Leverage Analysis
Dr. M.S. Ansari Assistant Professor
IEF, BU, Jhansi
Leverage Analysis
• Technique used to quantify risk and return relationship due to different cost and capital structure alternatives chosen by a corporate finance manager.
Fixed
Component
Variable Component
Leverage
Risk: Lack of certainty
Business and Financial risk respectively
Finance Mix Decision Assets
Mix Decision
Strategic Financial Decision
Genesis and nature of above risk
• Business Risk = Variability of EBIT because of changes in both internal and external business environment in which business operates. (Eg:
Business Cycle and Technological Obsolesce etc.
• Business Risk is unavoidable and is associated with Capital Budgeting Decision.
• Operating Leverage is a measure of Business Risk.
• Financial Risk = Variable in EBT because of use financial leverage. (Use of debt to fund its capital requirement)
• Financial leverage is a measure of Financial Risk
Operating Leverage
Concept
Firm’s ability to use fixed operating cost to magnify the effect of changes in sales on its EBIT.
%age change in operating profit will be more for a given change in sales for firms which are having higher degree operating leverage.
A firm which have ratio of fixed to total cost as zero is said to have no operating leverage.
A firm with zero operating leverage will observe no change in profit with changes in sales.
Measure of Operating Leverage
OR
OR
CASE 1
From the following particular compute DoL and Comment
I. Installed Capacity = 20,000 units
II. Actual Production and Sales 75% of the installed capacity
III. Selling Price per unit Rs. 10 IV. Fixed cost = Rs. 30,000 V. Total Operating Cost 80%
S = (0.75X20,000 units)X Rs.10= Rs. 1,50,000 V = (0.80X1,50,000)-Rs.30,000 = Rs. 90,000 C = 1,50,000 – 90,000 = 60,000
EBIT = Rs. 60,000 – Rs.30,000 DOL = 60,000 / 30,000 = 2 times
Comment
2 times DoL means that 1% increase in sales would result in 2% increase in EBIT and vice Versa
DoL = %Change in EBIT
%Change in Sales
DOL = ∆ EBIT/EBIT
∆ Sale /Sale
DoL = Contribution EBIT
C = S-V EBIT = S-V-F
Case2 and Case 3: Computation of DoL
Case 2 A Ltd. B. Ltd.
Sales unit 1000 1500
S.P per unit 10 10
EBIT 1,500 4,500
Case 3 X ltd. Y ltd.
Sales unit 2000 3000
S.P per unit 10 10
Tot. Op.
Cost
17,600 21,600
Case 2
DoL = ∆ EBIT/EBIT
∆ Sales/Sales
= (4500-1500)/1500___
(15000-10000)/10000
= 4 times Case 3
EBIT at 2000 units
(2000X10) – 17600 = 2400 EBIT at 3000 units
(3000X10) – 21600 = 8400 DoL = (8400 -2400)/2400__
(30000-20000)/20000
= 5 Times
Case 4: behaviour of Operating Leverage
Firm x Firm Y SP per
unit 8 8
FC( in
000) 80 200
VC per
unit 6 4
Compute BEP if sales range between 20,000 to 80,000 units
Profit at different level of sales
160
240
320
400
480
560
640
320
0 100 200 300 400 500 600 700
1 2 3 4 5 6 7
Sales (Rs 8) FC
TC Linear (Sales (Rs 8))
Linear (TC) Linear (TC) Linear (TC)
BEP for Firm X FC/S-V 40 BEP for Firm Y FC/S-V 50
BEP Analysis of Firm X
Units
Sales (Rs
8) VC FC TC EBIT
20 160 120 80 200 -40
30 240 180 80 260 -20
40 320 240 80 320 0
50 400 300 80 380 20
60 480 360 80 440 40
70 560 420 80 500 60
80 640 480 80 560 80
BEP Analysis of Firm Y
Units
Sales (Rs
8) VC FC TC EBIT
20 160 80 200 280 -120
30 240 120 200 320 -80
40 320 160 200 360 -40
50 400 200 200 400 0
60 480 240 200 440 40
70 560 280 200 480 80
80 640 320 200 520 120
160
240
320
400
480
560
640
0 100 200 300 400 500 600 700
1 2 3 4 5 6 7
Sales (Rs 8) FC TC
Case5: Selection of best option
One of the two companies is to be purchased. From the following information analyze and suggest.
