SG 06 FM Finhancial Operational Combined Leverage

FINANCIAL MANAGEMENT
Financial, Operational and Combined Leverage
STUDY GROUP -6
Ankit Verma (15020241024)
Anmol Pandita (15020241026)
Apoorva Shastri (15020241030)
Basu Bhattar (15020241034)
Chandreyee Saha Roy (15020241037)
Divyang Sonchhatra (15020241045)
GROUP - 6
Contents
SERIAL
NO.
TOPIC
PAGE
NO.
PRN NO.
FINANCIAL LEVRAGE, OPERATING LEVERAGE & COMBINED

LEVERAGE
1.
Financial
2-21
Leverage
Ankit Verma
(15020241024)
Basu Bhattar
(15020241034)
2.
OPERATING
LEVERAGE
22-42
Chandreyee Roy
(15020241037)
Apoorva Shastri
(15020241030)
3.
COMBINED
LEVERAGE
43-66
Divyang Sonchhatra
(15020241045)
Anmol Pandita
(15020241026)
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Leverage (FINANCE)
In finance, leverage is any technique to multiply gains and losses. Most often it
involves buying more of an asset by using borrowed funds, with the belief that the
income from the asset or asset price appreciation will be more than the cost of
borrowing. Almost always this involves the risk that borrowing costs will be larger
than the income from the asset, or that the value of the asset will fall, leading to
incurred losses.
Meaning and definition of financial leverage:

Financial leverage can be aptly described as the extent to which a business or
investor is using the borrowed money. Business companies with high leverage are
considered to be at risk of bankruptcy if, in case, they are not able to repay the
debts, it might lead to difficulties in getting new lenders in future. It is not that
financial leverage is always bad. However, it can lead to an increased
shareholders return on investment. Also, very often, there are tax advantages
related with borrowing, also known as leverage.
Financial leverage can be defined as the degree to which a company uses fixedincome securities, such as debt and preferred equity. With a high degree of
financial leverage come high interest payments. As a result, the bottom-line
earnings per share is negatively affected by interest payments. As interest
payments increase as a result of increased financial leverage, EPS is driven lower.
As mentioned previously, financial risk is the risk to the stockholders that is caused
by an increase in debt and preferred equities in a company's capital structure. As a
company increases debt and preferred equities, interest payments increase,
reducing EPS. As a result, risk to stockholder return is increased. A company
should keep its optimal capital structure in mind when making financing decisions
to ensure any increases in debt and preferred equity increase the value of the
company.
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Degree of Financial Leverage:

This measures the percentage change in earnings per share over the percentage
change in EBIT. This is known as "degree of financial leverage" (DFL). It is the
measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
Formula:
The most well-known financial leverage ratio is the debt-to-equity ratio (see also
debt ratio, equity ratio). It is calculated as:
Total debt / Shareholders Equity
DFL
= percentage
change
percentage change in EBIT
in
EPS or EBIT
EBIT-interest
A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be
equal to 1.
Calculating financial leverage

Financial leverage indicates the reliability of a business on its debts in order to
operate. Knowing about the method and technique of calculating financial leverage
can help you determine a business financial solvency and its dependency upon its
borrowings. The key steps involved in the calculation of Financial Leverage are:
Compute the total debt owed by the company. This counts both short term as
well as long term debt, also including commodities like mortgages and money
due for services provided.
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Estimate the total equity held by the shareholders in the company. This
requires multiplying the number of outstanding shares by the stock price. The
total amount thus obtained represents the shareholder equity.
Divide the total debt by total equity. The quotient thus obtained represents
the financial leverage ratio.
Norms and Limits:

If the financial leverage ratio of a company is higher than 2-to-1, it indicates
financial weakness. If the company is leveraged highly, it is considered to be near
bankruptcy. Also, it might not be able to secure new capital if it is incapable of
meeting its current obligations.
Example:
Degree of Financial Leverage:
Question:
With Newco's current production, its sales are $7 million annually. The company's
variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The
company's annual interest expense amounts to $100,000 annually. If we increase
Newco's EBIT by 20%, how much will the company's EPS increase?
Answer:
The
company's
DFL
is
calculated
as
follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase
21.2%.
Question:
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Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of
$400,000.
Mary
is
not
using
financial
leverage.
Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land
having a total cost of $1,200,000. Sue is using financial leverage. Sue is
controlling $1,200,000 of land with only $400,000 of her own money.
If the properties owned by Mary and Sue increase in value by 25% and are then
sold, Mary will have a $100,000 gain on her $400,000 investment, a 25%
return. Sue's land will sell for $1,500,000 and will result in a gain of $300,000.
Sue's $300,000 gain on her $400,000 investment results in Sue having a 75%
return. When
assets
increase
in value
leverage
works
well.
When assets decline in value the use of leverage works against you. Let's assume
that the properties owned by Mary and Sue decrease in value by 10% from their
cost and are then sold. Mary will have a loss of $40,000 on her $400,000
investmenta loss of 10% on Mary's investment. Sue will have a loss of
$120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30%
($120,000 divided by $400,000) on Sue's investment.
Financial Statement Analysis of Leverage:

The following financial statement analysis separates the effects of financing
liabilities and operating liabilities on the profitability of shareholders equity. The
analysis yields explicit leveraging equations from which the specifications for the
empirical analysis are developed.
Shareholder profitability, return on common equity, is measured as:
Leverage affects both the numerator and denominator of this profitability measure.
Appropriate financial statement analysis disentangles the effects of leverage. The
analysis below, which elaborates on parts of Nissim and Penman (2001), begins by
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identifying components of the balance sheet and income statement that involve
operating and financing activities. The profitability due to each activity is then
calculated and two types of leverage are introduced to explain both operating and
financing profitability and overall shareholder profitability.
Distinguishing the Profitability of Operations from the Profitability of

Financing
Activities:
With a focus on common equity (so that preferred equity is viewed as a financial
liability), the balance sheet equation can be restated as follows:
The distinction here between operating assets (like trade receivables, inventory and
property, plant and equipment) and financial assets (the deposits and marketable
securities that absorb excess cash) is made in other contexts. However, on the
liability side, financing liabilities are also distinguished here from operating
liabilities. Rather than treating all liabilities as financing debt, only liabilities that
raise cash for operationslike bank loans, short-term commercial paper and bonds
are classified as such. Other liabilitiessuch as accounts payable, accrued
expenses, deferred revenue, restructuring liabilities and pension liabilitiesarise
from operations. The distinction is not as simple as current versus long-term
liabilities; pension liabilities, for example, are usually long-term, and short-term
borrowing is a current liability.
Rearranging terms in equation,
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This equation regroups assets and liabilities into operating and financing activities.
Net operating assets are operating assets less operating liabilities. So a firm might
invest in inventories, but to the extent to which the suppliers of those inventories
grant credit, the net investment in inventories is reduced. Firms pay wages, but to
the extent to which the payment of wages is deferred in pension liabilities, the net
investment required to run the business is reduced. Net financing debt is financing
debt (including preferred stock) minus financial assets. So, a firm may issue bonds
to raise cash for operations but may also buy bonds with excess cash from
operations.
Its net indebtedness is its net position in bonds. Indeed a firm may be a net creditor
(with more financial assets than financial liabilities) rather than a net debtor. The
income statement can be reformulated to distinguish income that comes from
operating and financing activities:
Operating income is produced in operations and net financial expense is incurred

in the financing of operations. Interest income on financial assets is netted against
interest expense on financial liabilities (including preferred dividends) in net
financial expense. If interest income is greater than interest expense, financing
activities produce net financial income rather than net financial expense. Both
operating income and net financial expense (or income) are after tax.
Equations produce clean measures of after-tax operating profitability and the
borrowing rate:
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RNOA recognizes that profitability must be based on the net assets invested in
operations. So firms can increase their operating profitability by convincing
suppliers, in the course of business, to grant or extend credit terms; credit reduces
the investment that shareholders would otherwise have to put in the business.
Correspondingly, the net borrowing rate, by excluding non-interest bearing
liabilities from the denominator, gives the appropriate borrowing rate for the
financing activities.
Note that RNOA differs from the more common return on assets (ROA), usually
defined as income before after-tax interest expense to total assets. ROA does not
distinguish operating and financing activities appropriately. Unlike ROA, RNOA
excludes financial assets in the denominator and subtracts operating liabilities.
Nissim and Penman (2001) report a median ROA for NYSE and AMEX firms
from
19631999 of only 6.8%, but a median RNOA of 10.0%much closer to what one
would expect as a return to business operations.
Financial Leverage and its Effect on Shareholder Profitability:

From expressions, it is straightforward to demonstrate that ROCE is a weighted
average of RNOA and the net borrowing rate, with weights derived from equation:
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The FLEV measure excludes operating liabilities but includes (as a net against
financing debt) financial assets. If financial assets are greater than financial
liabilities, FLEV is negative. The leveraging equation (8) works for negative FLEV
(in which case the net borrowing rate is the return on net financial assets).
This analysis breaks shareholder profitability, ROCE, down into that which is due
to operations and that which is due to financing. Financial leverage levers the
ROCE over RNOA, with the leverage effect determined by the amount of financial
leverage
(FLEV) and the spread between RNOA and the borrowing rate. The spread can be
positive (favorable) or negative (unfavorable).
Financial Leverage of Companies in India

Companies differ in the use of financial leverage since it depends on a number of
factors which includes:
Size
Nature of product
Capital intensity
Technology
Market conditions
Management attitude
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In the following Table, we provide the measures of financial leverage for a few
largest companies in India for the year ending on 31 March 2004. It may be seen
that companies show wide variations in the use of financial leverage.
Infosys does not use any debt. SAILs debt ratio is highest and because of its low
EBIT, it does not provide much coverage to debt holders.
Company
Capital Gearing Income

Debt ratio
Gearing Debtequity ratio
Indian Oil
0.346
0.530
HPCL
0.180
0.220
BPCL
0.315
0.459
SAIL
0.862
6.247
ONGC
0.022
0.022
Tata Motors 0.261
0.353
TISCO
0.436
0.774
BHEL
0.101
0.112
Reliance
0.398
0.660
L&T
0.329
0.491
HLL
0.441
0.797
Infosys
0.000
0.000
Voltas
0.306
0.440
Interest
coverage
Interest
to
EBIT ratio
23.6
54.6
26.0
0.81
331.00
16.7
12.1
15.4
5.4
11.8
35.1
NA*
8.1
0.042
0.018
0.038
1.237
0.003
0.060
0.083
0.065
0.186
0.085
0.029
NA*
0.124
* NA = not applicable.
Determinants of Firms Financial Leverage

There are four theories which supports the concept:
Trade-Off Theory
Agency Theory
Pecking Order Theory
Market Timing Theory
Trade off Theory: The idea of Trade-Off theory is to find an optimal

compromise between equity and debt. This kind of theory try to balance between
the advantages of debt, like tax-deductibility of interests and disadvantage like
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direct and indirect costs of bankruptcy. Firms are striving for their goal of balance
between debt and equity.
Agency Theory: Agency theory also looks for its own kind of compromise to
find out optimal capital structure by balancing between agency costs and
advantages of debt. The explanation of Agency Theory states that scenario where
the amount of debt that set the limit to management actions is the most widely
accepted approach to explain choices of capital structure.
Pecking Order Theory: Theory is explained by asymmetric information

between management and outsider investors. Theory pushes firms to prefer
internal finance when funding their investments. In practice financial decisions
obey particular hierarchy where firm chooses first economical internal finance and
if needed, will fulfill the funds with external finance, starting from debt because of
its lower level of riskiness. After debt firm usually finance the project by using
forms between debt and equity, such as convertible bonds. In case firm still need
more funds it should decide to arrange share issue.
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Theory explains why profitable firms tend to keep their debt rate as low as
possible. That is because of their big profits that could be used for internal finance.
According to the Pecking order theory, there is no such thing as desirable optimal
capital structure. Rather changes of capital structure are driven by possible need
for external finance. Thus each formed capital structure is a cumulative result from
bygone hierarchic financing
Marketing Timing Theory: Market timing theory which is also known as

