Financial Management

Unit 6

Unit 6
Structure:
6.1 Introduction Learning objectives

Leverage

6.2 6.3 6.4 6.5 6.6 6.7 6.8

Operating Leverage Application of operating leverage Financial Leverage Uses of financial leverage Combined Leverage Uses of DTL Summary Solved Problems Terminal Questions Answers to SAQs and TQs

6.1 Introduction
A company uses different sources of financing to fund its activities. These sources can be classified as those which carry a fixed rate of return and those whose returns vary. The fixed sources of finance have a bearing on the return on shareholders. Borrowing funds as loans have an impact on the return on shareholders and this is greatly affected by the magnitude of borrowing in the capital structure of a firm. Leverage is the influence of power to achieve something. The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. Leverage is the influence of an independent financial variable on a dependent variable. It studies how the dependent variable responds to a particular change in independent variable. There are three types of leverage as shown in the following diagram 6.1 operating, financial and combined.

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Figure 6.1: Types of leverage

Operating leverage is associated with the asset purchase activities, while financial leverage is associated with the financial activities. However, combined leverage is the combination of operating leverage and the financial leverage. 6.1.1 Learning objectives
After studying this unit, you should be able to:

Explain the meaning of leverage Mention the different types of leverage Discuss the advantages of leverage

6.2 Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorised into three main sections as shown in figure 6.2 fixed costs, variable costs and semi-variable costs.

Figure 6.2: Classification of operating costs

Fixed costs Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time. These are incurred irrespective of the income and value of sales and generally cannot be reduced.
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For example, consider that a firm named XYZ enterprises is planning to start a new business. The main aspects that the firm should concentrate at are salaries to the employees, rents, insurance of the firm and the accountancy costs. All these aspects relate to or are referred to as fixed costs. Variable costs Variable costs are those which vary in direct proportion to output and sales. An increase or decrease in production or sales activities will have a direct effect on such types of costs incurred. For example, we have discussed about fixed costs in the above context. Now, the firm has to concentrate on some other features like cost of labour, amount of raw material and the administrative expenses. All these features relate to or are referred to as Variable costs, as these costs are not fixed and keep changing depending upon the conditions. Semi-variable costs Semi-variable costs are those which are partly fixed and partly variable in nature. These costs are typically of fixed nature up to a certain level beyond which they vary with the firms activities. For example, after considering both the fixed costs and the variable costs, the firm should concentrate on some-other features like production cost and the wages paid to the workers which act at some point of time as fixed costs and can also shift to variable costs. These features relate to or are referred to as Semi-variable costs.
The operating leverage is the firms ability to use fixed operating costs to increase the effects of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs any time a firm has fixed costs. The percentage change in profits with a change in volume of sales is more than the percentage change in volume.

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Solved Problem -1 A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses amount to Rs. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000 units and 3000 units. Solution The various levels of EBIT that result from sale of 1000 units, 2000 units and 3000 units is as shown under in table 6.1
Table 6.1: Various levels of EBIT

Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT

1000 10000 5000 5000 5000 000

2000 20000 10000 10000 5000 5000

3000 30000 15000 15000 5000 10000

If we take 2000 units as the normal course of sales, the results can be summed as :

A 50% increase in sales from 2000 units to 3000 units results in a 100% increase in EBIT. A 50% decrease in sales from 2000 units to 1000 units results in a 100% decrease in EBIT.

The illustration clearly tells us that when a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in earnings before interest and taxes (EBIT) and vice versa. The former is a favourable operating leverage and the latter is unfavourable. Another way of explaining this phenomenon is examining the effect of the degree of operating leverage (DOL). The DOL is a more precise measurement. It examines the effect of the change in the quantity produced on earnings before interest and taxes (EBIT). DOL = % change in EBIT / % change in output

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To put in a different way, (EBIT/EBIT) / (Q/Q) EBIT is Q(SV)F Where Q is quantity S is sales V is variable cost F is fixed cost Substituting this we get, {Q(SV)} / {Q(SV)F}
Solved Problem -2

Calculate the degree of leverage (DOL) of Guptha Enterprises based on the information provided in the table 6.2
Table 6.2: Information of Guptha enterprises

Quality produced and sold Variable cost Selling price per unit Fixed expenses
Solution

1000 units Rs.200 per unit Rs. 300 per unit Rs.20, 000

DOL = {Q(SV)} / {Q(SV)F}

= {1000(300200)}/{1000(300200)20000} = 100000/80000 DOL = 1.25 The degree of operating leverage of Guptha enterprises is 1.25.
If the company does not incur any fixed operating costs, there is no operating leverage.