Particulars X Ltd. Y ltd.
Sales Revenue 60,00,000 60,00,000
Less: Cost of goods sold (45,00,000) (45,00,000)
Selling Expenses (4,80,000) (4,80,000)
Administrative Exp. (1,80,000) (3,00,000)
Depreciation (2,40,000) (1,80,000)
EBIT 6,00,000 5,40,000
Cost break up Variable cost
Cost of goods sold 18,00,000 36,00,000
Selling expenses 3,00,000 3,00,000
The parent company wish to buy company with low business risk. Assume 1. Sales increases by 30%
2. Sales increases by 30% and additional sales generates a return of 10% on sales before interest and taxes. V C and Sales bears a linear relationship.
3. Sales increases by 30% and return on sales before interest and taxes improve by 5
Particular Case a case b case c
X ltd. Yltd X ltd. Yltd X ltd. Yltd
A. Sales 78.0 78.0 78.0 78.0 78.0 78.0
B. Less: Variable cost
I. cost of goods sold 23.4 46.8 23.4 46.8 23.4 46.8
II. Selling Expenses 3.9 3.9 3.9 3.9 3.9 3.9
Total Variable Cost 27.3 50.7 27.3 50.7 27.3 50.7
C. Contribution (A-B) 50.7 27.3 50.7 27.3 50.7 27.3
D. Less Fixed Cost
I. cost of goods sold 27.00 9.00 27.00 9.00 27.00 9.00
II. Selling Expenses 1.80 1.80 1.80 1.80 1.80 1.80
III. Administrative Expenses 1.80 3.00 1.80 3.00 1.80 3.00
IV. Depreciation 2.40 1.80 2.40 1.80 2.40 1.80
V. Additional Fixed cost 0.00 0.00 9.90 4.50 6.00 0.78
D.Total Fixed cost (sum I to V) 33.00 15.60 42.90 20.10 39.00 16.38
E. EBIT (C-D) 17.70 11.70 7.80 7.20 11.70 10.92
F. Operatiing Leverage (C/E) 2.86 2.33 6.50 3.79 4.33 2.50
Company Y has a lower degree of Operating leverage in all the three case.
This means that it has a lower degree of business risk. Therefore it is advisable to purchase Y ltd.
workihng Notes X Ltd. Y Ltd.
1Variable cost ratio
(VC/Sales) *100 (21/60)*100 (39/60)*100
35% 65%
2Additional fixed cost for Case B.
A Additional Sales 18.0 18.0
B. Add. VC 35%A, 65% B 6.3 11.7
C. Additional Contribution (A-B) 11.7 6.3
D Less Add. EBIT@10%(0.10*C) 1.8 1.8
E Additional Fixed cost (C-D) 9.9 4.5
3Exisitng and new rates of return
(EBIT/Sales)*100 (6/60)*100 (5.4/60)*100
Existing EBIT 10% 9%
Improved EBIT 5% 5%
new EBIT 15% 14%
4Additional Fixd cost in case of C
A Sales 78.00 78.00
B less VC 35%/65% 27.30 50.70
C contribution (A-B) 50.70 27.30
D Less: EBIT @15% of A, 14% of A 11.70 10.92
E Total FC (C-D) 39.00 16.38
F less Fixed Cost (exisiting) 33.00 15.60
G Additional fixed cost (E-F) 6.00 0.78
Financial Leverage of firm is 1.5. What does this mean?
How to calculate financial leverage?
DFL = %change in EPS = ∆EPS/EPS
%change in EBIT ∆EBIT/EBIT If there is no preference dividend = EBIT/EBT If there is preference dividend
= EBIT / EBT-(Pref. dividend/1-t))
Installed Capacity 2000 units, Actual production and sales 75% of Installed capacity, SP per unit Rs. 10, VC60% DOL 2, 10% Debt Rs.1 lacs, 15% Preference Share Rs.20,000. Tax Rate 40%.
