UNIT - III

• Leverages - Operating and Financial leverage – measurement

of leverages – degree of Operating & Financial leverage –
Combined leverage, EBIT – EPS Analysis- Indifference point.
• Capital structure – Theories – Net Income Approach, Net
Operating Income Approach, MM Approach – Determinants of
Capital structure.
• Dividend decision- Issues in dividend decisions, Importance,
Relevance & Irrelevance theories –Walter‟s – Model,
Gordon‟s model and MM model. – Factors determining
dividend policy – Types of dividend policies – forms of
dividend
 LEVERAGES
• The Leverage Defines “The employment of an asset
or funds for which the firms pays a fixed cost or fixed
return”.
Three types of leverages

1. Operating Leverage
2. Financial Leverage
3. Composite leverage
 1. Operating Leverage
Operating leverage may be defined as the
firm’s ability to use operating cost to magnify the
effects of changes in sales on its earnings before
interest and taxes. Operating investment is
associated with investment activities
Operating leverage in a firm is a function of
three factors:
1. The amount of fixed cost
2. The contribution
3. The volume of sales
 Contribution
Operating Leverage = --------------------------
Operating Profit (or) EBIT
Operating leverage may be favourable or
unfavourable. In case the contribution (i.e. sales less variable
cost) exceed the fixed cost, there is favourable operating
leverage. In a reverse case, the operating leverage will be
termed as unfavourable.
Degree of Operating Leverage:
The Degree of operating leverage may be defined as
percentage change in the profits resulting from a percentage
change in sales.
Percentage of change in profits
Degree of Operating Leverage = --------------------------------
Percentage of change in sales
 2. Financial leverage
The financial leverage may be defined as the
tendency of the residual net income to vary
disproportionately with operating profit. It indicates the
change that takes place in the taxable income as a
result of change in the operating income.
Operating profit
Financial Leverage =---------------------------------------
Earnings Before Tax
Degree of Financial Leverage(DFL)
Degree of financial leverage may be defined as
the percentage change in taxable profit as a result of
percentage of change in operating profit
 Percentage Change in EPS
Degree of Financial Leverage = -----------------------------------
Percentage Change in EBIT
(or)
Percentage of Change in taxable income
= ----------------------------------------------------------------------
Percentage of change in the operating income
Financial leverage may be favourable or
unfavourable depending upon whether the earnings
made by the use of fixed interest or dividend-bearing
securities exceed or not the explicit fixed cost.
Financial leverage unfavourable or negative
leverage occurs when the firm does not earn as much as
the funds cost.
 Composite Leverage
operating leverage measures percentage
change in operating profit due to percentage change
in sales. It explains the degree of operating risk.
Financial leverage measures percentage change in
taxable profit (or EPS) on account of percentage
change in operating profit (i.e. EBIT). Thus, it explain the
degree of financial risk. Both these leverages are closely
concerned with firms capacity to meet its fixed costs
(both financial & operating). In case both the leverages
are combined, the result obtained will disclose the
effect of change in sales over change in taxable profit
(or EPS)
Composite leverage thus expresses the
relationship between revenue on account of sales (I.e.
contribution or sales less variable cost) and the taxable
income.
Composite leverage = Operating Leverage x Financial
Leverage
C OP C
Composite leverage= ----- x ------ = -----
OP EBT EBT
 INDIFFERENCE POINT / LEVEL OF EBIT
Out of several available financial plans, the firm may
have two or more financial plans which result in the same level
of EPS for a given EBIT. Such level of EBIT at which the firm has
two or more financial plans resulting in same level of EPS, is
known as indifference level of EBIT.

(X-I1) (1-t) – PD (1+Dt) (x-I2)(1-t)-PD(1+Dt)

------------------------------------ = -----------------------------------
ES1 ES2
Where,
X = EBIT I1I2 = Interest under alternatives 1 and 2
t = Tax Rate PD = Preference Dividend
Dt = Preference dividend tax
ES1, ES2 = No. of equity share outstanding under alternative 1
and 2
 Problem - 1
1. A firm has sales of 100000 units of Rs.10 Per unit,
variable cost of the produced products is 60
percent of the total sales revenue. Fixed cost is
Rs.20000. the firm has used a debt of Rs. 500000 at
20 percent interest. Calculate operating leverage
and financial leverage

