financial management
TRANSCRIPT
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NAGINDAS KHANDWALA
COLLEGE
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FINANCIAL MANAGEMENT 2
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LEVERAGES
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GROUP NO.1
NAMES ROLL NO.
TRIPTI. BANGERA 1KARISHMA. BHANDARI 2
RAJAT. BHOIR 3GOPI.CHAUHAN 4
KHUSHBOO. CHAURASIA 5RUSHABH DEDHIA 6JAINAM.DELIWALA 7RUTU. DOBARYA 8
POOJA GADA 10JINAL GAGLANI 11
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TABLE OF CONTENT
SR NO.
PARTICULARS
1. Introduction and meaning of leverages
2. Debt vs equity financing
3. Business risk and financial risk
4. Types of leverages- operating leverage
5. Financial leverage
6. Trading on equity
7. Combined leverage
8. Break-even point
9. EBIT- EPS Analysis
10. Measures of operating and financial leverage
11. Importance of leverages
12. Leverage- Implications
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INTRODUCTION TO LEVERAGE
LEVER MEANS A BAR RESTING ON A PIVOT
WHICH IS USED TO RAISE A HEAVIER
OBJECT.WHEN A LEVER IS USED PROPERLY , A
FORCE APPLIED AT ONE POINT IS
TRANSFORMED , OR MAGNIFIED , INTO
ANOTHER LARGE FORCE OR MOTION AT SOME
OTHER POINT. IN SHORT , THE FUNCTION OF
LEVER IS TO RAISE A HEAVY OBJECT WITH A
MINIMUM FORCE
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DEFINITION OF LEVERAGE
LEVERAGES IS THE EMPLOYMENT OF THE ASSETS OR FUND FOR
WHICH THE FIRM PAYS THE FIXED RETURNS
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DEBT V/S EQUITY FINANCING
• LENDER REUIRE A LOWER RATE OF RETURN THAN ORDINARY SHAREHOLDER.
•A PROFITABLE BUSINESS LESS PAY FOR DEBT THAN EQUTY.
• ISSUING AN TRANSACTIONS COST.
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RISK
MEANING
TYPES OF RISK
• BUSINESS RISK
• FINANCIAL RISK
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BUSINESS RISK
• MEANING
• VARIABILITY
• NATURE OF RISK
• MEASUREMENT
• CHANGE IN CAPITAL STRUCTURE
• LINKED TO
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FINANCIAL RISK
• MEANING
• VARIABILITY
• NATURE OF RISK
• MEASUREMENT
• CHANGE IN CAPITAL STRUCTURE
• LINKED TO
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TYPES OF LEVERAGE
OPERATING LEVERAGE
FINANCIAL LEVERAGE
COMBINED LEVERAGE
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WHAT IS OPERATING LEVERAGE ?
•MEASURES COMPANY FIXED TO ITS VARIABLE COST
•USED TO EVALUATE BREAK EVEN POINT OF A BUSINESS
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TWO SCENARIO OF OPERTING LEVERAGE
HIGH OPERATING LEVERAGE
LOW OPERATING LEVERAGE
• COSTS ARE FIXED COST
• SALES ARE VARIABLE COST
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DEGREE OF OPERATING LEVERAGE
DOL = CONTRIBUTION
EBIT
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WHAT DOES IT TELL US ?
• IF DOL = 2 , THEN 1 % INCREASE IN SALES WILL RESULT IN 2 % INCREASE
IN OPERATING INCOME ( EBIT)
SALES EBIT
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EFFECTS OF OPERATING LEVERAGE
MORE OPERATING LEVERAGE LEADS TO MORE BUSINESS RISK FOR THAN A SMALL SCALE DECLINE CAUSES A
BIG PROFIT DECLINE
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FINANCIAL LEVERAGE
• IT IS DEFINED AS THE USE OF FUNDS WITH A FIXED COST IN ORDER TO INCREASE EARNING PER SHARE
• FINANCIAL LEVERAGE IS A MEASURE OF FINANCIAL RISK
• AND THERE WILL BE NO FINANCIAL LEVERAGE IF THERE IS NO FIXED CHARGE FINANCING.
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DEGREE OF FINANCIAL LEVERAGE ( FORMULA)
STATIC. DYNAMICIN EPS
INEBIT
EBITEBT
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DEGREE OF FINANCIAL LEVERAGE
IF WE HAVE THE DATA, WE CAN USE FOLLOWING FORMULA
DFL= EBIT
EBIT- INTEREST
HERE, I =AMOUNT OF INTEREST CHARGES
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WHAT DOES IT TELL US ?
