financial management

NAGINDAS KHANDWALA

COLLEGE

FINANCIAL MANAGEMENT 2

LEVERAGES

GROUP NO.1

NAMES ROLL NO.

TRIPTI. BANGERA 1KARISHMA. BHANDARI 2

RAJAT. BHOIR 3GOPI.CHAUHAN 4

KHUSHBOO. CHAURASIA 5RUSHABH DEDHIA 6JAINAM.DELIWALA 7RUTU. DOBARYA 8

POOJA GADA 10JINAL GAGLANI 11

TABLE OF CONTENT

SR NO.

PARTICULARS

1. Introduction and meaning of leverages

2. Debt vs equity financing

3. Business risk and financial risk

4. Types of leverages- operating leverage

5. Financial leverage

6. Trading on equity

7. Combined leverage

8. Break-even point

9. EBIT- EPS Analysis

10. Measures of operating and financial leverage

11. Importance of leverages

12. Leverage- Implications

INTRODUCTION TO LEVERAGE

LEVER MEANS A BAR RESTING ON A PIVOT

WHICH IS USED TO RAISE A HEAVIER

OBJECT.WHEN A LEVER IS USED PROPERLY , A

FORCE APPLIED AT ONE POINT IS

TRANSFORMED , OR MAGNIFIED , INTO

ANOTHER LARGE FORCE OR MOTION AT SOME

OTHER POINT. IN SHORT , THE FUNCTION OF

LEVER IS TO RAISE A HEAVY OBJECT WITH A

MINIMUM FORCE

DEFINITION OF LEVERAGE

LEVERAGES IS THE EMPLOYMENT OF THE ASSETS OR FUND FOR

WHICH THE FIRM PAYS THE FIXED RETURNS

DEBT V/S EQUITY FINANCING

• LENDER REUIRE A LOWER RATE OF RETURN THAN ORDINARY SHAREHOLDER.

•A PROFITABLE BUSINESS LESS PAY FOR DEBT THAN EQUTY.

• ISSUING AN TRANSACTIONS COST.

RISK

MEANING

TYPES OF RISK

• BUSINESS RISK

• FINANCIAL RISK

BUSINESS RISK

• MEANING

• VARIABILITY

• NATURE OF RISK

• MEASUREMENT

• CHANGE IN CAPITAL STRUCTURE

• LINKED TO

FINANCIAL RISK

• MEANING

• VARIABILITY

• NATURE OF RISK

• MEASUREMENT

• CHANGE IN CAPITAL STRUCTURE

• LINKED TO

TYPES OF LEVERAGE

OPERATING LEVERAGE

FINANCIAL LEVERAGE

COMBINED LEVERAGE

WHAT IS OPERATING LEVERAGE ?

•MEASURES COMPANY FIXED TO ITS VARIABLE COST

•USED TO EVALUATE BREAK EVEN POINT OF A BUSINESS

TWO SCENARIO OF OPERTING LEVERAGE

HIGH OPERATING LEVERAGE

LOW OPERATING LEVERAGE

• COSTS ARE FIXED COST

• SALES ARE VARIABLE COST

DEGREE OF OPERATING LEVERAGE

DOL = CONTRIBUTION

EBIT

WHAT DOES IT TELL US ?

• IF DOL = 2 , THEN 1 % INCREASE IN SALES WILL RESULT IN 2 % INCREASE

IN OPERATING INCOME ( EBIT)

SALES EBIT

EFFECTS OF OPERATING LEVERAGE

MORE OPERATING LEVERAGE LEADS TO MORE BUSINESS RISK FOR THAN A SMALL SCALE DECLINE CAUSES A

BIG PROFIT DECLINE

FINANCIAL LEVERAGE

• IT IS DEFINED AS THE USE OF FUNDS WITH A FIXED COST IN ORDER TO INCREASE EARNING PER SHARE

• FINANCIAL LEVERAGE IS A MEASURE OF FINANCIAL RISK

• AND THERE WILL BE NO FINANCIAL LEVERAGE IF THERE IS NO FIXED CHARGE FINANCING.

DEGREE OF FINANCIAL LEVERAGE ( FORMULA)

STATIC. DYNAMICIN EPS

INEBIT

EBITEBT

DEGREE OF FINANCIAL LEVERAGE

IF WE HAVE THE DATA, WE CAN USE FOLLOWING FORMULA

DFL= EBIT

EBIT- INTEREST

HERE, I =AMOUNT OF INTEREST CHARGES

WHAT DOES IT TELL US ?