Signaling theory is very closely related to Pecking order theory, but often it is
concerned as a separate theory since the fundamental idea is different. In
accordance to Market timing theory firms would practice kind of tactical finance
as management owns favorable information of firm in their hands, when compared
to outsiders. Thus they do have some incentive for particular actions. Actions are
based on nominal, desirable gearing rate of firm. Rate can be changed
aggressively to indicate and give market a signal of current trend, direction or
condition of firm. Gearing rate tells the relation between debt and equity.
Investors have adopted high debt-rate as a sign of good profitability of firm and
that particular firm as an attractive investment object. So debt issuance is good
news for market, when share issue is known as last chance of financing and thus a
bad news that leads into decline in share price.
Despite theories does explain their statements, empirical evidence usually tells the
truth better as results are based on real practice. However there are innumerable
influencing things in results, sometimes reality and theory do fit
Theory
Trade
theory
Basis
off Optimal
Capital
Structure
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Point of View
Strength
Weakness
and Claim of
the theory
Optimal compromise
between equity and
debt.
Balancing
between
the
advantages
and
disadvantages of debt
+
Industrial
differences are taken
into account
Visibility
of
advantages
and
disadvantages.
The
higher
amount
of
tangible
assets, higher
the leverage
ratio.
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Agency Theory Optimal

Capital
Structure
Also
kind
of
compromise.
Balancing
between
debt agency costs and
advantages. Agency
theory argues that
amount of debt sets
limit to management
actions.
Pecking order Asymmetri Explained
by
Theory
c
asymmetric
Information information between
management
and
outsider
investors.
Financial
decisions
obey
particular
hierarchy where firm
chooses
first
economical
internal
finance and if needed,
will fulfill the funds
with external finance.
Market Timing Asymmetri Concerned as tactical
Theory
c
finance
where
Information management
owns
favorable information
of firm in their hands,
when compared to
outsiders.
+ Covenants to avoid
management moral
hazard
- Covenant costs
because of moral
hazard risk.
The more the

volatility in
sales
(growth),
lower
the
leverage ratio
of the firm.
+ Using the approach

of the theory provides
information of firm
profitability
Industrial
differences are NOT
taken into account in
the theory
The
higher
the
firm
profitability,
the lower the
leveraged
ratio of the
firm.
+
Possibility
to
enhance firm image
WITHOUT
moral
hazard
- Also possibilities
for moral hazard.
Higher
the
leverage ratio,
better
the
profitability
The Most Common Factors to Effect Leverage Ratio

Some of the most common factors are:
Bankruptcy costs and Riskiness
Profitability
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Firm Size
Growth Opportunities
Dividends
Taxation/ Tax Shield
Liquidity
Bankruptcy Costs and Riskiness: Higher the volatility of profits, bigger the
probability of financial crisis, when company could no longer manage their
liabilities. And whereas volatility keeps growing, it violates firms capacity to raise
18 new debt.
Trade-off Theory also states that firms with lower level volatility of profits and
thus lower risk for financial crisis tends to be more indebted.
Pecking Order Theory states that volatility of free cash flows has negative effect to
level of gearing ratio.
Profitability: According to the model of Trade-off theory, agency costs, taxes and
bankruptcy costs drives firms towards higher debt rate. Firms with best
profitability could control the agency problems of free cash flows 19 by paying
major part of profits before interests as dividends and liabilities. Therefore, in
order to control investment opportunities, paying dividend and level of debt are
positively dependent to profitability.
Pecking order theory explains well how remarkable profitability is when we are
making our choice of capital structure. Reason why equity is the last choice of
financing is simply due to its relatively high cost of issuance. In such cases all the
undivided profits are a very important factor when choosing the capital structure.
Thus Pecking order theory argues that higher profitability of firm makes its debt
ratio lower.
Firm Size: There is a common belief that; bigger the corporation, better the
economical stability. Trade-off theory also has a statement based on this; bigger the
corporation, higher the debt ratio. Trade-off also states that more stable firms
should have more debt. Another point is the fact that larger firms are able to raise
debt with lower costs than smaller firm could. Bigger corporations also have
smaller agency costs of debt, costs of monitoring and they actually need more debt
in order to take the benefit from tax-shields.
Growth Opportunities: The relationship between growth opportunities and
indebtedness in accordance to Trade-off theory: Higher the growth opportunities
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are, the more agency costs are involved and so companys ability to raise debt gets
weaker.
Pecking order theory instead provides two points of views in case of growth
opportunities:
Firms with high profitability are less indebted, as debt is not the primary
source of their financing. It concludes that profitable firms are tended to
possess higher market value and also better / higher growth opportunities.
Another is perhaps given less often, as it supposes growth-companies to
need always more funding in accordance to their development of growth
opportunities, whereas the relationship is positive instead.
An approach of Market timing theory, which states that Market-to-book item has
its own effect in companys capital 22 structure. In this assumption, if market-tobook- value is high, companies tend to use equity financing which decreases their
share of debt in capital structure.
Dividends: Trade-Off Theory states that there are multiple interpretations of
relationship between dividends / dividend policies and indebtedness. As companies
that pay dividends are supposed to possess lower business risk, Trade-Off -Theory
points that less risky companies own higher shares of debt as their bankruptcy
costs are lower. Thus companies that pay dividends are supposed to be more
indebted than companies that do not pay dividends.
Second possibility builds a scenario where firms to pay dividends do have lower
agency costs of equity and thus they are able to gather more equity. This settlement
states that dividend payers should have less debt than non-payers. With approach
of Agency Theory where they settle dividends and debt as substitutes in controlling
of issues in free cash flows. Here indebtedness and dividends are negatively related
as well. Trade-off provides two approaches to lean on. It verifies that negative
relationship is widely recognized phenomena.
Pecking Order Theory does not provide actual explanation why companies pay
dividends. Still when a company decides to pay dividends, it is supposed that
Pecking Order model do have an actual effect to decisions concerning dividends.
Taxation / Tax Shield: Taxes do possess two balancing effects in search of optimal
capital structure. Tax deductibility drive firms to raise more debt but on the other
hand higher personal tax-rate for debt than equity, pushes companies to keep their
debt-ratios lower, as interest incomes are more taxed than dividends. In big picture
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we need to see and understand the relationship between savings of the marginal
corporate-taxes and personal costs of taxation.
Trade-off theory compresses that, Companies with higher amount of tax-shields
(e.g. Depreciations of amortizations or costs of research and development) are
simply having lower expected tax rate and to have lower debt ratio as well.
Liquidity: Pecking Order Theory says about the relationship between liquidity and
leverage ratio. The example becomes from scenario where firms possess high
liquidity which allows them to fund their investments instead of raising new debt.
Thus their relationship is negative.
Also Agency Theory agrees with the idea that indebtedness is negatively related to
level of liquidity. On the other hand, management could in practice have an
incentive to bring benefit for share holders by manipulating their liquid assets,
whereas position of lenders respectively gets weaker which naturally increases
agency costs of debt.
Relationships between particular factors and indebtedness in

accordance to theories and majority of empirical evidence:
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FACTOR
Trade off Agency