IF DFL = 3, THEN A 1% INCREASE IN OPERATING INCOME WILL RESULT
IN A 3% INCREASE IN EARNING PER SHARE
IF DFL = % CHANGE IN EPS
% CHANGE IN EBIT
SALES EBIT EPS STOCKHOLDER
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EFFECTS OF DFL Firm A
EBIT. 100
- Interest. 10
EBT. 90
DFL = EBIT
EBT
= 100
90
= 1.11
Firm B
EBIT. 100
- Interest. 50
EBT. 50
DFL = EBIT
EBT
= 100
50
= 2
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FROM THE EXAMPLE WE COME TO KNOW THAT
IF INTEREST IS LOW, DFL WILL BE LOW
AND
IF INTEREST IS HIGH, DFL WILL BE HIGH
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IMPORTANCES OF FINANCIAL LEVERAGE
• IT IS USE TO FIND EPS AND MARKET VALUE OF EQUITY SHARE
• IT IS SUPERIOR THAN OPERATING LEVERAGE
• IT IS USE TO MAKE FINANCIAL DECISIONS
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TRADING ON EQUITY
EQUITY MEANS EQUITY SHARES
TRADING MEANS ‘TAKING ADVANTAGE OF’.
REFERRED TO AS FINANCIAL LEVERAGE
USE OF OWNER’S FUND AS WELL AS BORROWED FUNDS WITH A VIEW TO INCREASE THE EPS
COMPANY IS MAKING USE OF FIXED INTEREST AND DIVIDEND BEARING SECURITIES TO BENEFIT EQUITY SHAREHOLDERS.
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CAPITAL STRUCTURE PARTICULARS DIAMOND
LTD. (AMT.)GOLD LTD. (AMT.)
SILVER LTD. (AMT.)
EQUITY SHARES OF RS. 100 EACH
2,00,000 8,00,000 10,00,000
10% DEBENTURES OF RS.100 EACH
8,00,000 - -
8% PREFERENCE SHARES OF RS. 100 EACH
- 2,00,000 -
TOTAL CAPITAL EMPLOYED 10,00,000 10,00,000 10,00,000
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INCOME STATEMENT (WHEN ROCE IS 30%)
Particulars Diamond Ltd. (Amt.)
Gold Ltd. (Amt.)
Silver Ltd. (Amt.)
EBIT @30% 3,00,000 3,00,000 3,00,000
(-)Interest (80,000) NIL NIL
EBT 2,20,000 3,00,000 3,00,000
(-)Tax @50% (1,10,000) (1,50,000) (1,50,000)
EAT / NPAT 1,10,000 1,50,000 1,50,000
(-)Preference dividend NIL (16,000) NIL
Profit for Equity Shareholders
1,10,000 1,34,000 1,50,000
÷ No. of Equity shares 2000 8000 10000
Earnings Per Share (EPS)
Rs.55/- Rs.16.75/- Rs.15/-
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DIAMOND LTD
Equity shares 10% Debt
2,00,000 @ 30% 8,00,000 @30%
EBIT 60,000 2,40,000
- Interest NIL (80,000)
EBT 60,000 1,60,000
- Tax@50% (30,000) (80,000)
EAT / NPAT 30,000 80,000
- Pref. Dividend NIL NIL
NP for ESH 30,000 80,000
+ 80,000
1,10,000
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GOLD LTD
EQUITY SHARES 8 % PREF. SHARES
8,00,000 @ 30% 2,00,000 @30%
EBIT 2,40,000 60,000
INTEREST NIL NIL
EBT 2,40,000 60,000
TAX@50% (1,20,000) (30,000)
EAT / NPAT 1,20,000 30,000
PREF. DIVIDEND NIL (16,000)
NP FOR ESH 1,20,000 14,000
+ 14,000
1,34,000
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ROCE > Interest Rate
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INCOME STATEMENT (WHEN ROCE IS 8 %)
Particulars Diamond Ltd. (Amt.)
Gold Ltd. (Amt.)
Silver Ltd. (Amt.)