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Solved Problem - 3

Calculate the degree of leverage (DOL) of Utopia Enterprises based on the information provided in the table 6.3
Table 6.3: Information of Utopia Enterprises

Quality produced and sold Variable cost Selling price per unit Fixed expenses
Solution

2000 units Rs.300 per unit Rs. 400 per unit Rs.25, 000

DOL = {Q(SV)} / {Q(SV)F}

= {2000(400300)}/{2000(400300)25000} = 200000/175000 DOL = 1.14 The degree of operating leverage of Utopia Enterprises is 1.14.

Solved Problem -4 The table 6.4 shows the statistics of a firm and its sales requirements. Compute the degree of operating leverage (DOL) according to the values given in the table.
Table 6.4: Statistics of a firm Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT 1000 10000 5000 5000 0 5000

Solution DOL= {Q(SV)} / {Q(SV)F} {1000(5000)} / {1000(5000) 0} = 5000000/5000000 = DOL=1 The degree of operating leverage according to the values given in the table is 1.
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Solved Problem - 5 The table 6.5 given below shows the statistics of a firm and its sales requirements. Compute the degree of operating leverage (DOL) according to the values given in the table.
Table 6.5: Statistics of a firm

Sales in units Sales revenue Rs. Variable cost Contribution Fixed cost EBIT
Solution

2000 20000 10000 6000 0 6000

DOL= {Q(SV)} / {Q(SV)F} {2000(10000)} / {2000(10000) 0} = 2000000/2000000 = DOL=1 The degree of operating leverage according to the values given in the table is 1.
As operating leverage can be favourable or unfavourable, high risks are attached to higher degrees of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the operating risks of the company and hence a higher degree of operating leverage. Higher operating risks can be taken when income levels of companies are rising and should not be ventured into when revenues move southwards.

6.2.1 Application of Operating Leverage The applications of operating leverage are as follows: Business risk measurement Production planning

Measurement of business risk

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Risk refers to the uncertain conditions in which a company performs. A business risk is measured using the degree of operating leverage (DOL) and the formula of DOL is:
DOL = {Q(SV)} / {Q(SV)F}

Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa. Production planning A change in production method increases or decreases DOL. A firm can change its cost structure by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL. This situation can be justified only if the company is confident of achieving a higher amount of sales thereby increasing its earnings.

6.3 Financial Leverage

Financial leverage as opposed to operating leverage relates to the financing activities of a firm and measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company. A companys sources of funds fall under two categories Those which carry a fixed financial charges like debentures, bonds and preference shares and Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Though dividends are not contractual obligations, dividend on preference shares is a fixed charge and should be paid off before equity shareholders are paid any. The equity holders are entitled to only the residual income of the firm after all prior obligations are met.

Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the presence of fixed financial charges in the companys income stream. Such expenses have nothing to do with the firms performance and earnings and should be paid off regardless of the amount of earnings before income and tax (EBIT).

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It is the firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage. Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading on Equity.
Solved Problem -6

The EBIT of a firm is expected to be Rs. 10000. The firm has to pay interest at a rate of 5% on debentures of worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How does EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken as 40% and number of outstanding shares as 1000. Solution The various changes of EPS if EBIT is Rs. 15,000, Rs. 10,000 and Rs. 5,000 is shown under in table 6.6
Table 6.6: Various changes of EPS

EBIT Interest on debt EBT Tax 40% EAT Preference div. Earnings available to equity holders EPS
Interpretation

5000 1250 3750 1500 2250 1200 1050 1.05

10000 1250 8750 3500 5250 1200 4050 4.05

15000 1250 13750 5500 8250 1200 7050 7.05

A 50 % increase in EBIT from Rs.10,000 to Rs.15,000 results in 74% increase in EPS A 50 % decrease in EBIT from Rs.10,000 to Rs.5,000 results in 74% decrease in EPS

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This example shows that the presence of fixed interest source funds leads to a value more than that occurs due to proportional change in EPS. The presence of such fixed sources implies the presence of financial leverage. This can be expressed in a different way. The degree of financial leverage (DFL) is a more precise measurement. It examines the effect of the fixed sources of funds on EPS.