Theory
Theory
Pecking
Order
Theory
Market
timing
Theory
Negative
Negative
Majority
of
Empirical
evidence
Negative
Negative
Negative
Bankruptcy
costs
and
Riskiness
Positive
Negative
Positive
Positive
Negative
Positive/
Negative
Positive/
Negative
Positive
Profitability
Positive
Size
Growth
opportunities
Dividends
Negative
Negative
Positive
Negative
Negative
Positive
Taxation/Tax
Shield
Negative
Liquidity
Data and Methodology
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Positive/
Negative
Negative
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The idea is to bring in the relevant background for each variable and their
motivations and assumptions to be used as a hypothesis.
Revenues provide a strong indication about firms positions within the market they
operate in, and thus is a very central part in measurement of predictability of firm
performance in future. In theoretical part we brought out that Trade-Off theory
suggests revenues and liabilities to be tended to develop hand in hand. Whereas the
baseline is that revenues are relatively stable, in the long run the relationship
between revenues and financial leverage is supposed to be positive. In other words
we are about to figure out whether Trade-Off theory holds or not.
Hypothesis 1: Revenues and Financial Leverage are positively related
As revenues are the indication of market share, Growth rate shows if particular
firm is becoming more or less interesting within its markets. Growth rate is tested
from point of view of the particular firm and average growth of Telecom sector. In
accordance to both Agency theory and empirical evidence of study made by
Titman and Wessels (1988), growth opportunities are tended and supposed to be
negatively related with the leverage ratio. So we are testing if Agency Theory
holds with our data. The respective assumptions of theory and empirical evidence
are taken in this study as well as follows:
Hypothesis 2: Firm growth opportunities and Financial Leverage are negatively
related
Profitability of firm shows investors if the firm can handle its business they are
operating in, usually from aspect of long time interval. Net margin / profitability
have both positive and negative relationships suggested between firm leverage
ratios. As pecking order theory does the assumption of negative relationship with
no industrial differences taken into account we do not see this approach suitable in
the case of telecom sector firms. Market timing theory instead suggests that
profitability is related positively to firms financial leverage. We are also aware
that telecom firms are tended to possess very high operating leverage. Thus as
Ross (1977) stated, also our assumption of positive relationship is much closer to
the relevance we are looking for. In case we find Market timing theory to hold with
our data, also the following hypothesis will be confirmed:
Hypothesis 3: Profitability and Financial Leverage ratio are positively related
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Cash flow information gives a strong note of firms preconditions to their business
challenges and thus the level of vulnerability is known more specified. Free cash
flows are stated to be negatively related to leverage ratio by Norvaiien and
Stankeviien (2007) from behalf of Pecking Order Theory. Theoretic point of
view was also confirmed in the paper. Thus our fourth hypothesis tests whether
Pecking Order Theory holds as we assume that the respective relationship is
negative within Telecom companies as well.
Hypothesis 4: Free cash flows (FCF) and Financial Leverage are negatively related
It is usually reasonable to beware of changes in business. Whether the changes
come or not, at least the short term liabilities require each firm to take care of their
sufficient liquidity. Current ratio is the most usual item to indicate the measure.
Feidakis and Rovolis (2007) stated that there is a positive relationship 46 between
level of liquidity and firm leverage ratio. The perspective of Pecking Order Theory
states that firms with adequate liquidity do not need to raise debt and hence have
lower leverage, which indicates the relationship assumed to be negative. This is
our assumption in this study as well as we figure out if the theory holds or not.
Hypothesis 5: Liquidity and Financial Leverage are negatively related
Capital expenditures are investments to tangible assets. Share of tangible assets are
often tested in capital structure examinations. Trade-off theory shows that the more
tangible assets of firm are, the higher is the leverage ratio of the firm (Brealey et.
al. 2006). Also Qiu and La (2010) provide evidence for respective relationship.
Tangibility is ratio between fixed assets and total assets. In this study we test if
Trade-Off theory holds in case the tangibility ratio is supposed to be in positive
relationship between the ratios of financial leverage.
Hypothesis 6: Tangibility and Financial Leverage ratio are positively related
Capital expenditures are investments to tangible assets. Net investments instead
tell the difference of capital expenditures and depreciations. Thus net investments
indicate it further if total of tangible assets are growing or decreasing. Pecking
Order Theory was formed by Myers and Maijuf in 1984. As indicated before in
this study, theory pushes firms to prefer internal finance when funding their
investments . Thus also we test if Pecking Order Theory holds and assume that
relationship between Net investments and leverage ratio is negative.
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Hypothesis 7: Net investments and Financial Leverage ratio are negatively related
All the absolute independent variables are announced in currencies as they are
given in each companys quarter reports. Numbers in percents are given with 2 47
decimals and absolute financial key items with 1 decimal. Figures are restated as
far as restated values were available. In cases of back up figures, they are taken
from annual reports. If restated values were not provided from ThomsonOne or
annual reports either due to unavailability of particular period, we have used
original value as a final choice.
EXAMPLE
Calculate financial leverage and from the following data under situations I and II
and financial plans, A and B.
Installed capacity = 4,000 units
Actual production and sales = 75 per cent of the capacity
Selling price = Rs 30 per unit
Variable cost = Rs 15 per unit
Fixed cost:
Under situation I, Rs 15,000
Under situation II, 20,000
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SOLUTION:
Determination of financial leverage:
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OPERATING LEVERAGE
Leverage in a business
Assume that you are approached with an opportunity to start your own business. You are to
manufacture and market industrial parts, such as ball bearings, wheels, and casters. You are faced
with two primary decisions.
First, you must determine the amount of fixed cost plant and equipment you wish to use in the
production process. By installing modern, sophisticated equipment, you can virtually eliminate
labour in the production of inventory. At high volume, you will do quite well, as most of your
costs are fixed. At low volume, however, you could face difficulty in making your fixed
payments for plant and equipment. If you decide to use expensive labour rather than machinery,
you will lessen your opportunity for profit, but at the same time you will lower your exposure to
risk (you can lay off part of the workforce). Second, you must determine how you will finance
the business. If you rely on debt financing and the business is successful, you will generate
substantial profits as an owner, paying only the fixed costs of debt. Of course, if the business
starts off poorly, the contractual obligations related to debt could mean bankruptcy. As an
alternative, you might decide to sell equity rather than borrow, a step that will lower your own
profit potential (you must share with others) but minimize your risk exposure. In both decisions,
you are making very explicit decisions about the use of leverage. To the extent that you go with a
heavy commitment to fixed costs in the operation of the firm, you are employing operating
leverage. To the extent that you utilize debt in the financing of the firm, you are engaging in
financial leverage. We shall carefully examine each type of leverage and then show the
combined effect of both.
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Operating Leverage
Operating leverage reflects the extent to which fixed assets and associated fixed costs are utilized
in the business. As indicated in Table below(5-1), a firms operational costs may be classified as
fixed, variable, or semivariable.
For purposes of analysis, variable and semivariable costs will be combined. In order to evaluate
the implications of heavy fixed asset use, we employ the technique of break-even analysis.
Break-Even Analysis
How much will changes in volume affect cost and profit? At what point does the firm break
even? What is the most efficient level of fixed assets to employ in the firm? A break-even chart is
presented in Figure 5-1 to answer some of these questions. The number of units produced and
sold is shown along the horizontal axis, and revenue and costs are shown along the vertical axis.
Note, first of all, that our fixed costs are $60,000, regardless of volume, and that our variable
costs (at $0.80 per unit) are added to fixed costs to determine total costs at any point. The total
revenue line is determined by multiplying price ($2) times volume.
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Of particular interest is the break-even (BE) point at 50,000 units, where the total costs and total
revenue lines intersect. The numbers are as follows:
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The break-even point for the company may also be determined by use of a simple formulain
which we divide fixed costs by the contribution margin on each unit sold, with the contribution
margin defined as price minus variable cost per unit. The formula is shown at the top of the next
page.
Since we are getting a $1.20 contribution toward covering fixed costs from each unit sold,
minimum sales of 50,000 units will allow us to cover our fixed costs (50,000 units X $1.20 5=
$60,000 fixed costs). Beyond this point, we move into a highly profitable range in which each
unit of sales brings a profit of $1.20 to the company. As sales increase from 50,000 to 60,000
units, operating profits increase by $12,000 as indicated in Table 5-2; as sales increase from
60,000 to 80,000 units, profits increase by another $24,000; and so on. As further indicated in
Table 5-2, at low volumes such as 40,000 or 20,000 units our losses are substantial ($12,000 and
$36,000 in the red).
It is assumed that the firm depicted in Figure 5-1 is operating with a high degree of leverage. The
situation is analogous to that of an airline that must carry a certain number of people to break
even, but beyond that point is in a very profitable range. This has certainly been the case with
Southwest Airlines, which has its home office in Dallas, Texas, but also flies to many other
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states. The airline systematically offers lower fares than American, Delta, and other airlines to
ensure maximum capacity utilization.
A More Conservative Approach

Not all firms would choose to operate at the high degree of operating leverage exhibited in
Figure 5-1. Fear of not reaching the 50,000-unit break-even level might discourage some
companies from heavy utilization of fixed assets. More expensive variable costs might be
substituted for automated plant and equipment. Assume fixed costs for a more conservative firm
can be reduced to $12,000but variable costs will go from $0.80 to $1.60. If the same price
assumption of $2 per unit is employed, the breakeven level is 30,000 units, as shown at the top
of the next page.
With fixed costs reduced from $60,000 to $12,000, the loss potential is small. Furthermore, the
break-even level of operations is a comparatively low 30,000 units. Nevertheless, the use of a
virtually unleveraged approach has cut into the potential profitability of the more conservative
firm, as indicated in Figure 5-2.
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Even at high levels of operation, the potential profit in Figure 5-2 is rather small. As indicated in
Table 5-3 on the next page, at a 100,000-unit volume, operating income is only $28,000some
$32,000 less than that for the leveraged firm previously analyzed in Table 5-2 .
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The Risk Factor

Whether management follows the path of the leveraged firm or of the more conservative firm
depends on its perceptions about the future. If the vice president of finance is apprehensive about
economic conditions, the conservative plan may be undertaken. For a growing business in times
of relative prosperity, management might maintain a more aggressive, leveraged position. The
firms competitive position within its industry will also be a factor. Does the firm desire to
merely maintain stability or to become a market leader? To a certain extent, management should
tailor the use of leverage to meet its own risk-taking desires. Those who are risk averse (prefer
less risk to more risk) should anticipate a particularly high return before contracting for heavy
fixed costs. Others, less averse to risk, may be willing to leverage under more normal conditions.
Simply taking risks is not a virtueour prisons are full of risk takers. The important idea, which
is stressed throughout the text, is to match an acceptable return with the desired level of risk.
Cash Break-Even Analysis

Our discussion to this point has dealt with break-even analysis in terms of accounting flows
rather than cash flows. For example, depreciation has been implicitly included in fixed expenses,
but it represents a noncash accounting entry rather than an explicit expenditure of funds. To the
extent that we were doing break-even analysis on a strictly cash basis, depreciation would be
excluded from fixed expenses. In the previous example of the leveraged firm in Formula 5-1 on
page 128, if we eliminate $20,000 of assumed depreciation from fixed costs, the break-even
level is reduced from 50,000 units to 33,333 units.
Other adjustments could also be made for noncash items. For example, sales may initially take
the form of accounts receivable rather than cash, and the same can be said for the purchase of
materials and accounts payable. An actual weekly or monthly cash budget would be necessary to
isolate these items. While cash break-even analysis is helpful in analyzing the short-term outlook
of the firm, particularly when it may be in trouble, break-even analysis is normally conducted on
the basis of accounting flows rather than strictly cash flows. Most of the assumptions throughout
the chapter are based on concepts broader than pure cash flows.
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Degree of Operating Leverage

Degree of operating leverage (DOL) may be defined as the percentage change in operating
income that occurs as a result of a percentage change in units sold.
Highly leveraged firms, such as Ford Motor Company or Dow Chemical, are likely to enjoy a
rather substantial increase in income as volume expands, while more conservative firms will
participate in an increase to a lesser extent. Degree of operating leverage should be computed
only over a profitable range of operations. However, the closer DOL is computed to the company
break-even point, the higher the number will be due to a large percentage increase in operating
income. 1 Let us apply the formula to the leveraged and conservative firms previously discussed.
Their income or losses at various levels of operation are summarized in Table 5-4.
We will now consider what happens to operating income as volume moves from 80,000 to
100,000 units for each firm. We will compute the degree of operating leverage (DOL) using the
formula given below.
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We see that the DOL is much greater for the leveraged firm, indicating at 80,000 units a 1
percent increase in volume will produce a 2.7 percent change in operating income, versus a 1.6
percent increase for the conservative firm. The formula for degree of operating leverage may be
algebraically manipulated to read:
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Limitations of Analysis
Throughout our analysis of operating leverage, we have assumed that a constant or linear
function exists for revenues and costs as volume changes. For example, we have used $2 as the
hypothetical sales price at all levels of operation. In the real world, however, we may face
price weakness as we attempt to capture an increasing market for our product, or we may face
cost overruns as we move beyond an optimum-size operation. Relationships are not so fixed as
we have assumed. Nevertheless, the basic patterns we have studied are reasonably valid for most
firms over an extended operating range (in our example, that might be between 20,000 and
100,000 units). It is only at the extreme levels that linear assumptions fully break down, as
indicated in Figure 5-3.
Why Japanese Firms Tend to Be So Competitive?

What do firms such as Sony, Honda, Fujitsu, Hitachi, and Mitsubishi have in common? Not only
are they all Japanese companies, but they are also highly leveraged, both from operational and
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financing perspectives. Japanese companies are world leaders in bringing high technology into
their firms to replace slower, more expensive labor. They are known for automated factories,
laser technology, robotics, memory chips, digital processing, and other scientific endeavors.
Furthermore, the country has government groups such as the Ministry of International Trade and
Industry (MITI) and the Science and Technology Agency encouraging further investment and
growth through government grants and shared research. To enjoy the benefits of this technology,
Japanese firms have a high fixed cost commitment. Obviously high initial cost technology
cannot easily be laid off if business slows down. Even the labor necessary to design and
operate the technology has somewhat of a fixed cost element associated with it. Unlike in the
United States, workers are not normally laid off and many people in Japan consider their jobs to
represent a lifetime commitment from their employers. Not only does the Japanese economy
have high operating leverage as described above, but Japanese companies also have high
financial leverage. The typical Japanese company has a debt-to-equity ratio two to three times
higher than its counterparts in the United States. The reason is that credit tends to be more
available in Japan because of the traditional relationship between an industrial firm and its bank.
They both may be part of the same cartel or trading company with interlocking directors
(directors that serve on both boards). Under such an arrangement, a bank is willing to make a
larger loan commitment to an industrial firm and theres a shared humiliation if the credit
arrangement goes badly. Contrast this to the United States, where a lending institution such as
Citibank or Bank of America has extensive provisions and covenants in its loan agreements and
is prepared to move in immediately at the first sign of a borrowers weakness. None of these
comments imply that Japanese firms do not default on their loans. There were, in fact, a number
of bad loans sitting on the books of Japanese banks in the 2000s. The key point is that Japanese
firms have high operating leverage as well as high financial leverage and that makes them act
very competitively. If a firm has a combined leverage of 6 or 8 times, as many Japanese
companies do, the loss of unit sales can be disastrous. Leverage not only magnifies returns as
volume increases, but magnifies losses as volume decreases. As an example, a Japanese firm that
is in danger of losing an order to a U.S. firm for computer chips is likely to drastically cut prices
or take whatever action is necessary to maintain its sales volume. A general rule of business is
that firms that are exposed to high leverage are likely to act aggressively to cover their large
fixed costs and this rule certainly applies to leading Japanese firms. This, of course, may well be
a virtue because it ensures that a firm will remain market oriented and progressive.
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OPERATING LEVERAGE CONTINUED.