IF DFL = 3, THEN A 1% INCREASE IN OPERATING INCOME WILL RESULT

IN A 3% INCREASE IN EARNING PER SHARE

IF DFL = % CHANGE IN EPS

% CHANGE IN EBIT

SALES EBIT EPS STOCKHOLDER

EFFECTS OF DFL Firm A

EBIT. 100

- Interest. 10

EBT. 90

DFL = EBIT

EBT

= 100

90

= 1.11

Firm B

EBIT. 100

- Interest. 50

EBT. 50

DFL = EBIT

EBT

= 100

50

= 2

FROM THE EXAMPLE WE COME TO KNOW THAT

IF INTEREST IS LOW, DFL WILL BE LOW

AND

IF INTEREST IS HIGH, DFL WILL BE HIGH

IMPORTANCES OF FINANCIAL LEVERAGE

• IT IS USE TO FIND EPS AND MARKET VALUE OF EQUITY SHARE

• IT IS SUPERIOR THAN OPERATING LEVERAGE

• IT IS USE TO MAKE FINANCIAL DECISIONS

TRADING ON EQUITY

EQUITY MEANS EQUITY SHARES

TRADING MEANS ‘TAKING ADVANTAGE OF’.

REFERRED TO AS FINANCIAL LEVERAGE

USE OF OWNER’S FUND AS WELL AS BORROWED FUNDS WITH A VIEW TO INCREASE THE EPS

COMPANY IS MAKING USE OF FIXED INTEREST AND DIVIDEND BEARING SECURITIES TO BENEFIT EQUITY SHAREHOLDERS.

CAPITAL STRUCTURE PARTICULARS DIAMOND

LTD. (AMT.)GOLD LTD. (AMT.)

SILVER LTD. (AMT.)

EQUITY SHARES OF RS. 100 EACH

2,00,000 8,00,000 10,00,000

10% DEBENTURES OF RS.100 EACH

8,00,000 - -

8% PREFERENCE SHARES OF RS. 100 EACH

- 2,00,000 -

TOTAL CAPITAL EMPLOYED 10,00,000 10,00,000 10,00,000

INCOME STATEMENT (WHEN ROCE IS 30%)

Particulars Diamond Ltd. (Amt.)

Gold Ltd. (Amt.)

Silver Ltd. (Amt.)

EBIT @30% 3,00,000 3,00,000 3,00,000

(-)Interest (80,000) NIL NIL

EBT 2,20,000 3,00,000 3,00,000

(-)Tax @50% (1,10,000) (1,50,000) (1,50,000)

EAT / NPAT 1,10,000 1,50,000 1,50,000

(-)Preference dividend NIL (16,000) NIL

Profit for Equity Shareholders

1,10,000 1,34,000 1,50,000

÷ No. of Equity shares 2000 8000 10000

Earnings Per Share (EPS)

Rs.55/- Rs.16.75/- Rs.15/-

DIAMOND LTD

Equity shares 10% Debt

2,00,000 @ 30% 8,00,000 @30%

EBIT 60,000 2,40,000

- Interest NIL (80,000)

EBT 60,000 1,60,000

- Tax@50% (30,000) (80,000)

EAT / NPAT 30,000 80,000

- Pref. Dividend NIL NIL

NP for ESH 30,000 80,000

+ 80,000

1,10,000

GOLD LTD

EQUITY SHARES 8 % PREF. SHARES

8,00,000 @ 30% 2,00,000 @30%

EBIT 2,40,000 60,000

INTEREST NIL NIL

EBT 2,40,000 60,000

TAX@50% (1,20,000) (30,000)

EAT / NPAT 1,20,000 30,000

PREF. DIVIDEND NIL (16,000)

NP FOR ESH 1,20,000 14,000

+ 14,000

1,34,000

ROCE > Interest Rate

INCOME STATEMENT (WHEN ROCE IS 8 %)

Particulars Diamond Ltd. (Amt.)

Gold Ltd. (Amt.)

Silver Ltd. (Amt.)

