Ch 12 Leverage

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FINANCIAL AND OPERATING LEVERAGE

CHAPTE

R 14


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LEARNING OBJECTIVES

Explain the concept of financial leverage

Discuss the alternative measures of financial leverage

Understand the risk and return implications of financialleverage

Analyze the combined effect of financial and operating

leverage

Highlight the difference between operating risk and

financial risk

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Capital Structure Defined

The term capital structure is used to represent theproportionate relationship between debt and equity.

The various means of financing represent the financialstructure of an enterprise. The left-hand side of the

balance sheet (liabilities plus equity) represents thefinancial structure of a company. Traditionally, short-

term borrowings are excluded from the list of methodsof financing the firmscapital expenditure.

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4

The capital structure decision process


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While making the Financing

Decision...

How should the investment project be financed?

Does the way in which the investment projects arefinanced matter?

How does financing affect the shareholders risk, return

and value?Does there exist an optimum financing mix in terms of the

maximum value to the firmsshareholders?

Can the optimum financing mix be determined in practicefor a company?

What factors in practice should a company consider indesigning its financing policy?

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Meaning of Financial

Leverage

The use of the fixed-charges sources of funds, such as debt and

preference capital along with the owners equity in the capital

structure, is described as financial leverageorgearingortrading

on equity.

The financial leverage employed by a company is intended to earn

more return on the fixed-charge funds than their costs. The surplus

(or deficit) will increase (or decrease) the return on the owners

equity. The rate of return on the ownersequity is levered above or

below the rate of return on total assets.

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Measures of Financial

Leverage

Debt ratio

Debtequity ratio

I nterest coverage

The first two measures of financial leverage can beexpressed either in terms of book values or market values.These two measures are also known as measures ofcapital gearing.

The third measure of financial leverage, commonly known

as coverage ratio. The reciprocal of interest coverage is ameasure of the firmsincome gearing.

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Financial Leverage of Ten

Largest Indian Companies, 2008


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Financial Leverage and the

Shareholders Return

The primary motive of a company in using financial leverage isto magnify the shareholdersreturn under favourable economicconditions. The role of financial leverage in magnifying thereturn of the shareholdersis based on the assumptions that the

fixed-charges funds (such as the loan from financial institutionsand banks or debentures) can be obtained at a cost lower thanthe firmsrate of return on net assets (RONA or ROI).

EPS, ROE and ROI are the important figures for analysing theimpact of financial leverage.

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EPS and ROE Calculations

For calculating ROE either the book value or the marketvalue equity may be used.

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na yz ng erna ve nanc aPlans:

Constant EBIT

The firm is considering twoalternative financial plans:

(i) either to raise the entirefunds by issuing 50,000

ordinary shares at Rs 10 pershare, or

(ii) to raise Rs 250,000 byissuing 25,000 ordinaryshares at Rs 10 per share and

borrow Rs 250,000 at 15 per

cent rate of interest.

The tax rate is 50 per cent.

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Effect of Financial Plan on EPS and ROE:Constant EBIT


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Interest Tax ShieldThe interest charges are tax deductible and,

therefore, provide tax shield, which increases the

earnings of the shareholders.

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Effect of Leverage on ROE

and EPS

Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i

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Effect of Financial Plan on EPS

and ROE: Varing EBIT14


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Effect of Financial Plan on

EPS and ROE: Varing EBIT15


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EBITEPS chart-Example16


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Calculation of indifference

point

The EPS formula under all-equity plan is

The EPS formula under debtequity plan is:

Setting the two formulae equal, we have:

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Sometimes a firm may like to make a choice between two

levels of debt. Then, the indifference point formula will be:

The firm may compare between an all-equity plan and an

equity-and-preference share plan. Then the indifference point

formula will be:

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Calculation of indifference

point


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Operating Leverage

Operating leverageaffectsa firms operating profit(EBIT).

The degree of operating

leverage(DOL) is definedas the percentage change inthe earnings before interestand taxes relative to agiven percentage change in

sales.

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% Change in EBIT

DOL % Change in Sales

EBIT/EBITDOL

Sales/Sales


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Degree of Financial LeverageThe degree of financial leverage (DFL) is defined

as the percentage change in EPS due to a given

percentage change in EBIT:

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Combining Financial and

Operating Leverages

Operating leverageaffects a firmsoperating profit(EBIT), while financial leverageaffects profit aftertax or the earnings per share.

The degrees of operating and financial leveragesis combined to see the effect of total leverage onEPS associated with a given change in sales.

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Combining Financial and

Operating Leverages

The degree of combined leverage(DCL) is given

by the following equation:

another way of expressing the degree of combined

leverage is as follows:

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% Change in EBIT % Change in EPS % Change in EPS

% Change in Sales % Change in EBIT % Change in Sales

( ) ( ) ( )DCL( ) ( ) INT ( ) INTQ s v Q s v F Q s v

Q s v F Q s v F Q s v F

Fi i l L d th


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Financial Leverage and the

Shareholders Risk

The variability of EBIT and EPS distinguish between twotypes of riskoperating riskand financial risk.

Operating riskcan be defined as the variability of EBIT(or return on total assets). The environmentinternal and

externalin which a firm operates determines thevariability of EBIT

The variability of EBIT has two components:

variability of sales

variability of expenses

The variability of EPS caused by the use of financialleverage is called financial risk. Financial risk is anavoidable risk if the firm decides not to use any debt in itscapital structure.

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Measuring Operating and

Financial Risk

We can use two measures of risk:

Standard deviation and

Coefficient of variation.

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2 2 2 21 1 2 2

2

1

1 1 2 2 1

(EPS) [EPS (EPS)] [EPS (EPS)] [EPS (EPS)]

[EPS (EPS)]

(EPS) EPS EPS EPS EPS

j j

n

j j

j

n

j j j jj

E P E P E P

E P

E P P P P


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Risk-Return Trade-off If the firm wants higher return (EPS or ROE) for the

shareholders for a given level of EBIT, it will have to employ

more debt and will also be exposed to greater risk (as

measured by standard deviation or coefficient of variation).

In fact, the firm faces a trade-off between risk and return.

Financial leverage increases the chance or probability ofinsolvency.

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Ch 12 Leverage