Should a business increase or reduce the number of units it is producing? Should it rely more or
less heavily on borrowed money? The answer depends upon how a change would affect risk and
return. Operating leverage is the name given to the impact on operating income of a change in
the level of output. Financial leverage is the name given to the impact on returns of a change in
the extent to which the firms assets are financed with borrowed money. Despite the fact that
both operating leverage and financial leverage are concepts that have been discussed and
analyzed for decades, there is substantial disparity in how they are defined and measured by
academics and practitioners.
Literature Review
In their 1969 college textbook, Weston and Brigham told some of todays businessmen and
women that, "High fixed costs and low variable costs provide the greater percentage change in
profits both upward and downward." [Weston, 86]
In his 1995 book, Brigham says that, "If a high percentage of a firms costs are fixed, and hence
do not decline when demand decreases, this increases the companys business risk. This factor is
called operating leverage." [Brigham, 425] "If a high percentage of a firms total costs are fixed,
the firm is said to have a high degree of operating leverage." {Brigham, 426] "The degree of
operating leverage (DOL) is defined as the percentage change in operating income (or EBIT)
that results from a given percentage change in sales....In effect, the DOL is an index number
which measures the effect of a change in sales [number of units] on operating income, or EBIT."
[Brigham, 440]
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In their 1970 book, Grunewald and Nemmers told that, "When fixed costs are very large and
variable costs consume only a small percentage of each dollar of revenue, even a slight change in
revenue will have a large effect on reported profits." [Grunewald, 76]
In his 1970 book, Cherry said that, "Operating leverage, then, refers to the magnified effect on
operating earnings (EBIT) of any given change in sales...And the more important, proportionally,
are fixed costs in the total cost structure, the more marked is the effect on EBIT." [Cherry, 254]
In his 1971 book, Van Horne said that, "one of the most dramatic examples of operating leverage
is in the airline industry, where a large portion of total costs are fixed." [Van Horne, 680]
Archer and DAmbrosio in their 1972 book said that, "The higher the proportion of fixed costs to
total costs the higher the operating leverage of the firm..." [Archer, 421]
In their 1972 book, Schultz and Shultz, said that, "Since a fixed expense is being compared to an
amount which is a function of a fluctuating base (sales), profit-and-loss results will not bear a
proportionate relationship to that base. These results in fact will be subject to magnification, the
degree of which depends on the relative size of fixed costs vis-a-vis the potential range of sales
volume. This entire subject is referred to as operating leverage." [Schultz, 86]
where:
q = quantity
p = price per unit
v = variable cost per unit
f = total fixed costs
Block and Hirt in their 1997 book say that operating leverage measures the effect of fixed costs
on the firm, and that the degree of operating leverage (DOL) equals:
DOL = q(p - v) divided by q(p - v) - f
that is:
Degree of operating leverage = Sales revenue less total variable cost divided by sales revenue
less total cost [Block, 116]
In their 1997 article, Buccino and McKinley define operating leverage as the impact of a change
in revenue on profit or cash flow. It arises, they say, whenever a firm can increase its revenues
without a proportionate increase in operating expenses. Cash allocated to increasing revenue,
such as marketing and business development expenditures, are quickly. "consumed by high fixed
expenses." (This is certainly a different definition!)
In his 1997 article, Rushmore says that positive operating leverage occurs at the point at which
revenue exceeds the total amount of fixed costs.
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There seems to be more uniformity in the definition of financial leverage. "Financial leverage,"
say Block and Hirt, reflects the amount of debt used in the capital structure of the firm. Because
debt carries a fixed obligation of interest payments, we have the opportunity to greatly magnify
our results at various levels of operations. [Block, 116]
According to Weston and Brigham back in 1969, the degree of financial leverage is computed as
the percentage change in earnings available to common stockholders associated with a given
percentage change in earnings before interest and taxes.
According to Brigham in 1995, "The degree of financial leverage (DFL) is defined as the
percentage change in earnings per share [EPS] that results from a given percentage change in
earnings before interest and taxes (EBIT), and it is calculated as follows:"
DFL = Percentage change in EPS divided by Percentage change in EBIT
[Brigham, 442]
This calculation produces an index number which if, for example, it is 1.43, this means that a
100 percent increase in EBIT would result in a 143 percent increase in earnings per share. (It
makes no difference mathematically if return is calculated on a per share basis or on total equity,
as in the solution of the equation EPS cancels out.)
Clarity in regard to operating and financial leverage is important because these concepts are
important to businesses. As Conrad Lortie observes in an article, small and medium-sized
businesses often have difficulty using the highly sophisticated quantitative methods large
companies use. Fortunately, he observes, the simple break-even graph is simple and easy to
interpret; yet it can provide a significant amount of information. The algebra necessary to
compute operating and financial leverage, too, is not very complex. Unfortunately, it comes in a
several guises; not all equally easy to understand or equally useful.
Operating Leverage
To make it readily apparent something that is wrong with the typical description of operating
leverage, a very simple example is used in Tables 1 and 2. Assumed is that Widget Works has
fixed costs of Rs.5,000 and variable costs per unit of Rs.1.00. Bridget Brothers, on the other
hand, has fixed costs of Rs.2,000 and variable costs per unit of Rs.1.60. Both firms selling price
is Rs.2.00 per unit. Shown in Tables 1 and 2 (below) are their revenues and costs for the
production of up to 25,000 units of output.
Table 1
Widget Works
Number
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EBIT
Total
Total
Profit
GROUP - 6
Variable
of Units
Cost
Cost
5,000
Rs.10,000
Rs. 5,000
Rs.10,000
Rs.
10,000
20,000
10,000
15,000
5,000
15,000
30,000
15,000
20,000
10,000
20,000
40,000
20,000
25,000
15,000
25,000
50,000
25,000
30,000
20,000
Table 2
Gidget Brothers
Total
Number
of Units
Total
EBIT
Variable
Cost
Profit
Cost
5,000
Rs.10,000
Rs. 8,000
Rs.10,000
Rs.
10,000
20,000
16,000
18,000
2,000
15,000
30,000
24,000
26,000
4,000
20,000
40,000
32,000
34,000
6,000
25,000
50,000
40,000
42,000
8,000
Someone looking at the data in Tables 1 and 2 who is familiar with descriptions of operating
leverage like those cited earlier would say that Widget Works has the higher degree of operating
leverage because its its fixed cost is absolutely and relatively larger than Bridget Brothers. Yet,
computing operating leverage as Brigham does: the percent change in operating profit (EBIT)
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divided by the percent change in the number of units produced, indicates that both firms
experience the same amount of operating leverage when these firms increase their output from
5,000 to 10,000 units. (See below.)
DOL = [c(p -v)] / [q(p - v) -f] divided by c/q
where:
DOL = operating leverage
p = price per unit
c = change in quantityv = variable cost per unit
q = original quantity
f = total fixed costs
The above equation simplifies to:

DOL = [q(p - v)] divided by [q(p - v) - f]
therefore, when quantity increases from 5,000 to 10,000:
Widget Works: DOL = Rs.5,000/Rs.5,000 divided by 5,000/10,000 = 2
Bridget Brothers: DOL = Rs.5,000/Rs.5,000 divided by 5,000/10,000
=2
Block and Hirts method produces the same results when operating leverage is computed at the
10,000 unit level of output.
Widget Works: DOL = 10,000(Rs.2 - Rs.1) divided by 5,000/10,000 = 2
Bridget Brothers: DOL = 10,000(Rs.2.00 - Rs.1.60) divided by 10,000(Rs.2.00 - Rs.1.60)

- Rs.2,000 = 2
An even more extreme case is produced by letting Widget Works have fixed costs of Rs.10,000
and variable costs per unit of Rs.1.00, while Bridget Brothers has fixed costs of only Rs.100 and
variable cost per unit of Rs.1.99. Observe that now Widget Works fixed costs are 100 times
Bridget Brothers, and that its variable costs are just barely over one-half of Bridget Brothers.
For Widget Works at 20,000 units of output:
DOL = 20,000(Rs.2.00 - Rs.1.00) divided by 20,000(Rs.2.00 - Rs.1.00) - Rs.10,000 = 2
For Bridget Brothers at 20,000 units of output:
DOL = 20,000(Rs.2.00 - Rs.1.99) divided by 20,000(Rs.2.00 - Rs.1.99) - Rs.100 = 2
The explanation for the equality of operating leverage in the two examples above when, if the
equation for figuring the degree of operating leverage did what is supposed to do: reflect the
difference in the relative importance of fixed cost, is that in both cases break-even takes place at
the same level of output, and each product sells for the same price. Why this is true is explained
below:
B = f/(1 - v/p)
where: B = break-even level of sales
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If B1 = B2, that is, f1 / (1 - v1/p) = f2 / (1 - v2/p)

and p1 = p2.
then: [q(p - v1)] / [q(p - v1)- f1] will equal [q(p - v2)] / [q(p - v2) - f2]
This is because, simplifying the above:
f1(1 - v2/p) = f2(1 - v1/p) or
f1 = [f2(p - v1)] divided by [p - v2]
and substituting this value of f1 in the equation for the operating leverage produces:
DOL1 = [q(p - v2)] divided by [q(p - v2) - f2]
This is not, however, the only situation in which operating leverage does to distinguish between
firms whose fixed costs relative size differs. For example, assume that Widget Works has a
selling price of Rs.3; variable costs per unit of Rs.1; and fixed costs of Rs.100. Assume that
Bridget Brothers has a selling price of Rs.0.40; variable costs per unit of Rs.0.20, and fixed costs
of Rs.10. At 100 units of output, leverage, respectively, is, where w stands for Widget Works and
B stands for Bridget Brothers:
OLw = [100(Rs.3.00 - Rs.1.00)] / [100(Rs.3.00 - Rs.1.00) - Rs.100] = 2
OLb = [100(Rs.0.40 - Rs.0.20)] / [100(Rs.0.40 - Rs..20)] - Rs.10] = 2
How to determine which sets of data produce the same DOL is shown below:
This type of result shown is obtained by setting:

[q(p1 - v1)] / [q(p1 - v1) - f1] = [q(p2 - v2)] / [q(p2 - v2) - f2]
where: f1 > f2 and v2/p2 > v1/p1
Fixed costs play no role in determining how rapidly profit rises after break-even. This is
determined by the ratio of variable cost per unit to price per unit.
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It is true, of course, that if a businesses substitutes capital for labor; thereby raising its fixed
costs, it will simultaneously reduce a variable cost, labor cost, per unit. Some businesses by their
very nature, such as airlines, must employ a high ratio of capital to labor. If at the maximum
possible level of output fixed costs are a large percent of total costs, price per unit will have to be
high relative to variable cost per unit in order for the business to be able to earn a profit. If a
price much greater than variable cost per unit cannot be obtained, the business will be liquidated.
What Counts: The Bottom Line

