ch 12 leverage
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FINANCIAL AND OPERATING LEVERAGE
CHAPTE
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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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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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