afm session 2

Advanced Financial Management

Session -2

LEVERAGES

What is Leverage?

RISK

LEVERAGES

• MEANING: Leverage refers to an increased means of achieving some purpose

• Leverage allows us to accomplish certain things which are otherwise not possible, namely lifting of heavy objects with the help of leverage.

Leverages

• In corporate finance the term Leverage applies to the use of certain fixed costs that result in a manifold increase in a firm’s profitability. For a business firm, the lever is the fixed operating cost and the fixed financing costs in the cost structure of the firm.

TYPES OF LEVERAGES

Types of leverages

Activity

operating Financial combined

Strutural

Operating leverage

A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs.

1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged.

2. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged.

3. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability.

The Operating Leverage can be calculated by using the following Formula:-

• Operating Leverage = Contribution Net Operating Income

• Degree of Operating Leverage = Percentage Change in NOIPercentage Change in Sales

Operating leverage deals with:– Business risk– Unavoidable risk– Uncontrollable risk

FINANCIAL LEVERAGE

• Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share.

• Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt;

• They may also be unable to find new lenders in the future. Financial leverage is not always bad.

• It emphasizes the use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

The Financial Leverage can be calculated by using the following Formula:-

• Financial Leverage = EBIT EBT

• Degree of Financial Leverage = Percentage Change in EPSPercentage Change in EBIT

• Operating leverage deals with:o Financial risko Avoidable risko Controllable risk

Financial Leverage of Ten Largest Indian Companies, 2008

COMBINED LEVERAGE

• Combined leverage is a leverage which refers to high profits due to fixed costs.

• Competitive firms choose high level of degree of combined leverage whereas conservative firms choose lower level of degree of combined leverage.

• Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share.

The Combined Leverage can be calculated by using the following Formula

• Combined Leverage = Operating Leverage X Financial Leverage or,Contribution / EBT

• Degree of Combined Leverage = Percentage Change in EPSPercentage Change in SALES

SALES EBIT EPS

DEGREE OF OPERATING LEVERAGE

SALES EBIT EPS

DEGREE OF FINANCIAL LEVERAGE

SALES EBIT EPS

DEGREE OF COMBINED LEVERAGE

EXAMPLE

• Based on the following information on Levered Company, answer these questions:

1. Calculate operating leverage.

2. Calculate financial leverage.

3. Calculate combined leverage.

LEVERED COMPANY

Sales (100,000 units) Rs.1,400,000

Variable Costs Rs.800,000

Fixed Costs Rs.250,000

Interest paid Rs.125,000

Tax rate 34%

Common shares outstanding 100,000

1,400,000 - 800,000 350,000

= 1.714

=

OLs = Sales - Variable Costs EBIT

OPERATING LEVERAGE

DFL = EBIT EBIT - I

= 350,000 225,000

= 1.556

FINANCIAL LEVERAGE

DCL = Sales - Variable Costs EBIT - I

1,400,000 - 800,000 225,000

= 2.667

=

COMBINED LEVERAGE

Question 1:

A firm sells its products for Rs. 50 per unit, has variable operating cost of Rs. 30 per unit and fixed operating cost of Rs. 5000 per year. Its current level of sales is 300 units.

• Determine the operating leverage. • What will happen to EBIT if sales change

(a) Increase by 16.67%(b) Decrease by 16.67%

SolutionUnits: 300 units

Particulars Amount (Rs.)Sales 15000Less: Variable Cost 9000

Contribution 6000Fixed Cost 5000

EBIT 1000

Contribution = 6000 EBIT 1000

= 6

(a)

Units: 250 units Units:350 unitsParticulars Amount (Rs.) Amount (Rs.)

Sales 12500 17500Less: Variable Cost 7500 10500Contribution 5000 7000Fixed Cost 5000 5000EBIT 0 2000

(b)

• Lets practice some more examples…..

Question 2:

A firm selling price of its product is Rs.100 per unit. The variable cost per unit is Rs.50 and the fixed operating costs are Rs.50,000 per year. The fixed interest expenses (non-operating) are Rs.25,000 and the firm has 10,000 shares outstanding. Tax rate = 35%.Evaluate the EBIT/EPS resulting from sale of (a) 2000 units (b) 3000 units.

SolutionCASE I CASE II

Units: 2000 Units: 3000Particulars Amount (Rs.) Amount (Rs.)