Since the "bottom-line" for a business is the rate of return on equity, it would seem that the most
appropriate method of computing operating leverage is to compute what EBIT will be at various
levels of output.
The change in the rate of return as a result of increasing the level of output is:
r2 - r1 = (q2 - q1)(p - v) divided by e
where:
e is the value of equity,
and r2 is the return after output is changed from q1 to q2 where q1 < q2
In evaluating the wisdom of their investment in a corporation, its owners should use the current
market value of its stock, because this is what they would have available to invest elsewhere if
they liquidated the stock.
Businesses change the level of output in order increase the rate of return enjoyed by their
owners. This can be done either by selling more units or avoiding producing units which cannot
be sold without a rate-of-return-reducing reduction in price. Here it is assumed that changing the
level of output will not affect price, which is certainly often true in the real world for a small
business.
Owners rate of return before interest and taxes (r) = EBIT divided by e or:
r = q(p - v) - f divided by e
where: e = equity
rs value after there is a change in level of output =
q1(p - v) - f (+) or (-) (q2 - q1)(p - v) divided by e
let i = interest expense (Rs.)
then:
r2 - r1 = [q2(p - v) - f - i - q1(p - v) - f - i] divided by e
this simplifies to:
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(q2 - q1)(p - v) divided by e

The simplified version of equation of the equation reveals that the change in owners rate of
return resulting from a change in the level of output is not affected by interest expense.
A Suggested Way to Measure Operating Leverage

Tables 1 and 2 make clear the fact that the difference in the bottom-line impact of changing the
level of output between Widget Works and Bridget Brothers isnt the rate at which profit expands
after break-even, as in both cases it doubles between 10,000 and 20,000 units; rises by fifty
percent between 20,000 and 30,000; etc., instead it is Widget Works higher ratio of profit to total
revenue. Therefore, a simpler, more meaningful way to the owner(s) of a business to measure
operating leverage is to compute the change in the following ratio resulting from a given increase
or decrease in the level of output from its current level.
m = pq - (qv + f) divided by pq
where:
m = profit margin before interest and taxes, that is, EBIT/sales revenue
The value of this ratio is greater the lower is the ratio of variable cost per unit to price per unit;
so, the greater is this ratio, the higher is operating leverage.
Conclusions
Operating leverage has often been misleadingly described. Its magnitude is determined by the
ratio of variable cost per unit to price per unit, rather than by the relative size of fixed costs.
Because business owners evaluate the success of the operation of their business on the basis rate
of the return earned on equity, measures of operating and financial leverage that produce percent
rates of return would appear to be more useful to them than those that produce index numbers.
The following equation can be used to determine the current rate of return on equity before taxes
and the impact on it of a change in the level of output, amount of debt financing, cost of debt
financing, price, and costs. It can be used to compute the impact of either operating or financial
leverage or both of them simultaneously. (If no debt financing is used, the term d/e would, of
course, be omitted from the equation.)
re = (d/e)[(qp - qv - f )/a) - rd] + (qp - qv - f )/a
That is:
The return on equity = (the ratio of debt to equity) times
(the return on assets minus the cost of debt plus the return on assets)
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A ratio of two versions of this equation produces an index number that will, by placing in the
numerator the equation involving the higher level of output and/or debt to equity ratio, measure
the degree of operating or financial leverage, that is, a ratio of the rate of return on equity after
the level of output is increased or more debt is utilized to the rate of return before these changes
are made.
It is to the business communitys advantage for methods of financial analysis to be easy to learn
and apply. Adopting this equation appears to be a way to achieve this.
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COMBINED LEVERAGE
If both operating and financial leverage allow us to magnify our returns, then we will get
maximum leverage through their combined use in the form of combined leverage. We have said
that operating leverage affects primarily the asset structure of the firm, while financial leverage
affects the debt-equity mix. From an income statement viewpoint, operating leverage determines
return from operations, while financial leverage determines how the fruits of our labor will be
allocated to debt holders and, more importantly, to stockholders in the form of earnings per
share. Table 5-6 shows the combined influence of operating and financial leverage on the income
statement.
You will observe, first, that operating leverage influences the top half of the income statement
determining operating income. The last item under operating leverage, operating income, then
becomes the initial item for determining financial leverage. Operating income and Earnings
before interest and taxes are one and the same, representing the return to the corporation after
production, marketing, and so forth but before interest and taxes are paid. In the second half of
the income statement, we then show the extent to which earnings before interest and taxes are
translated into earnings per share. A graphical representation of these points is provided in Figure
5-5 .
The values in Table 5-6 are drawn from earlier material in the chapter ( Tables 5-2 and 5-5 ). We
assumed in both cases a high degree of operating and financial leverage (i.e., the leveraged firm).
The sales volume is 80,000 units.
Figure 5-5 Combining operating and financial leverage
$ Earnings generated
Sales = $160,000
Operating income = EBIT
$36,000 $36,000
Financial leverage
EPS = $1.50
Leverage impact
Operating leverage
Sales (total revenue) (80,000 units @ $2) .................................... $160,000
Operating leverage
2 Fixed costs............................................................................. 60,000
2 Variable costs ($0.80 per unit) ................................................ 64,000
Operating income....................................................................... $ 36,000
Earnings before interest and taxes ............................................. $ 36,000
2 Interest.................................................................................... 12,000
Financial leverage
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Earnings before taxes................................................................. $ 24,000

2 Taxes...................................................................................... 12,000
Earnings after taxes.................................................................... $ 12,000
Shares ........................................................................................ 8,000
Earnings per share ..................................................................... $1.50
Table 5-6 Income statement
Degree of combined leverage (DCL) uses the entire income statement and shows the impact of
a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and
degree of financial leverage are, in effect, being combined. Table 5-7 shows what happens to
profitability as the firms sales go from $160,000 (80,000 units) to $200,000 (100,000 units).
The formula for degree of combined leverage is stated as:
Degree of combined leverage (DCL)
5
Percent change in EPS
________ __ ______ ____ ____ _____
Percent change in sales (or volume)
(5-6)
Degree of Combined Leverage
What do firms such as Sony, Honda, Fujitsu, Hitachi, and Mitsubishi have in common? Not only
are they all Japanese companies, but they are also highly leveraged, both from operational and
financing perspectives. Japanese companies are world leaders in bringing high technology into
their firms to replace slower, more expensive labor. They are known for automated factories,
laser technology, robotics, memory chips, digital processing, and other scientific endeavors.
Furthermore, the country has government groups such as the Ministry of International Trade and
Industry (MITI) and the Science and Technology Agency encouraging further investment and
growth through government grants and shared research. To enjoy the benefits of this technology,
Japanese firms have a high fixed cost commitment. Obviously high initial cost technology
cannot easily be laid off if business slows down. Even the labor necessary to design and
operate the technology has somewhat of a fixed cost element associated with it. Unlike
in the United States, workers are not normally laid off and many people in Japan consider
their jobs to represent a lifetime commitment from their employers.
Not only does the Japanese economy have high operating leverage as described above, but
Japanese companies also have high financial leverage. The typical Japanese company has a debtto-equity ratio two to three times higher than its counterparts in the United States. The reason is
that credit tends to be more available in Japan because of the traditional relationship between an
industrial firm and its bank. They both may be part of the same cartel or trading company with
interlocking directors (directors that serve on both boards). Under such an arrangement, a bank is
willing to make a larger loan commitment to an industrial firm and theres a shared humiliation if
the credit arrangement goes badly. Contrast this to the United States, where a lending institution
such as Citibank or Bank of America has extensive provisions and covenants in its loan
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agreements and is prepared to move in immediately at the first sign of a borrowers weakness.
None of these comments imply that Japanese firms do not default on their loans. There were, in
fact, a number of bad loans sitting on the books of Japanese banks in the 2000s.
The key point is that Japanese firms have high operating leverage as well as high financial
leverage and that makes them act very competitively. If a firm has a combined leverage of 6 or 8
times, as many Japanese companies do, the loss of unit sales can be disastrous. Leverage not
only magnifies returns as volume increases, but magnifies losses as volume decreases. As an
example, a Japanese firm that is in danger of losing an order to a U.S. firm for computer chips is
likely to drastically cut prices or take whatever action is necessary to maintain its sales volume.
A general rule of business is that firms that are exposed to high leverage are likely to act
aggressively to cover their large fixed costs and this rule certainly applies to leading Japanese
firms. This, of course, may well be a virtue because it ensures that a firm will remain market
oriented and progressive.
Finance in
ACTION
Why Japanese Firms Tend to Be So Competitive
Using data from Table 5-7 :
Percent change in EPS
__________ _________
Percent change in sales
5
$1.50
_____
$1.50
3 100
_______ ______ _
$40,000
________
$160,000
3 100
5 _1_0_0_%_
25%
54
Every percentage point change in sales will be reflected in a 4 percent change in earnings per
share at this level of operation (quite an impact).
An algebraic statement of the formula is:
DCL 5
Q(P 2 VC)
________ __ _____ ____
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Q(P 2 VC) 2 FC 2 I
(5-7)
From Table 5-7 :
Beginning Q (Quantity) 5 80,000; P (Price per unit) 5 $2.00; VC (Variable
costs per unit) 5 $0.80; FC (Fixed costs) 5 $60,000; and I (Interest) 5 $12,000.
DCL 5
80,000($2.00 2 $0.80)
__________ _________ _________ _________
80,000($2.00 2 $0.80) 2 $60,000 2 $12,000
5
80,000($1.20)
_________ __ ______ ____
80,000($1.20) 2 $72,000
DCL 5
$96,000
______ __ ____ ____
$96,000 2 $72,000
5
$96,000
_______
$24,000
54
The answer is once again shown to be 4. 3
80,000 units 100,000 units
Sales$2 per unit ................................................... $160,000 $200,000
2 Fixed costs .......................................................... 60,000 60,000
2 Variable costs ($0.80 per unit) ............................. 64,000 80,000
Operating income 5 EBIT ....................................... $ 36,000 $ 60,000
2 Interest ................................................................. 12,000 12,000
Earnings before taxes .............................................. $ 24,000 $ 48,000
2 Taxes ................................................................... 12,000 24,000
Earnings after taxes ................................................. $ 12,000 $ 24,000
Shares ..................................................................... 8,000 8,000
Earnings per share .................................................. $ 1.50 $ 3.00
Table 5-7 Operating and financial leverage
3 The formula for DCL may also be rewritten as:
DCL 5
Q(P 2 VC)
_______ __ _____ ____
Q(P 2 VC) 2 FC 2 I
5
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Q(P) 2 Q(VC)
_________ __ ______ ____
Q(P) 2 Q(VC) 2 FC 2 I
We can rewrite the second terms as:
Q ( P ) 5 S, or Sales (Quantity 3 Price)
Q (VC) 5 TVC, or Total variable costs (Quantity 3 Variable costs per unit)
FC 5 Total fixed costs (remains the same term)
I 5 Interest (remains the same term)
We then have:
DCL 5
S 2 TVC
_______ __ ____ ____
S 2 TVC 2 FC 2 I
, or
$160,000 2 $64,000
_________ _________ ________ _ ________
$160,000 2 $64,000 2 $60,000 2 $12,000
5
$96,000
_______
$24,000
54
To calculate the degree of operating and financial leverage, the analyst needs sales or revenues,
operating income (EBIT), interest expense (I), net income (NI), and earnings per share (EPS).
This information is available to external analysts from the income statement, but the calculations
are based on yearend data. If operating costs rise or fall during the next year, the profit margin
will rise or fall with that change and the degree of operating leverage will be affected.
The degree of financial leverage is also based on year-end data and assumes that variables such
as interest rates, the amount of debt, and the number of shares stay the same.
However, in the real world, these variables change from year to year. What happens when these
variables change? For example, the debt-to-asset ratio, the cost of debt, and the number of shares
outstanding affect financial leverage. Lets look at an example.
Wockhardt is among the top five pharmaceutical companies in India, and is listed on the Bombay
Stock Exchange (BSE). Wockhardts sales increased 16.1 percent from 2011 to 2012, and
operating income went up 54.7 percent for a degree of operating leverage of 3.4 times. After a
rough period precipitated by high levels of debt, Wockhardt restructured and sold some of its
assets to reduce its debt burden. Wockhardt currently has very low levels of debt, but the aftertax profit margin, despite being low, was nearly four times that of the previous year. In 2011 it
was 2 percent and grew to 8 percent in 2012; the degree of financial leverage was five times.
This is because as the operating income (EBIT) went up 54.7 percent, earnings per share went up
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276.7 percent. When operating and financial leverage are combined, the degree of combined
leverage was a healthy 17 times. So, for every 1 percent that Wockhardts sales increased,
earnings per share increased 17.17 percent.
If analysts had predicted that these leverage factors could be used to predict performance from
2012 to 2013, they would have been disappointed. Wockhardt had another good
Operating and Financial LeverageWockhardt, India
WOCKHARDT
2011 2012
% Change
20112012 2012 2013
% Change
20122013
Sales (in crores of Rupees) ................................. 3767 4374 16.1% 4374 5661 29.4%
Operating income (EBIT) ................................... 932 1442 54.7% 1442 2139 48.3%
Operating profit margin .................................. 25% 33% 33% 38%
Interest expense ................................................ 267.1 269 0.7% 269 215 219.9%
Net income ........................................................ 90.52 343 278.6% 343 1594 365.2%
Aftertax profit margin 5 NI/Revenue ............. 2% 8% 8% 28%
Long-term debt ................................................. 195.65 208 6.3% 208 201 23.5%
EPS .................................................................... 8.27 31 276.7% 31 143 360.2%
Shares outstanding ........................................... 109435903 109980633 0.5% 109980633
111212751 1.1%
1232118
DOL (operating leverage) 5 % Change in EBIT/% Change in revenues 5 3.40 1.64
DFL (financial leverage) 5 % Change in earnings per share/% Change in 5.06 7.45
DCL (combined leverage) 5 % Change in EPS/% Change in revenues 5 17.17 12.24
DCL (combined leverage) 5 DCL 5 DOL 3 DFL 5 17.17 12.24
Exchange rate 2011: USD1 5 INR 44.61
INR 1 Crore 5 INR 10,000,000
INR 5 INDIAN RUPEE
increase in sales in 2013, but the operating profit margin increased marginally as costs rose on
account of exceptional items, (mostly related to product testing and compliance with regulation)
on a sales increase of 29.4 percent for a degree of operating leverage of 1.64 times. This was
nearly half of the previous year because the increase in sales did not result in an equal increase in
operating profit. However, there was very little debt on the balance sheet and Wockhardts longterm debt went down to INR 201 crores in 2013 and shares outstanding only increased by 1.23
million. Moreover, the aftertax profit margin increased over three times the previous year to 28
percent. The combined effect created an increased degree of financial leverage of 7.45. This
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means that for every 1 percent change in earnings, EPS increased 7.45 times. The financial
leverage combined with operating leverage resulted in a good but lower than before combined
leverage of 12.24 times. So, for every 1 percent that sales went up, EPS went up a modest 12.24
percent.
Wockhardt has used its operating and financial leverage to position itself competitively
in a way that allows it to exploit the future growth in the market, whilst sacrificing little growth.
A strategic move, which most analysts agree, is a sound one.
Source: Wockhardt annual reports for 2012 and 2013.
COMBINING FINANCIAL AND OPERATING LEVERAGES
Operating leverage affects a firms operating profit (EBIT), while financial leverage affects
profit after tax or the earnings per share. The combined effect of two leverages can be quite
significant for the earnings available to ordinary shareholders.
7.6.1 Degree of Operating Leverage
The degree of operating leverage (DOL) is defined as the percentage change in the earnings
before interest and taxes relative to a given percentage change in sales. Thus:
Sales/Sales
DOL EBIT/EBIT
% Change in Sales
DOL % Change in EBIT
(19)
The following equation is also used for calculating DOL:
QsvF
Qsv
()
DOL ( )
(20)
where Q is the units of output, s is the unit selling price, v is the unit variable cost and F is the
total fixed costs. Equation (20) can also be written as follows:
DOL = Contribution
EBIT (21)
Since contribution = EBIT + Fixed cost, Equation (21) can be expressed as follows:
EBIT
1
EBIT
DOL EBIT+ Fixed Cost F (22)
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Suppose that in the earlier example of the Brightways Ltd. the management had developed the
following income statement based on an expected sales volume of 100,000 units:
Rs
Sales (100,000 units at Rs 8) 800,000
Less: Variable costs (100,000 at Rs 4) 400,000
Contribution 400,000
Less: Fixed costs 280,000
EBIT 120,000
Applying Equation (20), DOL is:
3.33
120,000
Rs 400,000
100,000 (Rs 8 Rs 4) Rs 280,000
DOL 100,000 (Rs 8 Rs 4)
DOL of 3.33 implies that for a given change in Brightways sales, EBIT will change by 3.33
times.
Let us suppose in the case of Brightways that a technical expert appointed by the management
tells them that they can choose more automated production processes which will reduce unit
variable cost to Rs 2 but will increase fixed costs to Rs 480,000. If the management accepts the
experts advice, then the income statement will look as follows:
Rs
Sales (100,000 units at Rs 8) 800,000
Sales (100,000 at Rs 8) 800,000
Less: Variable costs (100,000 at Rs 2) 200,000
Contribution 600,000
Less: Fixed costs 480,000
EBIT 120,000
With high fixed costs and low variable costs, DOL for Brightways will be:
5.0
Rs 120,000
DOL Rs 600,000
If the Brightways Ltd. chooses high-automated technology and if its actual sales happen to be
more than expected, its EBIT will increase greatly; an increase of 100 per cent in sales will lead
to a 500 per cent increase in EBIT.
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7.6.2 Degree of Financial Leverage