DFL = %change in EPS %change in EBIT

DFL={EPS/EPS} {EBIT/EBIT}

Or DFL = EBIT {EBITI{Dp/(1-T)}} I is Interest, Dp is dividend on preference shares, T is tax rate.

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Solved Problem -7
Kusuma Cements Ltd. has an EBIT of Rs. 5,00,000 at 5000 units of production and sales. The capital structure of the company is briefly described in table 6.7 Table 6.7: Capital structure of the company

Capital structure Paid up capital 500000 equity shares of Rs. 10 each 12% Debentures 10% Preference shares of Rs. 100 each Total Corporate tax rate may be taken at 40% Solution EBIT Less Interest on debentures EBT 500000 48000 452000

Amount Rs. 5000000 400000 400000 5800000

DFL= EBIT {EBITI{Dp/(1-T)}} 500000/(50000048000{40000/(10.40)} DFL=1.30 The degree of financial leverage of Kusuma Cements Ltd. is found to be 1.30.

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Solved Problem - 8
XYZ Enterprises Ltd. has an EBIT of Rs. 2,00,000 at 4000 units of production and sales. The capital structure of the company is briefly described in table 6.8 Table 6.8: Capital structure

Capital structure Paid up capital 200000 equity shares of Rs. 10 each 10% Debentures 5% Preference shares of Rs. 100 each Total Corporate tax rate may be taken at 50% Solution EBIT Less Interest on debentures EBT 200000 50000 150000

Amount Rs. 2000000 500000 500000 3000000

DFL= EBIT {EBITI{Dp/(1-T)}} 200000/(20000050000{25000/(10.50)} DFL=2.0 The degree of financial leverage of XYZ Enterprises is found to be 2.0.

6.3.1 Use of Financial Leverage Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy. One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS).
Like operating leverage, the risks are high at high degrees of financial leverage (DFL). High financial costs are associated with high DFL. An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments.

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A firm which is not capable of honouring its financial commitments may be forced to go into liquidation by the lenders of funds. The existence of the firm is shaky under these circumstances. On one side the trading on equity improves considerably by the use of borrowed funds and on the other hand, the firm has to constantly work towards higher EBIT to stay alive in the business. All these factors should be considered while formulating the firms mix of sources of funds. One main goal of financial planning is to devise a capital structure in order to provide a high return to equity holders. But at the same time, this should not be done with heavy debt financing which drives the company on to the brink of winding up.

Impact of financial leverage Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities. On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities. Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.

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Solved Problem - 9 The following table 6.9 displays the balance sheets of two firms firm A and firm B.
Table 6.9: Balance sheets of firms A and B Balance sheet of A Equity capital 100000 Assets 100000 Equity capital Debt @ 15% Total 100000 Total 100000 Total Balance sheet of B 40000 60000 100000 Total 100000 Assets 100000

Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and interpret the results thereof. Solution DFL=

EBIT {EBIT I {Dp /(1 T )}}

40000 1 40000 0 0 40000 Company B = 1.29 40000 9000 0

Company A = The degree of financial leverage of the companies A and B are 1 and 1.29.
The company not using debt to finance its assets has a higher DFL compared to that of a company using it. Financial leverage does not exist when there is no fixed charge financing.

6.4 Total or combined leverage

The combination of operating and financial leverage is called combined leverage. Operating leverage affects the firms operating profit EBIT and financial leverage affects PAT or the EPS. These cause wide fluctuations in EPS. A company having a high level of operating or financial leverage will find a drastic change in its EPS even for a small change in sales volume. Companies whose products are seasonal in nature have fluctuating EPS, but the amount of changes in EPS due to leverages is more pronounced.
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The combined effect is quite significant for the earnings available to ordinary shareholders. Combined leverage is the product of degree of operating leverage (DOL) and degree of financial leverage (DFL). DTL =
Q(S V ) Q(S V ) F I {Dp /(1 T )}

Solved Problem -10 Calculate the DTL of Pooja Enterprises Ltd., given the information regarding the expenses, shares and sales of the company in table 6.10
Table 6.10: Details of Pooja Enterprises Ltd.

