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P = price per unit Analysis of Leverage

Where, x = level of output (or sales) at which DOL V = variable cost per unit F0 = operating fixed cost

is to be calculated
Financial Management

ANALYSIS OF LEVERAGE
The concept of Leverage When a lever (a bar or other strong tool used for lifting or moving something heavy) is used properly, a force is applied at one point is transformed or magnified, into another, larger force or motion at some other point. In business context, leverage means use of fixed costs in an attempts to magnify (or lever up) profitability. Leverage magnifies variability of EBIT or EPS and thus affects a firms overall risk and return. In this chapter we will explore the principles of both operating and financial leverage. The formal is due to fixed operating costs associated with the production of goods and services, while the later is due to the existence of fixed financial costs in particular, interest on debt. Operating and Financial Leverage Fixed costs can be classified into two groups: a. Operating fixed costs that is administrative expenses, depreciation expenses etc. and b. Financial fixed costs that is interest expenses, preferred dividend etc. Operating leverage arises when there are fixed operating cost in the firms cost structure. On the other hand, financial leverage means use of debt or preferred share in the firms capital structure. In other hands, when a firm is financially levered, it has to incur certain fixed obligation to some third parties. Degree of Operating Leverage Operating leverage magnifies sensitivity of the firms operating income (or loss) to the level of sales (or volume of activity). A quantitative measure of this sensitivity of a firms operating profit to a change in the firms sales is called the degree of operating leverage (DOL). The degree of operating leverage of a firm at a particular level of output (or sales) is simply the percent change in operating profit (EBIT) resulting from a 1 percent change in output (or sales) DOL = Relative change (% change) in operating profit (EBIT) Relative change (% change) in output (sales) = x (p-v) x (p-v) F0 EBIT + F0 EBIT

Deriving the DOL Formula By definition EBIT = Px Vx - F0 = x (P-V) - F0 -----------------(i) EBIT = {x (P-V) - F0} [taking the first order derivative] EBIT = x (P-V) [since p, v, and F0 do not change] Divide both sides by equation (i) EBIT x (P-V) = EBIT x (P-V) - F0 Now divide both sides by x / x EBIT / EBIT = x/x DOL = x (P-V) x (P-V) - F0 x (P-V) x (P-V) - F0 x (P-V) - F0 + Fo x (P-V) - F0 EBIT + F0 EBIT Implication of DOL in Profit planning and Control The greater is a firms DOL, the more its EBIT will vary with sales fluctuations. DOL is therefore an indicator of business risk (variability of EBIT, if sales vary) of a firm. A high DOL indicated a high risk. In other hands, DOL measures the sensitivity of a firms operating profit to changes in the volume of sales. The greater the DOL the greater is the sensitivity of EBIT to the volume of sales. Business Risk refers to the uncertainty or variability of the firms EBIT. A company with a highly unpredictable EBIT has high business risk. Operating leverage is often incorrectly used as a synonym for business risk. It is true that the greater is the DOL, the more sensitive is EBIT to a given change in unit sales and that, everything else being equal, a higher DOL means higher business risk. But risk also depends on two other factors: the variability of the firms sales and the variability of the companys cost and price structure. EBIT can vary not only because sales fluctuate but also because of changes in the companys output, price and costs that is changes in P, F0, and V. Also, if price and costs are uncertain, DOL is uncertain, since DOL is defined in term of P, F 0 and V. In this case, the use of DOL in evaluating business risk is somewhat limited. The degree of operating leverage should thus be viewed as measure of potential risk which becomes active only in the presence of sales and production cost variability. . x (P-V) / x (P-V) - F0 x/x x x

DOL =

DOL =

at a given level of EBIT


Analysis of Leverage

EBIT = x (P-V) F0 EBIT Ff = x (P-V) F0 - Ff = x (P-V) - F F = (F0 + Ff) = Total Fixed Cost

