OPERATING, FINANCIAL & COMBINED LEVERAGEPRESENTED BYSIMRAN KAUR

LEVERAGELeverage is the employment of

an asset/source of finance for which firm pays fixed cost/fixed return

If earnings available to shareholders less than variable cost exceed the fixed cost, or earnings before interest and taxes exceed the fixed return requirement, the leverage is called favourable

TYPES OF LEVERAGEOPERATING LEVERAGE : leverage

associated with investment (asset acquisition) activities

FINANCING LEVERAGE : leverage associated with financing activities

OPERATING LEVERAGEOperating leverage may be

defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earning before interest and taxes.

It is determined by the relationship between the firm’s sales revenues and its earning before interest and taxes.

It is caused due to fixed operating expenses in a firm.

OPERATING LEVERAGEThe operating costs of a firm fall into three categories:1. Fixed costs : which don’t vary

with sales volume2. Variable costs : which vary

directly with sales3. Semi-variable or Semi-fixed

costs : which are partly fixed and partly variable

DEGREE OF OPERATING LEVERAGE (DOL)DOL measures in quantitative terms the

extent or degree of operating leverageThe greater the DOL, the higher is the

operating leverageDOL = EBIT = Q(S-V)-FWhere Q = sales quantity in unitsS = selling price per unitV = variable cost per unitF = total fixed cost

DEGREE OF OPERATING LEVERAGE (DOL)Since DOL depends on fixed

operating costs, it largely follows that the larger the fixed operating costs, the higher is the degree of operating leverage of the firm.

Higher operating leverage is good when revenues are rising and bad when they are falling.

FINANCIAL LEVERAGEFinancial leverage is defined as the

ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on EPS

It is caused due to fixed financial costs (interests) to the firm

It represents the relationship between the firm’s earnings before interest and taxes (operating profits) and the earnings available for ordinary shareholders

FINANCIAL LEVERAGEUse of fixed interest source of funds

provides increased return on equity investment without additional requirements of funds from shareholders. Thus, it is also called “trading on equity”

It measures the degree of the use of debt and other fixed cost sources of fund to finance the assets of the firm has required

It can be expressed in “Stock terms” and “Flow terms”

STOCK TERMS OF FINANCIAL LEVERAGEThe financial leverage 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 capitalization

Each of these measures indicates the relative proportion of the funds to total funds of the firm on which it is to pay fixed financial charges

FLOW TERMS OF FINANCIAL LEVERAGEThe 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 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

DEGREE OF FINANCIAL LEVERAGE (DFL)DFL = > 1DFL = , when debt is usedDFL = , when debt and

preference capital is usedDFL = , when dividends paid on

preference share capital are subject to dividend tax

COMBINED LEVERAGECombined leverage is the product of operating leverage and financial leverage

CL = OL * FL

DEGREE OF COMBINED LEVERAGEDCL = DOL * DFLDCL = DCL measures the percentage

change in EPS due to percentage change in sales

IMPORTANT TERMSFINANCIAL RISK : risk of not being able

to cover fixed financial costs by a firmFINANCIAL BREAK-EVEN POINT : level

of EBIT which is equal to firm’s fixed financial costs

INDIFFERENCE POINT : EBIT level beyond which benefits of financial leverage accrue with respect to EPS

EBIT-EPS ANALYSIS : comparison of alternative methods of financing at various levels of EBIT

INDIFFERENCE POINT FOR A NEW COMPANYEquity shares versus Debentures

Equity shares versus Preference shares

Equity shares versus Preference shares with tax on Preference dividend

INDIFFERENCE POINT FOR A NEW COMPANYEquity shares versus Preference

shares and Debentures

INDIFFERENCE POINT FOR AN EXISTING COMPANYIf the debentures are already outstanding, let us assume

Then indifference point would be determined by

NOTATIONS IN INDIFFERENCE POINTX = EBIT at indifference point = Number of equity shares

outstanding if only equity shares are issued

= Number of equity shares outstanding if both debentures and equity shares are issued

= Number of equity shares outstanding if both preference and equity shares are issued

NOTATIONS IN INDIFFERENCE POINT = Number of equity shares

outstanding if both preference shares and debentures are issued

I = Amount of interest on debentures

= Amount of dividend on preference shares

t = Corporate income tax rateDt = tax on preference dividend

EBIT-EPS ANALYSISIf the expected level is to exceed the

indifference level of EBIT, the use of fixed-charge source of funds (debt) would be advantageous from the viewpoint of EPS, that is, financial leverage will be favourable and lead to an increase in EPS available to shareholders

If the expected level of EBIT is less than the indifference point, the advantage of EPS would be available from the use of equity capital

EBIT-EPS ANALYSISThe greater the likely level of

EBIT than the indifference point, the stronger is the case for using levered financial plans to maximize EPS

The lower the likely level of EBIT in relation to the indifference point, the more useful the unlevered financial plan would be from the viewpoint of EPS

EBIT-EPS ANALYSISOn the basis of level of EBIT which ensures identical market price for alternative financial plans, the indifference point can be symbolically computed by Where= ratio of unlevered plan = ratio of levered plan

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