Quantity sold Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt Preference shares dividend Tax rate Solution DTL =

10,000 units Rs.100 per unit Rs.500 per unit Rs.10,00,000 1,00,000 Rs.10,00,000 @ 20% interest 10,000 shares of Rs.100 each @ 10% 50%

Q(S V ) Q(S V ) F I {Dp /(1 T )}

10000 (500 100 ) 10000 (500 100 ) 1000000 200000 {100000 / 0.5}
DTL=1.53 Cross verification: DOL =

{Q(S V )} {Q(S V ) F}

10000 (500 100 ) 10000 (500 100 ) 1000000

DOL=1.33

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EBIT = [Q(S-V)-F} DFL=

EBIT EBIT I {Dp /(1 T )}}

3000000 3000000 200000 {100000 / 0.5}

DFL=1.15 DTL=DOL*DFL 1.53 =1.33*1.15 Hence the degree of total leverage of Pooja Enterprises Ltd. is 1.54.

Solved Problem -11 Calculate the degree of total leverage of Utopia Enterprises Ltd., given the following information regarding the expenses, shares and sales of the company in table 6.11.
Table 6.11: Details of Utopia Enterprises Ltd. Quantity sold Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt Preference shares dividend Tax rate 20,000 units Rs.200 per unit Rs.600 per unit Rs.20,00,000 1,50,000 Rs.20,00,000 @ 20% interest 20,000 shares of Rs.200 each @ 10% 40%

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Solution DTL =

Q(S V ) Q(S V ) F I {Dp /(1 T )}

20000 (600 200) 20000 (600 200) 2000000 400000 {400000 / 0.6}
DTL=1.62
Cross verification:

DOL=

{Q(S V )} {Q(S V ) F}

20000(600 200) 20000(600 200) 2000000

DOL=1.33

DFL=

EBIT EBIT I {Dp /(1 T )}}

6000000 6000000 400000 {400000 / 0.6}

DFL=1.22 DTL=DOL*DFL
1.62 = 1.33*1.22

Hence the degree of total leverage of Utopia enterprises Ltd. is 1.60

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Solved Problem -12 Calculate the degree of total leverage of CMA Enterprises Ltd., given the following information regarding the expenses, shares and sales of the company in table 6.12
Table 6.12: Details of CMA Enterprises Ltd. Quantity sold Variable cost per unit Selling price per unit Fixed expenses Number of equity shares Debt Preference shares dividend Tax rate 30,000 units Rs.300 per unit Rs.700 per unit Rs.30,00,000 2,00,000 Rs.30,00,000 @ 30% interest 30,000 shares of Rs.200 each @ 20% 30%

Solution DTL =

Q(S V ) Q(S V ) F I {Dp /(1 T )}

30000 (700 300) 30000 (700 300) 3000000 900000 {1200000 / 0.7}
DTL=1.88 Cross verification: DOL=

{Q(S V )} {Q(S V ) F}

30000(700 300) 30000(700 300) 3000000

DOL=1.33 EBIT DFL= EBIT I {Dp /(1 T )}}

6000000 6000000 900000 {1200000 / 0.7}

DFL=1.77 DTL=DOL*DFL 1.33*1.77=2.35 Hence the degree of total leverage of CMA enterprises Ltd. is 2.35
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6.4.1 Uses of degree of total leverage (DTL)

Degree of total leverage (DTL) measures the total risk of the company as DTL is a combined measure of both operating and financial risk Degree of total leverage (DTL) measures the variability of EPS

Self Assessment Questions Fill in the blanks: 1. __________ arises due to the presence of fixed operating expenses in the firms income flows 2. EBIT is calculated as _______. 3. Higher operating risks can be taken when ______ of companies are rising. 4. Dividend on _________ is a fixed charge. 5. Financial leverage is also referred to as ___________. 6. Operating leverage is categorised into _____, ____ and _______. 7. The three types of leverage a company faces are ______, ________ and __________.

6.5 Summary
Leverage is the use of influence to attain something else. The advantage a company has, with the current status of the leverage can be used to gain other benefits. There are three measures of leverage operating leverage, financial leverage and total or combined leverage. Operating leverage examines the effect of change in quantity produced upon EBIT and is useful to measure business risk and production planning. Financial leverage measures the effect of change in EBIT on the EPS of the company. It also refers to the debt-equity mix of a firm. Total leverage is the combination of operating and financial leverages.