Sales 200000 300000Less: Variable Cost -100000 -150000Contribution 100000 150000Fixed Cost -50000 -50000EBIT 50000 100000Less: Interest -25000 -25000EBT 25000 75000Less: Tax (35%) -8750 -26250PAT 16250 48750

No. of Outstanding Equity Shares 10000 10000Earnings Per Share 1.625 4.875

• Percentage change in EPS = (4.875-1 .625) x 100 = 200%

1.625

• Percentage change in EBIT = (100000-50000) x 100 = 100%

50000

• Degree of Financial Leverage: Percentage change in EPS = 200 = 2Percentage change in EBIT 100

Question 3:

Consider the following information forKaunark Enterprise

(a) Calculate all the leverages(b) Calculate the % change in EPS, if the sales

increased by 5%

Rs in LakhParticulars Amount (Rs.)

EBIT 1120PBT 320Fixed Cost 700

SolutionOperating Leverage: = Contribution EBIT = 1120+700 = 1.625 1120

Financial leverage = EBIT PBT = 1120 = 3.5 320

Combined Leverage = Contribution EBT = 1120+700 = 5.6875 320

Calculation of the % change in EPS, if thesales increased by 5%

Degree of Combined leverage =% Change in EPS

% Change in Sales 5.687 = % Change in EPS 5% Change in EPS = 5.687*5 = 28.44%

Question 4

If the combined leverage and operating leverage figures of a company are 2.5 and 1.25 respectively, find the financial leverage and P/V ratio, given that: the

•Equity dividend per share is Rs. 2•Interest payable per year is Rs. 1 lakh•Total Fixed cost Rs. 0.5 lakhs•Sales Rs. 10 lakhs

SolutionCombined Leverage = Operating leverage * financial leverage

2.5 = 1.25 * financial leverage

Financial Leverage = 2.5 = 2 1.25

Financial Leverage = EBIT EBT

= EBT + Interest EBT 2 = EBT + 1,00,000 EBTEBT = 1,00,000

Therefore EBIT = EBT + 1,00,000 =1,00,000 + 1,00,000 = 2,00,000

Operating leverage = Contribution EBIT 1.25 = Contribution 2,00,000Therefore, Contribution is Rs. 2,50,000

Therefore P.V. Ratio = Contribution * 100 Sales = 2,50,000 * 100 = 25% 10,00,000

Question 5

Well established company’s balance sheet is as follows

Liablities Amount(Rs.) Assets Amount(Rs.)Equty Capital( Rs 10 per share) 60000 Net Fixed Assets 15000010% long term debt 80000 Current Assets 50000Retained Earnings 20000Current liablities 40000

200000 200000

• Company’s total asset turnover ratio is 3; its fixed asset operating cost are Rs. 1,00,000 and the variable operating costs ratio is 40 per cent. The income tax rate is 35%

a) Calculate all types of leveragesb) Determine the likely level of EBIT if EPS is

Rs.1 Rs. 3 Zero

SolutionParticulars Amount (Rs.)

Sales 600000Less: Variable Cost 240000Contribution 360000Fixed Cost 100000EBIT 260000Less: Interest 8000EBT 252000Less: Tax 88200PAT 163800

Operating Leverage = Contribution EBIT = 600000-240000 = 1.38 260000Financial leverage = EBIT PBT = 260000 = 1.03 252000Combined Leverage : Contribution EBT = 1.38 * 1.03 = 1.42

• EPS = ( EBIT – I ) (1 – t) N

Rs. 1 = ( EBIT – 8000 ) (1 – 0.35) 6000

EBIT = Rs. 17,231

Rs. 3 = ( EBIT – 8000 ) (1 – 0.35) 6000

EBIT = Rs. 35,692

Rs. 0= ( EBIT – 8000 ) (1 – 0.35) 6000

EBIT = Rs. 8,000

Particulars Amount (Rs.) Amount (Rs.) Amount (Rs.)EBIT 8000 17231 35692

Less: Interest 8000 8000 8000EBT 0 9231 27692

Less: Tax 0 3231 9692PAT 0 6000 18000

Number of shares 6000 6000 6000EPS (NI+ N) 0 1 3

Question 6

The selected financial data for A, B & C companies for the current year ended 31st March are as follows :

a) Prepare income statements for A, B & C companies.b) Comment on the finanacial position and structure of these

companies.