EBIT @8% 80,000 80,000 80,000
(-)Interest (80,000)
NIL NIL
EBT NIL 80,000 80,000
(-)Tax @50% NIL (40,000) (40,000)
EAT / NPAT NIL 40,000 40,000
(-)Preference dividend NIL (16,000) -
Profit for Equity Shareholders
NIL 24,000 40,000
÷ No. of Equity shares 2000 8000 10000
Earnings Per Share (EPS)
NIL Rs.3 /- Rs.4/-
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GOLD LTD
EQUITY SHARES 8 % PREF. SHARES
8,00,000 @ 8 % 2,00,000 @ 8 %
EBIT 64,000 16,000
INTEREST NIL NIL
EBT 64,000 16,000
TAX@50% (32,000) (8,000)
EAT / NPAT 32,000 8,000
PREF. DIVIDEND NIL (16,000)
NP FOR ESH 32,000 ( 8,000)
- 8,000
24,000
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TRADING ON EQUITY
GENERATES HIGHER RETURNS TO EQUITY SHAREHOLDERS, PROVIDED THE COMPANY’S -
ROCE > INTEREST RATE
PRESENTS THE RISKS OF OUTRIGHT BANKRUPTCY
OTHER BENEFITS
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RELATIONSHIP BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE
OPERATING LEVERAGE FINANCIAL LEVERAGE
• Operating leverage is concerned with investment activities of the firm.
• Financial leverage is concerned with financing activities of the firm.
• It is determined by the cost structure of the firm.
• It is determined by the capital structure of the firm.
• It is the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.
• It is the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on its earnings per share.
• Degree of operating leverage enables us to measure the business risk associated with the firm.
• Degree of financial leverage enables us to measure the degree of financial risk, associated with the firm.
• DOL = Contribution EBIT
• DFL = EBIT EBT
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COMBINED LEVERAGE
• INTRODUCTION
• DEGREE OF COMBINED LEVERAGE
• PRODUCT OF OPERATING LEVERAGE AND FINANCIAL LEVERAGE
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DEGREE OF COMBINED LEVERAGE
• DEGREE OF COMBINED LEVERAGE:
= DEGREE OF OPERATING LEVERAGE(DOL) * DEGREE OF FINANCIAL LEVERAGE(DFL)
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DEGREE OF COMBINED LEVERAGE
• DEGREE OF COMBINED LEVERAGE (DCL):
OR
DCL = CONTRIBTION
EBT
DCL = % CHANGE IN EPS % CHANGE IN
SALES
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COMBINED LEVERAGE
•WHEN DCL = % CHANGE IN EPS
% CHANGE IN SALES
• THEN IF DCL = 4, THEN A 1% INCREASE IN SALES WILL RESULT IN A 4% INCREASE IN EARNINGS PER SHARE
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BREAK EVEN ANALYSIS
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DEFINITION
• THE POINT WHERE GAINS EQUAL THE LOSSES
• POINT WHERE INVESTMENT WILL GENERATE POSITIVE RETURNS
• SALES OR REVENUE EQUALS LOSSES
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FORMULA
Break even Point = Fixed Cost
Contribution
Where,
Contribution = Selling cost – Variable cost
Fixed cost = Contribution - Profit
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GRAPHICAL VIEW
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EBIT-EPS ANALYSIS
INTRODUCTION
EBIT – EPS ANALYSIS IS AN APPROACH WHICH HELPS IN DESIGNING THE OPTIMUM CAPITAL STRUCTURE FOR THE COMPANY OR THE FIRM.
TO DESIGN VARIOUS ALTERNATIVES OF DEBT, EQUITY AND PREFERENCE TO MAXIMIZE THE EPS .
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CALCULATION OF EPS
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MEASURES OF OPERATING LEVERAGE
FIXED COSTS TO TOTAL COSTS
PERCENTAGE CHANGE IN OPERATING INCOME TO THE
PERCENTAGE CHANGE IN SALES
NET INCOME TO FIXED COSTS
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MEASURES OF FINANCIAL LEVERAGE
DEBT TO ASSETS RATIO
DEBT TO EQUITY RATIO INTEREST COVERAGE RATIO
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IMPORTANCE OF OPERATING LEVERAGE & FINANCIAL LEVERAGE
MEASUREMENT OF
OPERATING RISK
MEASUREMENT OF
FINANCIAL RISK MANAGING
RISK
DESIGNING APPROPRIATE
CAPITAL STRUCTURE MIX
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INCREASE PROFITABILI
TY
MAGNIFICATION OF
SHAREHOLDER PROFITS IMPROVEMEN
T IN CREDIT RATING
CAPTURING ECONOMIES OF SCALE
INCREASED FREE CASH
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LEVERAGES – PRO’S & CON’S
1.CREDIT RATING IMPROVES
2.ECONOMIES OF SCALE
3.CAH AVAILABILITY
4. INCREASE SHAREHOLDER’S EQUITY
5.FINANCIAL RISK
6.BIGGER LOSSES
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CONCLUSION
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