Sales = (75% of 20,000 units) XRs.10 = Rs. 1,50,000 VC = 60% of Rs.1,50,000 = Rs.90,000
C = S-V = 1,50,000-90,000
DOL = C/EBIT Therefore EBIT Rs.60,000/2 = Rs.30,000
EBT = EBIT – Interest = Rs.30,000 – (10% of Rs.1,00,000 = Rs.20,000 DoF = EBIT/EBT-(Pref. Div/1-t)
= Rs.30,000/ Rs.20,000-(0.15*20,000/1- 0.40)
= Rs. 30,000/Rs.15,000 = 2
How does use of Financial Leverage affect the Financial Risk?
Effect on In case of High Degree of financial leverage
In case of low degree of financial leverage
Variability in share holding
Increases Decreases
Probability of Insolvency
Increases Decreases
Effect of Financial Leverage on EPS
1. EPS will increase if ROI > Cost of Debt 2. EPS will decrease if ROI < Cost of Debt
What is Trading on Equity ?
The use of the sources of funds with fixed cost such debt and preference share along with the owners’ equity capital in the capital structure is know as financial leverage or trading on equity.
It is so called because it is the owner’s equity that is used as a basis to raise debt, which is the equity that is traded upon.
EBIT-EPS analysis shows the impact of various alternative financial plans on EPS at various levels of EBIT.
Format of EBIT-EPS Analysis Statement
Particlualrs Equity alternative Debt Alternative
Financial Plan A
Financial Plan B
Financial Plan A
Financial Plan B
A. EBIT
B. Less interest C. EBT (A-B) D. Less : Tax E. EAT (C-D) F. Less Pref. Div
G. Earning for Equity holders
H. No. Equity shareholder I. EPS = (G/H)
J. RoE (EBIT and Pref.
Div)/Equity funds
Case Analysis
Show the effect of financial leverage on EPS by considering the following two financial plans if EBIT is (a) Rs.2,00,000 (b) Rs.1,00,000
I. Total funds required Rs.10,00,000
II. Financial Plan A – 100% Equity shares of Rs.
10 each
III. Financial Plan B- 50% equity of Rs. 10 each and 50% 15% Debt,
IV. Tax Rate – 40%
Advantage and Disadvantages of use of debt
The financial leverage is a double edged sword because on one hand it increases the risk and on the other hand it increase the return of share holders
Favourable impact on EPS : RoI>Kd Unfavourable impact on EPS : RoI< Kd
Note:
Interest is an allowable deduction for the purpose of income tax therefore it saves tax. However, if the firm is not in the position to service debt , financial leverage leads to financial distress.
The firm can avoid this distress by not going for financial leverage, but by not doing so the shareholders will be deprived fruits of higher EPS.
Best things would be conduct micro-macro business environment analysis and scenario analysis and then do Cost –Best Analysis.
Should the firm employ debt?
A Scenario Analysis
If RoI > cost of Debt If RoI < Cost of debt Case Effect on EPS Effect on
Financial Risk
Effect on EPS Effect on Financial Risk Use of more
debt in Capital Structure
Increase Increase Decreases and it may even lead to negative EPS
Increase threat of insolvency
Use of less debt in Capital structure
Relative less increase
Relatively less increase
Relatively less decrease
Relatively less increase
Combined Leverage
The percentage in EPS occurring due to a given percentage change in Sales is known as Degree of Combined leverage. It is a measure of Total Risk.
Combined Leverage (CL) = DoL X DoF
•It is associate with Cap. Budgeting Decision and Capital Structure Decision. Degree of CL differs with the use different form of financing.
•CL exists if there are either fixed cost or funds bearing fixed financial payment or both.
How to Calculate Combined Leverage
1. DCL = % Change in EPS /%Change in Sale (∆EPS/EPS)/(∆Sales/Sales)
2. If no preference dividend is used
= (C/EBIT) X (EBIT/EBT) = C/EBT 3. If there is preference dividend
= (C/EBT)X EBIT/EBT- (Pref. Div/1-t)
= C/EBT – (PD/1-t)
What does CL Indicates?
DoL DFL Nature of Situation
High High Risk
High Low Normal
Low High Normal
Low Low Ideal
CL ratio should be as low as possible., which can be done only if one of the two leverage is kept low.
However, it is preferable to have low OL and High FL provided the RoI is higher than the cost of capital