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6.6 Solved Problems

13. The information, shown in table 6.13, has been collected from the annual report of Garden Silks. What is the degree of financial leverage?
Table 6.13: Annual report of Garden silks

Total sales Contribution ratio Fixed expenses Outstanding bank loan Applicable tax rate Solution

Rs.14,00,000 25% Rs.1,50,000 Rs.4,00,000 @ 12.5% 40%

DFL = EBIT / (EBIT-I) = 200000/200000-50000 = 1.33 EBIT = Sales*25% less fixed expenses 1400000*25% = 350000-150000 = 200000 14. Suppose X and Y have provided the information regarding the sales and the cost of their expense in table 6.14. Which firm do you consider to be risky?
Table 6.14: Information of X and Y

Sales in units Price per unit Variable cost p.a. Fixed financing cost Fixed financing cost Solution:

X Ltd. Y Ltd. 40000 40000 60 60 20 25 Rs. 100000 Rs. 50000 Rs. 300000 Rs. 200000

DOL = Q(S-V) / Q(S-V)-F Company X: 40000(60-20) / 40000(60-20)-400000 1600000/1200000 = 1.33 Company Y: 40000(60-25) / 40000(60-25)-250000 1400000/1150000= 1.22

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15. Calculate EPS with the following information shown in table 6.15.
Table 6.15: Information of a firm

EBIT Interest No. of outstanding shares Tax rate applicable

Rs.11,80,000 Rs.2,20,000 40,000 40%

Solution: Earnings per share is calculated using the table 6.16

Table 6.16 Earnings per share

EBIT Less interest EBT Tax @ 40% EAT

Rs.11,80,000 Rs.2,20,000 9.60,000 Rs.3,84,000 Rs.5,76,000

EPS = EAT/no of shares outstanding 576000/40000 = Rs. 14.4 16. The leverages of three firms is as shown in table 6.17 given below. Which one of the combinations should be chosen for the combined leverage to be maximum and what are the inferences?
Table 6.17: Leverages of three firms

A Operating leverage Financial leverage 1.14 1.27

B 1.23 1.3

C 1.33 1.33

Solution: We should calculate the combined leverage to draw inferences. Combined leverage of A is 1.14*1.27 = 1.45, Combined leverage of B is 1.23*1.3 = 1.60, Combined leverage of C is 1.33*1.33 = 1.77 We find that the combined leverage is highest for firm C and this suggests that this firm is working under very high risky situation.
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6.7 Terminal Questions

1. Mishra Ltd. provides the information as shown in the table 6.11. What is the degree of operating leverage?
Table 6.18: Details of Mishra Ltd.

Output Fixed costs Variable cost per unit Interests on borrowed funds Selling price per unit

25,000 units Rs.15,000 Rs. 0.50 Rs.15,000 Rs. 1.50

2. X Ltd. provides the following information as shown in table 6.19. What is the degree of financial leverage?
Table 6.19: Details of X Ltd.

Output Fixed costs Variable cost Interest on borrowed funds Selling price

25,000 units Rs. 25,000 Rs. 2.50 per unit Rs.15,000 Rs. 8 per unit

3. The information available in table 6.20 describes the sales, costs and interests of two firms. Comment on their relative performance through leverage?
Table 6.20: Sales and costs of two firms A and B

A Ltd. (Rs. In lakhs) Sales Variable cost Fixed cost EBIT Interest 1000 300 250 450 50

B Ltd. (Rs. In lakhs) 1500 600 400 500 100

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4. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.
Table 6.21: Details of ABC Ltd.

Output Fixed costs Variable cost Interest on borrowed funds Selling price per unit

20,000 units Rs.3,500 Rs.0.05 per unit Nil 0.20

6.8 Answers to SAQs and TQs

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. Operating leverage Q(SV)F Income levels Preference shares Trading on Equity Fixed costs, variable costs and semi-variable costs. Operating leverage, financial leverage and combined leverage.

Answers to Terminal Questions

1. Hint DOL = 2. Hint DFL =

{Q(S V )} {Q(S V ) F} EBIT {EBIT I {Dp /(1 T )}}

EBIT EBIT I {Dp /(1 T )}}

3. Hint calculate DFL 4. Hint calculate DFL =

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