EBIT @8% 80,000 80,000 80,000

(-)Interest (80,000)

NIL NIL

EBT NIL 80,000 80,000

(-)Tax @50% NIL (40,000) (40,000)

EAT / NPAT NIL 40,000 40,000

(-)Preference dividend NIL (16,000) -

Profit for Equity Shareholders

NIL 24,000 40,000

÷ No. of Equity shares 2000 8000 10000

Earnings Per Share (EPS)

NIL Rs.3 /- Rs.4/-

GOLD LTD

EQUITY SHARES 8 % PREF. SHARES

8,00,000 @ 8 % 2,00,000 @ 8 %

EBIT 64,000 16,000

INTEREST NIL NIL

EBT 64,000 16,000

TAX@50% (32,000) (8,000)

EAT / NPAT 32,000 8,000

PREF. DIVIDEND NIL (16,000)

NP FOR ESH 32,000 ( 8,000)

- 8,000

24,000

TRADING ON EQUITY

GENERATES HIGHER RETURNS TO EQUITY SHAREHOLDERS, PROVIDED THE COMPANY’S -

ROCE > INTEREST RATE

PRESENTS THE RISKS OF OUTRIGHT BANKRUPTCY

OTHER BENEFITS

RELATIONSHIP BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

OPERATING LEVERAGE FINANCIAL LEVERAGE

• Operating leverage is concerned with investment activities of the firm.

• Financial leverage is concerned with financing activities of the firm.

• It is determined by the cost structure of the firm.

• It is determined by the capital structure of the firm.

• It is the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.

• It is the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on its earnings per share.

• Degree of operating leverage enables us to measure the business risk associated with the firm.

• Degree of financial leverage enables us to measure the degree of financial risk, associated with the firm.

• DOL = Contribution EBIT

• DFL = EBIT EBT

COMBINED LEVERAGE

• INTRODUCTION

• DEGREE OF COMBINED LEVERAGE

• PRODUCT OF OPERATING LEVERAGE AND FINANCIAL LEVERAGE

DEGREE OF COMBINED LEVERAGE

• DEGREE OF COMBINED LEVERAGE:

= DEGREE OF OPERATING LEVERAGE(DOL) * DEGREE OF FINANCIAL LEVERAGE(DFL)

DEGREE OF COMBINED LEVERAGE

• DEGREE OF COMBINED LEVERAGE (DCL):

OR

DCL = CONTRIBTION

EBT

DCL = % CHANGE IN EPS % CHANGE IN

SALES

COMBINED LEVERAGE

•WHEN DCL = % CHANGE IN EPS

% CHANGE IN SALES

• THEN IF DCL = 4, THEN A 1% INCREASE IN SALES WILL RESULT IN A 4% INCREASE IN EARNINGS PER SHARE

BREAK EVEN ANALYSIS

DEFINITION

• THE POINT WHERE GAINS EQUAL THE LOSSES

• POINT WHERE INVESTMENT WILL GENERATE POSITIVE RETURNS

• SALES OR REVENUE EQUALS LOSSES

FORMULA

Break even Point = Fixed Cost

Contribution

Where,

Contribution = Selling cost – Variable cost

Fixed cost = Contribution - Profit

GRAPHICAL VIEW

EBIT-EPS ANALYSIS

INTRODUCTION

EBIT – EPS ANALYSIS IS AN APPROACH WHICH HELPS IN DESIGNING THE OPTIMUM CAPITAL STRUCTURE FOR THE COMPANY OR THE FIRM.

TO DESIGN VARIOUS ALTERNATIVES OF DEBT, EQUITY AND PREFERENCE TO MAXIMIZE THE EPS .

CALCULATION OF EPS

MEASURES OF OPERATING LEVERAGE

FIXED COSTS TO TOTAL COSTS

PERCENTAGE CHANGE IN OPERATING INCOME TO THE

PERCENTAGE CHANGE IN SALES

NET INCOME TO FIXED COSTS

MEASURES OF FINANCIAL LEVERAGE

DEBT TO ASSETS RATIO

DEBT TO EQUITY RATIO INTEREST COVERAGE RATIO

IMPORTANCE OF OPERATING LEVERAGE & FINANCIAL LEVERAGE

MEASUREMENT OF

OPERATING RISK

MEASUREMENT OF

FINANCIAL RISK MANAGING

RISK

DESIGNING APPROPRIATE

CAPITAL STRUCTURE MIX

INCREASE PROFITABILI

TY

MAGNIFICATION OF

SHAREHOLDER PROFITS IMPROVEMEN

T IN CREDIT RATING

CAPTURING ECONOMIES OF SCALE

INCREASED FREE CASH

LEVERAGES – PRO’S & CON’S

1.CREDIT RATING IMPROVES

2.ECONOMIES OF SCALE

3.CAH AVAILABILITY

4. INCREASE SHAREHOLDER’S EQUITY

5.FINANCIAL RISK

6.BIGGER LOSSES

CONCLUSION