Problem - 2
Calculate operating leverage and financial leverage under
situations A, B and C and financial plans I, II and III
respectively from the following information relating to the
operation and capital structure of XYZ Co. Also find out the
combinations of operating and financial leverage which give
the highest value and the least value. How are these
calculations useful to financial manager in a company?
Installed Capacity 1200 units
Actual Production and Sales 800 Units
Selling price per unit Rs.15
Variable cost per unit Rs.10
Fixed Cost : Situation A Rs.1000
Situation B Rs.2000
Situation C Rs.3000

Capital Structure:
Financial Plan
____________________________________
I II III
Equity Shares Rs.5000 Rs.7500 Rs.2500
Debt Rs.5000 Rs.2500 Rs.7500
Cost of Debt 12%
 Problem - 3
The capital structure of the progressive corporation consists of
an ordinary share capital of Rs.1000000 (Shares of Rs.100 par
value) and Rs.1000000 of 10% debentures. Sales increased by
20% from 100000 units to 120000 units, the selling price is Rs.10
per unit; variable cost amount to Rs.6 per unit and fixed
expenses amount to Rs.200000. the income tax rate is assumed
to be 50 per cent.
You are required to calculate the following:
i) The percentage increase in earning per share
ii) The degree of financial leverage at 100000 units and
120000 units
iii) The degree of operating leverage at 100000 units and
120000 units.
Comment on the behaviour op operating and financial
leverages in relation to increase in production from
100000nits to 120000 units.
 MARCH 2010
• A firm has sale of Rs.750000. variable cost of
Rs.4200000 and fixed cost of Rs.600000. it has a
debt of Rs.4500000 at 9 % and equity of Rs.5500000.
calculate operating , financial and combined lever
of the firm
 NOV/DEC 2010
Penta four ltd., has currently an all equity capital
structure of 15000 equity shares of Rs.100 each. The
management is planning to raise another Rs.25 lakh to
fiancé a major expansion programme and is
considering these alternatives methods of financing.
i) To issue 25000 equity share of Rs.100 each
ii) To issue 25000, 8% debentures of Rs.100 each
iii) To issue 25000, 8% preference shares of Rs.100 each
The company's expected EBIT will be Rs.8 lakhs.
Assuming a corporate tax rate of 46 percent.
Determine the EPS in each financial plan and
determine the best one and why.
 MA Y / J UNE 2010
A company needs Rs.600000 for construction f a
new plant. The following three financial plans are
feasible. 1) The company may issue 60000 equity
share of Rs.10 each (2) The company may issue 30000
equity shares of Rs.10 each and 3000 debentures of
Rs.100 each bearing 8% coupon rate of interest. (3)
The company may issue 30000 equity shares of Rs.10
each and 3000 preference shares of Rs.100 each
bearing 8% rate of dividend.
The profit before interest and taxes (PBIT) is
expected to the Rs.150000. corporate tax rate is 50%.
Calculate the earnings per share under the three
plans. Which plan would you recommend and why?
 MA Y / J UNE 2010

• A new project requires an investment of Rs.600

lakhs. Two alternate methods of financing are
under consideration. (1) Issue of Equity share of
Rs.10 each for Rs.600 lakhs. (2) Issue of equity share
of Rs.10 each of Rs.400 Lakhs and issue of 15%
debentures for Rs.200 lakhs. Find out the
indifference level of EBIT assuming tax rate of 40%.
 Capital Structure
“ Capital structure is the permanent financing of the
firm represented by long-term debt, preferred stock
and net worth”. Capital structure refers to the
proportionate share of different securities and other
long-term funds such as loan from financial
institutions in total capitalization.
 Optimum Capital Structure

