KAILAS SREE CHANDRAN

M100447ME

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» The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return may be termed as Leverage.

» If the earnings before interest and taxes exceeds the fixed return requirement, the leverage is called favorable.

» Leverage: Operating Leverage

Financial Leverage

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» Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.

» Kinds of Sources of funds: 1. Those which carry a fixed financial charge

2. Those which do not involve any fixed charge.

» Financial Leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to the share holders.

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» EBIT= `10,000

» Bonds @ 5%= `40,000

» Preference Share @10% = `20,000

» Tax= 35%

» Ordinary shares = 1,000

» Case1, EBIT= `6000 (-40%)

» Case2, EBIT= `14000 (+40%)

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Case 1 Base Case 2

EBIT `6,000 `10,000 `14,000

Less: Interest on bonds 2,000 2,000 2,000

Earnings before taxes(EBT) 4,000 8,000 12,000

Less: Taxes(35%) 1,400 2,800 4,200

Earning after taxes(EAT) 2,600 5,200 7,800

Less: Preference Dividend 2,000 2,000 2,000

Earnings available for share holders 600 3200 5800

Earnings Per Share 0.6 3.2 5.8

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-81.25% +81.25%

Case 1 Base Case 2

EBIT `6,000 `10,000 `14,000

Less: Interest on bonds 2,000 2,000 2,000

Earnings before taxes(EBT) 4,000 8,000 12,000

Less: Taxes(35%) 1,400 2,800 4,200

Earning after taxes(EAT); Earnings available for share holders

2,600 5,200 7,800

Earnings Per Share 2.6 5.2 7.8

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-50% -50%

DFL = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇> 1

DFL = 𝐸𝐵𝐼𝑇

𝐸𝐵𝐼𝑇− 𝐼−𝐷𝑝/(1−𝑡)

Example Case 1 & 2: 81.25

40= 2.03

1% change in EBIT will cause 2.03% change in EPS.

Example Case 1 & 2(w/o Preference dividend): 50

40= 1.25

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» Method to study the effect of leverage.

» It involves the comparison of alternative methods of financing.

» Choices to raise funds: 1. Equity Capital

2. Debentures

3. Preference Capital

4. Combination of above

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A firm has a capital structure of ordinary shares amounting to `10 lakhs. Now the firm wishes to raise additional `10 lakhs. The firm has four alternative financial plans:

a) Entire Equity Capital

b) 50% Equity capital- 50% debentures @ 5%.

c) Entire Debentures @ 6%.

d) 50% Equity capital- 50% Preference capital @ 5%.

Existing EBIT: `1.2 lakhs. Tax rate: 35%. Ordinary shares: 10,000. Market Price/share: `100.

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Particulars Financing Plans

A B C D

EBIT `120,000 `120,000 `120,000 `120,000

Less: Interest - 25,000 60,000 -

Earnings before taxes 120,000 95,000 60,000 120,000

Taxes 42,000 33,250 21,000 42,000

Earnings after taxes 78,000 61,750 39,000 78,000

Less: Preference dividend - - - 25,000

Earnings available to ordinary share holders

78,000 61,750 39,000 53,000

Number of shares 20,000 15,000 10,000 15,000

Earnings per share 3.9 4.1 3.9 3.5

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» `80,000 (4% return on total assets)

» `100,000 (5% return on total assets)

» `130,000 (6.5% return on total assets)

» `160,000 (8% return on total assets)

» ` 200,000 (10% return on total assets)

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Particulars Financing Plans

A B C D

EBIT 80,000 80,000 80,000 80,000

Less: Interest - 25,000 60,000 -

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

Less: Taxes 28,000 19,250 7,000 28,000

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

Less: Preference Dividend - - - 25,000

EAT for equity-holders 52,000 35,750 13,000 27,000

Number of shares 20,000 15,000 10,000 15,000

EPS 2.6 2.38 1.3 1.8

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Earnings Per Share Financing Plans

EBIT A B C D

`80,000 2.6 2.38 1.3 1.8

`100,000 3.25 3.25 2.6 2.67

`130,000 4.22 4.55 4.55 3.97

`160,000 5.2 5.8 6.5 5.3

`200,000 6.5 7.6 9.1 7

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