Financial Management

Financial Leverage Financial leverage means use of fixed financial expenses in a firms capital structure. That is, when a firm uses fixed-cost financing the firm is said to be financially levered. Degree of Financial Leverage (DEL) Degree of financial leverage is a quantitative measure of the sensitivity of a firms earnings per share to a change in the firms operating profit. % Change in EPS DFL = % Change in EBIT = EBIT EBIT Ff

Deriving the DFL Formula (EBIT Interest) (1- tax rate) EPS = Total nos. of shares outstanding (EBIT Ff) (1- t)

EPS =

n The change in EPS due to change in EBIT equals D EBIT (1-t) DEPS = n Since, t, Ff and n are constants, therefore, the percent change in EPS equals DEPS {(1-t) DEBIT}/n DEBIT = = EPS {(1-t) (EBIT Ff)}/n EBIT Ff DFL = % Change in EPS % Change in EBIT EBIT/ EBIT Ff EBIT EBIT - Ff x (P-V) F0 x (P-V) F = EPS/EPS EBIT/EBIT

= EBIT/EBIT =

= DFL and Financial Risk

Broadly speaking, financial risk encompasses both the risk of insolvency and the added variability in earnings per share that is induced by the use of financial leverage. As a firm increases the proportion of fixed cost financing in its capital structure, fixed cash outflow increases. As a result, the probability of cash insolvency increases. In a nutshell the two aspect of financial risk (or financial leverage) a) Probability of cash insolvency b) Added variability of earnings per share. Illustration:
3

We suppose that two firms differ with respect to financial leverage but are identical in every other respect. Each has expected annual cash earnings before interest and taxes of $80,000. Firm A has no debt. Firm B has $200,000 worth of 15% bonds outstanding. Thus the total annual fixed financial charges for firm B is $ 30,000. If cash earnings for both the firms happen to be 75% lower than expected, namely $20,000, firm B will be unable to cover its financial charges with cash earnings. We see then the probability of cash insolvency increases with the financial charges incurred by the firm. Effect of financial leverage Financial leverage affects the level and variability of EPS. Now we can present a summary of income statement that shows how the financial leverage affects the variability of firms EPS. Forecasted Income Statement Information Expected EBIT Interest Expected Earnings before Tax Expected tax (40%) Firm A (100% Equity) 80,000 80,000 32,000 48,000 Preferred dividend Expected earnings available to common shareholder Number of share outstanding Expected EPS DFL at expected EBIT (EBIT / EBIT - Ff ) If EBIT changes by 10 % + Expected EBIT Interest Expected Earnings before Tax Taxes Expected earnings available to common shareholder EPS % Change in EPS If EBIT changes by 10 % ( - ) Expected EBIT Interest Expected Earnings before Tax Taxes 72,000 72,000 28,800 72,000 30,000 42,000 16,800 88,000 88,000 35,200 52,000 13.2 10% 88,000 30,000 58,000 23,200 34,800 17.4 16% Nill 48,000 4,000 (Tk.10 each) 12.00 1.00 Firm B (50% Equity) 80,000 30,000 50,000 20,000 30,000 Nill 30,000 2,000 (Tk.10 each) 15.00 1.60

Analysis of Leverage

Financial Management

Expected earnings available to common shareholder EPS % Change in EPS

43,200 10.8 10%

25,200 12.6 -16%

The leverage Multiplier The degree of financial leverage can be expressed more generally as a multiplier of the percentage change in EBIT, that is Percentage change in EPS = Leverage multiplier X percentage change in EBIT The leverage multiplier can be calculated from the leverage ration as follows Interest Leverage ratio = EBIT 1

Leverage multiplier =

(1- leverage ratio) If for example leverage multiplier is 1.2 then a 10% increase in EBIT will increase EPS by 12%.

Combined Leverage Combined leverage is the measure of the total leverage due to both operating and financial fixed cost.