We have seen earlier in this chapter that financial leverage affects the earnings per share. When
the economic conditions are good and the firms EBIT is increasing, its EPS increases faster with
more debt in the capital structure. The degree of financial leverage (DFL) is defined as the
percentage change in EPS due to a given percentage change in EBIT:
% Change in EBIT
DFL % Change in EPS
or
EBIT/EBIT
DFL EPS/EPS
(23)
In the case of the Brightways Ltd. when EBIT increases from Rs 120,000 to Rs 160,000, EPS
increases from Rs 1.65 to Rs 2.45, when it employs 50 per cent debt and pays interest charges of
Rs 37,500 (see Table 7.6). Applying Equation (23), DFL at EBIT of Rs 120,000 is:
1.456
0.333
0.485
(160,000 120,000) /120,000
DFL (2.45 1.65) /1.65
This implies that for a given change in EBIT, EPS will change by 1.456 times.
The following equation can also be used to calculate DFL:
PBT
1 INT
PBT
EBIT
EBIT INT
DFL
(24)
We know that EBIT = Q (p v) F (and EBIT INT = PBT). Thus Equation (24) can also be
written as follows:
( ) INT
DFL ( )
QsvF
QsvF
(25)
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The numerator of Equation (24) or (25) is earnings before interest and taxes and the denominator
is profit before taxes.
In the example, the Brightways Ltd. was considering four alternative debt levels (see Table 7.5).
Applying Equation (24), DFL for those alternatives at EBIT of Rs 120,000 is given below:
Table 7.9: Degree of Financial Leverage of Alternative Financial Plans at EBIT of Rs 120,000
Debt Level DFL
0 1.000
25% 1.185
50% 1.456
75% 1.882
It is indicated from Table 7.9 that if the firm does not employ any debt, EPS will increase at the
same rate at which EBIT increases. EPS increases faster for a given increase in EBIT when debt
is introduced in the capital structure; more the debt in the capital structure, the greater the
increase in EPS. The opposite will happen if EBIT declinesthe greater will be the fall in EPS
with more debt in the capital structure.
7.6.3 Combined Effect of Operating and Financial Leverages
Operating and financial leverages together cause wide fluctuation in EPS for a given change in
sales. If a company employs a high level of operating and financial leverage, even a small
change in the level of sales will have dramatic effect on EPS. A company with cyclical sales will
have a fluctuating EPS; but the swings in EPS will be more pronounced if the company also uses
a high amount of operating and financial leverage.
The degrees of operating and financial leverages can be combined to see the effect of total
leverage on EPS associated with a given change in sales. The degree of combined leverage
(DCL) is given by the following equation:
% Change in Sales
% Change in EPS
% Change in EBIT
% Change in EPS
% Change in sales
% Change in EBIT
(26)
Yet another way of expressing the degree of combined leverage is as follows:
( ) INT
()
( ) INT
()
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()
DCL ( )
QsvF
Qsv
QsvF
QsvF
QsvF
Qsv
(27)
Since Q (s v) is contribution and Q (s v) F INT is the profit after interest but before taxes,
Equation (27) can also be written as follows:
PBT
1 INT +
PBT
PBT+ INT +
PBT
EBIT+ Fixed costs
Profit before taxes
DCL Contribution
FF
(28)
For the Brightways Ltd. when it used less automated production processes, the combined
leverage effect at sales of Rs 8 lakh (100,000 units at Rs 8) and 50 per cent debt level is:
4.85
82,500
400,000
100,000(8 4) 280,000 37,500
DCL = 100,000(8 4)
In the case of the Brightways Ltd. combined effect of leverage is to increase EPS by 4.85 times
for one unit increase in sales when it chooses less automated production process and employs 50
per cent debt. Thus, if the Brightways sales increase by 10 per cent from Rs 8 lakh to Rs 8.80
lakh, then EPS will increase by: 10% 4.85 = 48.5%. EPS at the sales level of Rs 8 lakh is Rs
1.65 then the new EPS will be:
EPS 1.651.485 Rs 2.45
The results tally with those worked out in Table 7.5.
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Firms can employ operating and financial leverages in various combinations. The Brightways
Ltd., for example, can either choose high-automated production processes and high degree of
operating leverages or low automated production processes and low degree of operating leverage
associated with high or low level of debt. The following are the possible combinations of
operating and financial leverages for the Brightways Ltd.:
Table 7.10 indicates that the largest effect of leverage (9.41 times) will be obtained when the
firm combines higher amount of operating leverage (5.00 times) with the highest level of debt
(DFL = 1.882). If the company has this combination, EPS will increase by 9.41 times than the
increase in sales. Thus, if Brightways sales increase from Rs 8 lakh to Rs 11.60 lakhan
increase of 45 per cent, EPS increases from Rs 2.55 to Rs 13.35an increase by 423 per cent
(i.e., 45 per cent 9.41). Detailed calculations are given in Table 7.11.
Table 7.10: Combinations of Operating and Financial Leverage for the Brightways Ltd.
Low Automation High Automation
DOL DFL DCL DOL DFL DCL
3.33 1.000 3.33 5.00 1.000 5.00
3.33 1.185 3.95 5.00 1.185 5.93
3.33 1.455 4.85 5.00 1.456 7.28
3.33 1.882 6.27 5.00 1.882 9.41
Table 7.11: Brightways Ltd.: EPS Calculations for Change in Sales
Units sold 100,000 145,000
Sales (at Rs 8) 800,000 1,160,000
Less: Variable costs (at Rs 2) 200,000 290,000
Contribution 600,000 870,000
Less: Fixed costs 480,000 480,000
EBIT 120,000 390,000
Less: Interest 56,250 56,250
PBT 63,750 333,750
Less: Taxes (50%) 31,875 166,875
PAT 31,875 166,875
No. of shares 12,500 12,500
EPS 2.55 13.35
% Change in sales: 45%
800,000
1,160,000 800,000
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% Change in EPS: 423%