PARTICULARS A B C

Variable expenses as a percentage of sales 66.67 75 50

Interest expenses(Rs.) 200 300 1000

Degree of operating leverage 5 6 2

Degree of financial leverage 3 4 2

Income tax rate 0.35 0.35 0.35

Solution

Income statement of companies A, B & C for the current year, ended March 31

Particulars A B CSales 4500 9600 24000Less: Variable Cost 3000 7200 12000Contribution 1500 2400 12000Fixed Cost 1200 2000 10000EBIT 300 400 2000Less: Interest 200 300 1000EBT 100 100 1000Less: Tax 35 35 350PAT 65 65 650

• DFL = 3, DFL = EBIT EBIT - 1

• Company A:3= EBIT

EBIT – 200EBIT = 300DOL = Sales – Variable Costs

EBIT5= S – 0.667S

300S = Sales = Rs. 4500VC = 0.667 x 4500 = Rs. 3000

• Company B:4= EBIT

EBIT – 300EBIT = 400

DOL = Sales – Variable Costs EBIT

6= S – 0.75S400

S= Sales = Rs. 9600VC = 0.75 x 9600 = Rs. 7200

• Company C:2= EBIT

EBIT – 1000EBIT = 2000

DOL = Sales – Variable Costs EBIT

6= S – 0.50S2000

S= Sales = Rs. 24000VC = 0.50 x 24000 = Rs. 12000

• Financial position of Company C can be regarded as better than other companies.

• Least financial risk as minimum degree of financial leverage.

• Company C is better placed from DCL point of view. Total risk of Company C is lowest.

• Ability of Company C to meet its interest liability is better.

Company EBIT/Interest Value

A 2000/1000 2

B 300/200 1.5

C 400/300 1.33

Question 7

• Mr. Nitesh is an entrepreneur and has recently set up manufacturing unit of pens. He currently sells 1million pens in a year at Rs 5 each. His variable cost is Rs. 3 per pen and he has Rs. 15 lakhs in fixed costs. His sales to assets ratio is 5times and 40% of his assets are financed with 8%debt with the balance being financed by ordinary shares of Rs. 10 per share. Tax rate is 35%.

His newly appointed finance manager Mr. Vinit Shah thinks that Mr. Nitesh is doing it all wrong. By reducing his price to Rs. 4.50 per pen he could increase his sales volume by 40%. Fixed costs would remain constant and variable costs at Rs. 3 per unit. His sales to asset ratio would be 6.3 times. Furthermore he could increase his debt to asset ratio to 50%, with the balance in shares. It is assumed that interest rate would be up by 1% and that price of shares would remain constant.

A. Compute the EPS under the Nitesh and Vinit plans. Is Mr. Vinit’s perception right?

B. Mr. Nitesh’s partner Miss Hemanti does not think that fixed costs would remain constant under Vinit’s plan but they would go up by 15% . If this is the case should Mr Nitesh shift to Vinit’s plan, based on EPS?

C. What is the effect of total risk on the firm on switching from one plan to another?

Solution

Particulars Amount(Rs.)Nitesh’s Plan: Sales Revenue(1 million * Rs 5) 5000000Less: Variable Cost(1 million* Rs.3) 3000000

Contribution 2000000Less: Fixed Cost 1500000

EBIT 500000Less: Interest 32000

PBT 468000Less : Tax(0.35) 163800

PAT 304200N( numbers of Shares) 60000

EPS 5.07

Particulars Amount(Rs.)Vinit’s Plan:Sales Revenue(1million * 1.4* Rs 4.5) 6300000

Less: Variable Cost(1million * 1.4* Rs.3) 4200000Contribution 2100000

Less: Fixed Cost 1500000EBIT 600000

Less: Interest 45000PBT 555000

Less: Tax(0.35) 194250PAT 360750N( numbers of Shares) 50000EPS 7.215

Working note 1 :Sales / Assets = 5 Rs 50 lakh/ Assets =5 or Assets Rs.10 Lakhs40% of assets financed by 8% debt= Rs. 4 lakhInterest (0.08* Rs.4 lakh)= Rs.32000Number of shares (Rs. 6 lakh/Rs. 10 each share)=60,000

Working Note 2:Total Assets =Rs.10 lakhDebt/Assets = 50%Debt = Rs. 5 lakh at 8% + 1% =9%Interest = 0.09 * Rs.5 lakh = Rs. 45,000Number of shares (Rs.5 lakh / Rs.10) = 50,000Yes, Mr Vinit is right in his perceptions. Following his planwould increase the EPS to Rs.7.22 from Rs.5.07

(c) Computation of EPS The total risk is determined by the combined leverage which in turn isevaluated by combined operating and financial leverage.

Nitesh’s plan : Vinit’s plan :DOL = Contribution = 20 L = 4 DOL =Rs. 21 L

EBIT 5 LDFL = 6 L

DFL =EBIT = 5L 6 L – 0.45L EBIT-I 5L – 0.32L

DCL = DOL*DFL = 3.78DCL = DOL * DFL = 4.27

There is decrease in degree in the combined leverage , reflecting a decline inthe total risk of the company. With a lower degree of risk , the market priceof its share is likely to go up.