Analysis of Leverage

Financial Management

Problem # 1 Aldo Electronics produces electronic communications equipment. In 1990 the company had $200,000 earnings before interest and taxes. On January 1, 1990, the company borrowed $ 400,000 at a rate of interest of 10 percent. The company had no previous debt and its tax rate is 50 percent. a) What was the degree of financial leverage prior to 1990? b) What is the 1990 degree of financial leverage using the actual earnings figures? c) In 1990 what percentages change in after tax earnings per share (EPS) would result from a 50 percent increase in EBIT? d) In 1990 what percentage increase in EBIT would bring about a 20 percent increase in EPS? e) In 1990 the company sold 20,000 items at 60 per item. The fixed operating cost was $600,000 and the total variable operating cost $400,000. What was the degree of combined leverage using the actual 1990 earnings figures? Problem # 2 Broderick Corporation currently has a degree of combined leverage of 3 and a degree of operating leverage of 1.5. Broderick plans to purchase new machinery to replace old machinery. The new machinery will increase fixed operating cost but decrease variable cost per unit. Brodericks management believes the DOL will be 1.8 after the investment. Management considers a DCL of 4.5 to be the highest acceptable degree of combined leverage for the firm. a) Calculate the degree of financial leverage before the investment and the maximum acceptable degree of financial leverage after the investment. b) If the new EBIT is expected to be $6,000,000, what is the maximum amount of fixed financial cost the corporation will be able to cover? Problem # 3 Hydro, Incorporated has just recovered from a severe slump in business and has projected sales of $3,600,000 for the next year. Based on the existing production equipment, total fixed operating costs and total variable operating costs are expected to be $1,200,000 and $1,800,000, repetitively, so that the EBIT will be $600,000. The selling price per item produced is $50. The firm has a $1,500,000 five-year note outstanding on which it pays interest of 15 percent. Hydro plans to pay off the five-year note with funds borrowed at a lower interest rate. The production manager has suggested the modernization of the old equipment. This would result in a 30 percent increase in fixed operating costs and a 20 percent decrease in per unit variable operating costs. The general manager agrees with the modernization plan as long as the firms risk, as measured by the DCL, does not change. This could be made possible by the refunding of the outstanding five year note. Hydro will borrow $1,500,000 from the bank in order to pay off the note. How much lower must the interest rate on the new $1,500,000 loan be for the modernization plan to become acceptable in the eyes of the manager?

Problem # 4 A companys capacity is to produce 35,000 units per year and currently producing and selling 20,000 units. Following information relating to costs and sales are given. Selling price per unit: Variable cost per unit: Fixed operating cost (per year) Required: i) What is the degree of operating leverage? (a) 24,000 units and (b) 30,000 units. Problem # 5 The information of Company XYZ is given below. You are required to calculate the income statement of the company:Variable cost % of sales Interest expenses Degree of Operating Leverage Number of outstanding share Corporate tax rate Problem # 6 You are supplied with the following data relating to Madina Ltd:Variable expenses as % of sales Annual Interest expenses Degree of Operating Leverage Degree of financial Leverage Corporate tax rate 60% Tk. 5,000 6:1 3:1 30 % - 70% - Tk. 10,000 3 times 1,000 40 % ii) Show and explain the effect of leverage if the company increases sales to 5,00,000 Tk. 100 50

Degree of financial Leverage - 1.50 times

Compute Earnings After Tax (EAT) of the company. Problem # 7 Ashraf Ltd. Has the following capital structure:Equity (Tk. 100 per share) 12% Debt are available:i) 100 equity; ii) 50% equity and 50% debt @12%; iii) 100% debt. The expected EBIT is Tk. 20,00,000. The tax rate is 40%. Calculate the EPS and which one would you prefer? Calculate the indifference point of EBIT between (i) and (ii). Tk. 10,00,000 Tk. 5,00,000

The company wishes to raise Tk. 5,00,000 for expansion program. The following alternatives

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