2.55
13.35 2.55
This combination can, however, prove risky for the company. If sales decline, the adverse effect
on EPS will be very severe. The right combination of operating and financial leverages will
differ among companies. It would generally be governed by the behaviour of sales.
Public utilities such as electricity companies can afford to combine high operating leverage with
high financial leverage since they generally have stable or rising sales. A company whose sales
fluctuate widely and erratically should avoid use of high leverage since it will be exposed to a
very high degree of risk.
Solved Problems
P.18.12 Calculate (a) the operating leverage, (b) financial leverage and (c) combined leverage
from the following data under situations I and II and financial plans, A and B.
Installed capacity, 4,000 units
Actual production and sales, 75 per cent of the capacity
Selling price, Rs 30 per unit
Variable cost, Rs 15 per unit
Fixed cost:
Under situation I, Rs 15,000
Under situation II, 20,000
Capital structure:
Particulars Financial plan
AB
Equity Rs 10,000 Rs 15,000
Debt (0.20 interest) 10,000 5,000
20,000 20,000
Solution
(a) Determination of operating leverage
Particulars Situations
I II
Sales Rs 90,000 Rs 90,000
Less: Variable costs 45,000 45,000
Contribution 45,000 45,000
Less: Fixed costs 15,000 20,000
EBIT 30,000 25,000
Operating leverage 1.5 1.8
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(b) Determination of financial leverage

Particulars Situation I Situation II
Financial plans Financial plans
ABAB
EBIT Rs 30,000 Rs 30,000 Rs 25,000 Rs 25,000
Less: Interest on debt 2,000 1,000 2,000 1,000
EBT 28,000 29,000 23,000 24,000
Financial leverage (EBIT/EBT) 1.07 1.03 1.09 1.04
(c) Determination of combined leverage
Particulars Financial plans
AB
Situation I 1.5 1.07 = 1.61 1.5 1.03 = 1.54
Situation II 1.8 1.09 = 1.96 1.8 1.04 = 1.87
P.18.13 Skyline Software Ltd has appointed you as its finance manager. The comapny wants to
implement a project for which Rs 30 lakh is required to be raised from the market as a means of
financing the project.
The following financing plans and options are at hand: (Number in thousands)
Particulars Plan A Plan B Plan C
Option 1:
Equity shares 30 30 30
Option 2:
Equity shares 15 20 10
12% Preference shares Nil 10 10
10% Non-convertible debentures 15 Nil 10
Assuming corporate tax to be 35 per cent and the face value of all the shares and debentures to
be Rs 100 each, calculate the indifference points and earnings per share (EPS) for each of the
financing plans.
Which plan should be accepted by the company?
Solution
Determination of indifference point under plans A, B, C
Plan A:
OR X 0.35X = 2(0.65X Rs 97,500);
X 0.35X = 1.3X Rs 1,95,000
OR 0.65X = Rs 1,95,000 or X = Rs 1,95,000/0.65 = Rs 3,00,000
Plan B:
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OR
2(0.65X) = 3(0.65X Rs 1,20,000)
1.3X = 1.95X Rs 3,60,000
OR X = Rs 3,60,000/0.65 = Rs 5,53,846
Plan C:
OR
OR
X = Rs 5,55,000/1.3 = Rs 4,26,923
Determination of EPS under plans A, B and C for options 1 and 2
Particulars Plan A Plan B Plan C
121212
EBIT Rs 3,00,000 Rs 3,00,000 Rs 5,53,846 Rs 5,53,846 Rs 4,26,923 Rs 4,26,923
Less: Interest 1,50,000 1,00,000
EBT 3,00,000 1,50,000 5,53,846 5,53,846 4,26,923 3,26,923
Less: Taxes 1,05,000 52,500 1,93,846 1,93,846 1,49,423 1,14,423
EAT 1,95,000 97,500 3,60,000 3,60,000 2,77,500 2,12,500
Less: Dividend on preference shares 1,20,000 1,20,000
Earnings available for equity-holders
1,95,000 97,500 3,60,000 2,40,000 2,77,500 92,500
Number of equity 30,000 15,000 30,000 20,000 30,000 10,000
shares (N)
EPS 6.5 6.5 12 12 9.25 9.25
P.18.14 The capital structure of the Progressive Corporation Ltd consists of an ordinary share
capital of Rs 10,00,000 (shares of Rs 100 par value) and Rs 10,00,000 of 10% debentures. The
unit sales increased by 20 per cent from 1,00,000 units to 1,20,000 units, the selling price is Rs
10 per unit, variable costs amount to Rs 6 per unit and fixed expenses amount to Rs 2,00,000.
The income tax rate is assumed to be 35 per cent.
(a) You are required to calculate the following:
(i) The percentage increase in earnings per share.
(ii) The degree of financial leverage at 1,00,000 units and 1,20,000 units.
(iii) The degree of operating leverage at 1,00,000 units and 1,20,000 units.
(b) Comment on the behaviour of operating and financial leverage in relation to increase of
production from 1,00,000 to 1,20,000 units.
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Solution
(a) Determination of earnings per share (EPS)
Sales level (units) 1,00,000 1,20,000
Sales revenue Rs 10,00,000 Rs 12,00,000
Less: Variable costs 6,00,000 7,20,000
Less: Fixed costs 2,00,000 2,00,000
EBIT 2,00,000 2,80,000
Less: Interest 1,00,000 1,00,000
Earnings after interest 1,00,000 1,80,000
Less: Taxes 35,000 63,000
EAT 65,000 1,17,000
Number of equity shares 10,000 10,000
EPS (EAT N) 6.5 11.7
(i) Percentage increase per share
(ii) DFL (at 1,00,000 units) (at 1,20,000 units)
(iii) DOL (at 1,00,000 units) (at 1,20,000 units)
(b) As a result of increase in production and sales from 1,00,000 units to 1,20,000 units, EPS has
gone up by 80 per cent. Moreover, there has been a decrease in both types of leverages
operating as well as financialreflecting a decline in the total risk of the company.
P.18.15 X Ltd, a widely held company, is considering a major expansion of its production
facilities and the following alternatives are available:
Particulars Alternatives (Rs lakh)
ABC
Share capital 50 20 10
14% Debentures 20 15
Loan from a financial institution @ 18 per cent 10 25
The expected rate of return before interest and tax is 25 per cent. The rate of dividend of the
company is not less than 20 per cent. The company at present has no debt. The corporate tax rate
is 35 per cent. Which of the alternative would you choose, assuming maximising ROR on equity
capital as the objective of the firm?
Solution
Rate of return (ROR) on equity capital under proposed financial alternatives
Particulars Financing alternatives (Rs lakh)
ABC
EBIT (Rs 50 lakh 0.25) 12.5 12.5 12.5
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Less: Interest on debentures 2.8 2.1

Less: Interest on loan 1.8 4.5
EBT 12.5 7.9 5.9
Less: Taxes (0.35) 4.375 2.765 2.065
EAT 8.125 5.135 3.835
ROR on equity capital (%) 16.25 25.675 38.35
Alternative C is the best.
P.18.16 Consider the following information for Strong Ltd: (Rs in lakh)
EBIT 1,120
EBT 320
Fixed cost 700
Calculate the percentage of change in EPS, if sales increase by 5 per cent.
Solution
Degree of combined leverage (DCL) = (Degree of operating leverage Degree of financial
leverage) =
DCL = Alternatively, DCL can be determined as
DCL =
*Sales VC i.e., Contribution = EBIT + Fixed costs = Rs 1,120 lakh + Rs 700 lakh = Rs 1,820
lakh
DCL = (Contribution/EBT) i.e. (Rs 1,820 lakh/Rs 320 lakh) = 5.6875
5.6875 = Percentage change in EPS/Percentage increase in sales
Percentage change in EPS = Percentage increase in sales 5.6875 = 5% 5.6875 = 28.4375 per
cent
5 per cent increase in sales will cause 28.4375 per cent increase in EPS
Problem 7.1: AB Ltd. needs Rs 10 lakh (one million) for expansion. The expansion is expected
to yield an annual EBIT of Rs 160,000. In choosing a financial plan, AB Ltd. has an objective of
maximising earnings per share. It is considering the possibility of issuing equity shares and
raising debt of Rs 100,000, or Rs 400,000 or Rs 600,000. The current market price per share is
Rs 25 and is expected to drop to Rs 20 if the funds are borrowed in excess of Rs 500,000. Funds
can be borrowed at the rates indicated below: (a) up to Rs 100,000 at 8%; (b) over Rs 100,000
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up to Rs 500,000 at 12%; (c) over Rs 500,000 at 18%. Assume a tax rate of 50 per cent.
Determine the EPS for the three financing alternatives.
Solution: The EPS is determined as follows:
Alternatives
I II III
(Rs 100,000 debt) (Rs 400,000 debt) (Rs 600,000 debt)
Rs Rs Rs
EBIT 160,000 160,000 160,000
Interest 8,000 44,000 74,000
PBT 152,000 116,000 86,000
Taxes at 50% 76,000 58,000 43,000
PAT 76,000 58,000 43,000
No. of shares 36,000 24,000 20,000
EPS 2.11 2.42 2.15
The second alternative maximises EPS; therefore, it is the best financial alternative in the present
case. The interest charges for alternatives II and III are calculated as follows:
Interest Calculation, Alternative II
Rs Rs
100,000 @ 8% 8,000
300,000 @ 12% 36,000
Total 44,000
Interest Calculation, Alternative III
Rs Rs
100,000 @ 8% 8,000
400,000 @ 12% 48,000
100,000 @ 18% 18,000
Total 74,000
The numbers of shares are found out by dividing the amount to be raised through equity issue by
the market price per share. The market price per share is Rs 25 in case of first two alternatives
and Rs 20 in case of the last alternative.
Problem 7.2: A company needs Rs 500,000 for construction of a new plant. The following three
financial plans are feasible: (i) The company may issue 50,000 ordinary shares at Rs 10 per
share.
(ii) The company may issue 25,000 ordinary shares at Rs 10 per share and 2,500 debentures of
Rs 100 denominations bearing a 8 per cent rate of interest. (iii) The company may issue 25,000
ordinary shares at Rs 10 per share and 2,500 preference shares at Rs 100 per share bearing a 8
per cent rate of dividend.
If the companys earnings before interest and taxes are Rs 10,000, Rs 20,000 Rs 40,000, Rs
60,000 and Rs 100,000, what are the earnings per share under each of the three financial plans?
59 | P a g e
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Which alternative would you recommend and why? Determine the indifference points by
formulae and graphically. Assume a corporate tax rate of 50 per cent.
Solution: The earnings per share under the three financial plans are calculated as follows:
First Alternative:
Rs Rs Rs Rs Rs
EBIT 10,000 20,000 40,000 60,000 1,00,000
Interest 0 0 0 0 0
PBT 10,000 20,000 40,000 60,000 1,00,000
Taxes @ 50% 5,000 10,000 20,000 30,000 50,000
PAT 5,000 10,000 20,000 30,000 50,000
No. of shares 50,000 50,000 50,000 50,000 50,000
EPS 0.10 0.20 0.40 0.60 1.00
Second Alternative:
Rs Rs Rs Rs Rs
EBIT 10,000* 20,000 40,000 60,000 100,000
Interest 20,000* 20,000 20,000 20,000 20,000
PBT (10,000)* 0 20,000 40,000 80,000
Taxes @ 50% (5,000)* 0 10,000 20,000 40,000
PAT (5,000)* 0 10,000 20,000 40,000
No. of shares 25,000* 25,000 25,000 25,000 25,000
EPS (0.20)* 0.00 0.40 0.80 1.60
* It is assumed that the company will be able to set-off losses against other profits. If the
company has no profits from other operations, losses will be carried forward.
Third Alternative:
Rs Rs Rs Rs Rs
EBIT 10,000 20,000 40,000 60,000 100,000
Interest 0 0 0 0 0
PBT 10,000 20,000 40,000 60,000 100,000
Taxes @ 50% 5,000 10,000 20,000 30,000 50,000
PAT 5,000 10,000 20,000 30,000 50,000
Pref. Dividend 20,000 20,000 20,000 20,000 20,000
PAT for ordinary shareholders (15,000) (10,000) 0 10,000 30,000
No. of shares 25,000 25,000 25,000 25,000 25,000
EPS (0.60) (0.40) 0.00 0.40 1.20
The choice of the financial plan will depend on the state of economic conditions. If the
companys sales are increasing, the earnings per share will be maximum under the second
financial alternative.
Under favourable conditions, debt financing gives more benefit than equity or preference
financing. Debt capital is cheaper than preference capital because interest on debt is tax
deductible while preference dividend is not.
60 | P a g e
GROUP - 6
Figure 7.3: EBITEPS chart

