with three separate components, will be appropriate for medium sized shrubs. This will require an investment of Rs 30,00,000 with forecasted sales per annum of Rs 25,00,000, variable costs 64 per cent of sales value and fixed costs of Rs 5,00,000.


18 - 18 - 5252

Two financial plans are available:

a) It could borrow on a 10 years note at 9 per cent for either or both of the

projects of an amount not to exceed Rs 60,00,000.

b) Cumulative preference shares with a 10 per cent dividend upto an amount

of Rs 30,00,000.

Financing through the issue of equity shares would not be possible at the

present time.

Required

1) Without the new proposals, what would be the company’s operating,

fixed charges and combined leverages next year? Would the company

have favourable financial leverage?

2) How does the acceptance of each project affect the differing leverages

including asset leverages?

3) With each financing alternatives, do the company’s future earnings per

share increase or decrease, why?


18 - 18 - 5353

Solution

(1) Income statement at projected sales of Rs 80 lakh in current year

Sales revenue Rs 80,00,000

Less: Variable costs (Rs 80 lakh × 62.5% V/V ratio) 50,00,000

Contribution 30,00,000

Less: Fixed costs (Rs 14 lakh + 10%) 15,40,000

EBIT 14,60,000

Less: Interest 2,00,000

Earnings before taxes (EBT) 12,60,000

Less: Taxes (0.50) 6,30,000

Earnings after taxes 6,30,000

Determination of leverages (without the new proposals)

DOL = Contribution/EBIT (Rs 30,00,000/Rs 14,60,000) 2.0548

DFL = EBIT/EBT (Rs 14,60,000/Rs 12,60,000) 1.1587

DCL = Contribution/EBT (Rs 30,00,000/Rs 12,60,000) Or 2.0548 × 1.1587

2.3809


18 - 18 - 5454

The company is said to have favourable financial leverage if it earns more on the assets purchased (with debt funds) than the interest it pays on debt. For the purpose, ROR on capital employed is computed. It is (Rs 14,60,000/Rs 72,00,000) = 20.28 per cent. This return is higher than 10 per cent interest payable on long-term debt. Evidently, the firm is having positive financial leverage.

(2) Income statement showing earnings of two projects, DOL and assets leverage

Particulars Projects

Metal table and chair unit

Hardwood planter

Sales revenue Rs 15,00,000 Rs 25,00,000

Less: Variable costs 10,00,000 16,00,000

Contribution 5,00,000 9,00,000

Less: Fixed costs 2,00,000 5,00,000

EBIT 3,00,000 4,00,000

DOL (Contribution/EBIT) 1.667 2.25

Assets leverage (Sales/Total assets) 0.75 0.83

To determine other leverages, it will be useful to extend income statement to include the impact of financing costs.


18 - 18 - 5555

Income statement showing other leverages (DFL and DCL) and other ratios

Particulars Projects

Metal table and chair unit (Investments Rs 20 lakh)

Hardwood planter(Investments Rs 30

lakh)

(i) Financed through debt plan:

EBIT Rs 3,00,000 Rs 4,00,000

Less: Interest 1,80,000 2,70,000

Earnings before taxes (EBT) 1,20,000 1,30,000

Less: Taxes (0.50) 60,000 65,000

Earnings after taxes 60,000 65,000

DFL (EBIT/EBT) 2.5 2.0

DCL (DOL × DFL) 4.1675 4.5

Rate of return on capital employed (%) 15 13.33

(ii) Financed through cumulative preference share (Rs 30 lakh) + Rs 20 lakh debt for two combined projects EBIT

7,00,000

Less: Interest (Rs 20 lakh × 9%) 1,80,000

Earnings before taxes 5,20,000

Less: Taxes (0.50) 2,60,000

Earnings after taxes 2,60,000

Less: Dividends to preference share holders (Rs 30 lakh × 10%) 3,00,000

EAT (40,000)*

*Since EAT is negative, this financial plan is worth rejecting and hence warrants no more calculations for other leverages.


18 - 18 - 5656

It is apparent that acceptance of the Hardwood Planter project will adversely affect risk level (reflected in higher DOL, DFL and DCL). While the acceptance of Metal Table project decreases operating risk (lower DOL), it increases total risk (as DCL is 4.15). The asset leverages are also very low.

Though the ROR on capital employed is higher for both the projects than the interest rate paid, the acceptance of these projects will decrease the firm’s overall rate of return on capital employed (the existing ROR on capital employed is 20, 28 per cent).

(3) The impact of financing alternatives on company’s future EPS:

Financial plan (a): Since the rate of return on capital employed is higher (for both the projects) than the rate of interest (9 per cent) payable on funds borrowed, the projects will increase EPS.

Financing plan (b): Under this plan, funds are to be raised by the issue of Rs 30 lakh cumulative 10 per cent Preference shares, the EPS will decrease as payment of 10 per cent preference dividend requires 20 per cent pre-tax return on Rs 30 lakh; the projected pre-tax return is 17.33 per cent (Rs 5,20,000/Rs 30,00,000). In fact, taking two projects in a combined manner, the firm has negative returns for equity-holders. As a result, this financial plan will have depressing effect on the EPS and is not desirable.

In sum, the firm should go for both projects only when debt financing is possible for both such projects.

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