The indifference points are determined by formula and graphically as follows:
(i)Indifference point between first and second alternatives:
EBIT 2 20,000 Rs 40,000
20,000
50,000 25,000
EBIT INT 50,000
(1 )EBIT (EBIT INT)(1 )
12
1
12
NN
N
N
T
N
T
(ii)Indifference point between first and third alternatives:
EBIT 2 40,000 Rs 80,000
1 0.5
20,000
50,000 25,000
50,000
1
EBIT PDIV
(1 )EBIT (1 )EBIT PDIV
12
1
12
NNT
N
N
T
N
T
Problem 7.3: Two firms A and B have the following informa-tion:
Variable Costs Fixed Costs
Sales (Rs in lakh) (Rs in lakh) (Rs in lakh)
Firm A 1,800 450 900
Firm B 1,500 750 375
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GROUP - 6
You are required to calculate (a) profit to sales ratio, (b) break-even point, and (c) the degree of
operating leverage for both firms. Comment on the positions of the firms. If sales increase by 20
per cent what shall be the impact on the profitability of the two firms?
Solution:
(a) (i) Contribution ratio: Contribution/Sales
Firm A: 0.75or 75%
1,800
1,350
1,800
1,800 450
Firm B: 0.50 or 50%
1,500
750
1,500
1,500 750
(ii) Profit margin: Profit/Sales
Firm A: 0.25or 25%
1,800
450
1,800
1,350 900
Firm B: 0.25or 25%

1,500
370
1,500
750 375
(b) Break-even point

Firm A: Rs 1,200
0.75
900
Firm B: Rs 750
0.50
375
(c) Degree of operating leverage: Contribution/EBIT
Firm A: 3.0
450
1,350
Firm B: 2.0
375
750
62 | P a g e
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Firm A has a higher contribution ratio as well as a higher operating leverage. Therefore, under
favourable economic conditions, the firms profit margin (EBIT/Sales ratio) will increase at a
fast rate. Firm B has a lower contribution ratio but a lower break-even point and operating
leverage as compared to Firm A. Its profits would grow relatively at a lower rate. At present, the
profit margin for the two firms is same, but it would change with change in sales. If sales
increase by 20 per cent, then profit margin would be as follows:
0.29 or 29%
1,800
525
1,500 1.20
Firm : (1,500 1.20)0.50 375
0.33 or 33%
2,160
720
1,800 1.20
Firm : (1,800 1.20)0.75 900
B
A
You may notice that 20 per cent increase in sales led to 60 per cent increase in profits (from Rs
450 lakh to Rs 720 lakh) for A and 40 per cent increase for B (for Rs 375 lakh to Rs 525 lakh).
This has changed the profit margin for A higher than B.
Problem 7.4: Consider the following information for Kaunark Enterprise:
Rs in lakh
EBIT 1,120
PBT 320
Fixed cost 700
Calculate percentage change in earnings per share if sales increased by 5 per cent.
Solution:
(a) Degree of operating leverage
DOL = Contribution
EBIT
EBIT + Fixed Cost
EBIT
1 120 700
1 120
1 625
(b) Degree of financial leverage
3.5
320
1,120
63 | P a g e
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PBT
DFL EBIT
(c) Degree of combined leverage
DCL DOL DFL =1.625 3.5 = 5.6875
DCL can also be found out as:
5
5.6875= % Change in EPS
% Change in Sales
DCL = % Change in EPS
% change in EPS= 55.6875= 28.4375%
Problem 7.5: Arun Chemicals Ltd. is considering expansion of its plant capacity to meet the
growing demand. The company would finance the expansion either with 15 per cent debentures
or issue of 10 lakh shares at a price of Rs 16 per share. The funds requirement is Rs 160 lakh.
The companys profit and loss statement before expansion is as follows.
Rs in lakh
Sales 1,500
Less: Costs 1,050
EBIT 450
Less: Interest 50
PBT 400
Less: Tax at 51.75% 207
PAT 193
Number of shares (lakh) 50
EPS (Rs) 3.86
The companys expected EBIT with associated probabilities after expansion is as follows:
EBIT (Rs in lakh) Probability
250 0.10
450 0.30
540 0.50
600 0.10
You are required to calculate the companys expected EBIT and EPS and standard deviation of
EPS and EBIT for each plan.
Solution:
(a) + 540 0.50 + 600 0.10 = 490
Plan I and II : (EBIT) = 250 0.10 + 450 0.30
(EBIT) EBIT1 1 EBIT2 2 EBIT3 3
E
EPPP
(b)
64 | P a g e
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(EBIT) 8,700 93.27

8,700
(540 490) 0.50 (600 490) 0.10
(250 490) 0.10 (450 490) 0.30
[EBIT (EBIT)]
[EBIT (EBIT)]
(EBIT) [EBIT (EBIT)]
22
22
3
3
3
2
2
2
1
2
1
2
EP
EP
EP
(i) Plan I: issue of 15% debenture
EBIT 250 450 540 630
Less: Interest* 74 74 74 74
PBT 176 376 466 556
Tax at 51.75% 91 195 241 288
PAT 85 181 225 268
No. of shares 50 50 50 50
EPS 1.70 3.62 4.50 5.36
* Includes existing and incremental interest.
(EPS) 0.8805 0.94
0.8805
(4.50 4.036) 0.50 (5.36 4.036) 0.10
(EPS) (1.70 4.036) 0.10 (3.62 4.036) 0.30
4.036
(EPS) 1.70 0.10 3.62 0.30 4.50 0.50 5.36 0.10
22
222
E
(ii) Plan (ii) : Issue of shares
EBIT 250 450 540 630
Less: Interest 50 50 50 50
65 | P a g e
GROUP - 6
PBT 200 400 490 580

Tax at 51.75% 104 207 254 300
PAT 96 193 236 280
No of shares* 60 60 60 60
EPS 1.60 3.22 3.93 4.67
* Includes existing and new shares.
(EPS) 0.610496 0.7813
0.610496
(4.67 3.558) 0.10
(3.93 3.558) 0.50
(EPS) (1.60 3.558) 0.10 (3.22 3.558) 0.30
3.558
(EPS) 1.60 0.10 3.22 0.30 3.93 0.50 4.67 0.10
2
2
222
E
Plan I (issue of debenture) has not only a higher expected EPS but also a higher standard
deviation as well. The coefficient of variation is: 0.94/4.036 = 0.233 or 23.3%. The coefficient of
variation of EPS under Plan II is: 0.7813/3.558 = 0.2196 or 21.96%. Thus Plan I has higher
return as well as higher risk. The firms overall risk is reflected by the variability of EBIT. The
coefficient of variation of EBIT is: 93.27/490 = 0.1903 or 19.03%.
SUMMARY
Leverage may be defined as the use of fixed cost items to magnify returns at high levels of
operation. Operating leverage primarily affects fixed versus variable cost utilization in the
operation of the firm. An important conceptdegree of operating leverage (DOL) measures
the percentage change in operating income as a result of a percentage change in volume. The
heavier the utilization of fixed cost assets, the higher DOL is likely to be.
Financial leverage reflects the extent to which debt is used in the capital structure of the firm.
Substantial use of debt will place a great burden on the firm at low levels of profitability, but it
will help to magnify earnings per share as volume or operating income increases. We combine
operating leverage and financial leverage to assess the impact of all types of fixed costs on the
firm. There is a multiplier effect when we use the two different types of leverage.
66 | P a g e
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Because leverage is a two-edged sword, management must be sure the level of risk assumed is in
accord with its desires for risk and its perceptions of the future. High operating leverage may be
balanced off against lower financial leverage if this is deemed desirable, and vice versa.
67 | P a g e

SG 06 FM Finhancial Operational Combined Leverage

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FINANCIAL MANAGEMENT

Financial, Operational and Combined Leverage

FINANCIAL LEVRAGE, OPERATING LEVERAGE & COMBINED

Meaning and definition of financial leverage:

Degree of Financial Leverage:

Calculating financial leverage

Norms and Limits:

Financial Statement Analysis of Leverage:

Distinguishing the Profitability of Operations from the Profitability of

Operating income is produced in operations and net financial expense is incurred

Financial Leverage and its Effect on Shareholder Profitability:

Financial Leverage of Companies in India

Capital Gearing Income

Determinants of Firms Financial Leverage

Trade off Theory: The idea of Trade-Off theory is to find an optimal

Pecking Order Theory: Theory is explained by asymmetric information

Marketing Timing Theory: Market timing theory which is also known as

Agency Theory Optimal

The more the

+ Using the approach

The Most Common Factors to Effect Leverage Ratio

Relationships between particular factors and indebtedness in

Trade off Agency

Data and Methodology

Hypothesis 3: Profitability and Financial Leverage ratio are positively related

A More Conservative Approach

The Risk Factor

Cash Break-Even Analysis

Degree of Operating Leverage

Why Japanese Firms Tend to Be So Competitive?

OPERATING LEVERAGE CONTINUED.

p = price per unit

v = variable cost per unit

f = total fixed costs

p = price per unit

c = change in quantityv = variable cost per unit

The above equation simplifies to:

Widget Works: DOL = Rs.5,000/Rs.5,000 divided by 5,000/10,000 = 2

Bridget Brothers: DOL = Rs.5,000/Rs.5,000 divided by 5,000/10,000

Widget Works: DOL = 10,000(Rs.2 - Rs.1) divided by 5,000/10,000 = 2

Bridget Brothers: DOL = 10,000(Rs.2.00 - Rs.1.60) divided by 10,000(Rs.2.00 - Rs.1.60)

If B1 = B2, that is, f1 / (1 - v1/p) = f2 / (1 - v2/p)

This type of result shown is obtained by setting:

What Counts: The Bottom Line

(q2 - q1)(p - v) divided by e

A Suggested Way to Measure Operating Leverage

Earnings before taxes................................................................. $ 24,000

7.6.2 Degree of Financial Leverage

% Change in EPS: 423%

(b) Determination of financial leverage

Less: Interest on debentures 2.8 2.1

Figure 7.3: EBITEPS chart

Firm B: 0.25or 25%

(b) Break-even point

(EBIT) 8,700 93.27

PBT 200 400 490 580

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