• Optimum capital structure is that “ Capital Structure

or combination of debt and equity that lads to the
maximum value of the firms”.
 Patterns of Capital Structure
• Capital Structure with equity shares only.
• Capital structure with both equity and preference
shares
• Capital structure with equity shares and debentures
• Capital structure with equity shares, preference
shares and Debentures.
 Features of an Appropriate Capital
Structure
• Profitability / Return
• Solvency/Risk
• Flexibility
• Conservation/Capacity
• Control
 Factors to be considered in
Determining Capital Structure
1. Capacity of the company
2. Flexibility
3. Period of Finance
4. Nature of the firm
5. Tax Planning
6. Investors Requirement
7. Risk
8. Control
9. Government Policies
10. Purpose of financing
 Theories of Capital Structure
• There are four major theories/approaches
explaining the relationship between capital
structure, cost of capital and value of the firm
1. Net income (NI) Approach
2. Net Operating Income (NOI) Approach
3. Modigilani-Miller (MM) Approach
4. Traditional approach
 1. Net Income Approach
According to this approach capital structure
decision is relevant to the valuation of the firm. In
other words, a change in the capital structure causes
a corresponding change in the overall cost of capital
as well as the total value of the firm.
Assumptions:
1. There are no corporate taxes
2. The cost of debt is less than cost of equity or equity
capitalization rate.
3. The debt content does not change the risk
perception of the investors.
The value of the firm on the basis of NI approach can
be ascertained as follows:
V= S+B
Where:
V = Value of Firm
S = Market Value of Equity and
B = Market Value of Debt
Market value of equity can be ascertained as follows
NI
S = -------
Ke
Where:
S = Market Value of Equity
NI = Earnings available for Equity Share holders
Ke = Equity Capitalization Rate.
2. Net operating Income Approach
• According to this approach the market value of the firm
is not at all affected by the capital structure changes.
The market value of the firm is ascertained by
capitalizing the net operating income at the overall cost
of capital (k), which is considered to be constant. The
market value of equity is ascertained by deducing the
market value of the debt from the market value of the
firm.
• Value of the firm
EBIT
V= ------
k
Where: V = Value of the firm
k = Overall cost of capital
EBIT = Earnings before interest and tax
 Value of Equity:
S=V–B
Where
S = Value of Equity
V = Value of firm
B= Value of Debt
Modigiliani – Miller (MM) Approach
MM theory relating to the relationship between cost of
capital and valuation of the firm under the following
two respects.
i) When the absence of the corporate taxes
This approach identical to NOI approach.
ii) When the corporate taxes are assumed to exist.
MM argued that the capital structure would affect
the cost of capital and the value of the firm even
there are corporate taxes.
Assumptions:
1.Capital markets are perfect
a) Investors are free to buy and sell securities
b) the investors can borrow without restriction on the
same terms on which the firm can borrow
c) the investors are well informed
d) there are no transaction costs.
2. The firms can be classified into homogeneous risk classes.
All firm within the same class will have the same degree of
business risk.
3. All investors have the same expectation of a firm’s net
operating income (EBIT) with which to evaluate the value
of any firm.
4. The dividend pay-out ratios is 100%. In other words, there
are no retained earnings.
5. There are no corporate taxes. However, this assumption
has been removed later.
1. Levered Firm
In any firm having debt content in its
capital structure is known as levered firm.
Value of Levered Firm
Vi = Vu + Bt
Where, Vi = Value of levered firm
Vu = Value of Unlevered firm
B = Amount of debt
t = Tax rate
2. Unlevered Firm
In any particular firm does not having debt content
in its capital structure is known as unlevered firm.
Value of Unlevered Firm
Vu = S
Vu = Market Value of an unlevered firm
S = Market Value of equity
NI
S =-------------
Ke
 4. Traditional Approach
The traditional approach or the intermediate approach
is a mid-way between the two approaches. It partly
contains features of both the approaches given below.
1. The traditional approach is similar to NI approach to
the extent that it accepts that the capital structure or
leverage of the firm affects the cost of capital and its
valuation.
2. It subscribes to the NOI approach that beyond a
certain degree of leverage, the over all cost of
capital increases resulting in decrease in the total
value of the firm. However, it differs from NOI
approach in the sense that the overall cost of capital
will not remain constant for all degrees of leverages.
 Problem - 1
X ltd. Is expecting annual EBIT of Rs.1 Lakh. The
company has Rs.4 lakh in 10% debentures. The equity
capitalization rate is 12.5%. The company desires to
redeem debentures of Rs.1 lakh by issuing additional
equity shares of Rs.1 lakh.
You are required to calculate the value of the
firm and the overall cost of capital.
 Problem - 2
XY ltd. Has an EBIT of Rs.1 lakh. The cost of debt
is 10% and the outstanding debt amounts to Rs.4 Lakh.
Presuming the overall capitalization rate as 12.5%.
Calculate the total value of the firm and the equity
capitalization rate.
 Problem - 3
Two firms A and B are identical in all respects
except that the firm a has 10% Rs.50000 debentures.
Both the firms have the same earnings before interest
and tax amounting to Rs.10000. The equity
capitalization rate of firm A is 16% while that of firm B is
12.5%.
You are required to calculate the total market
value of each of the firms and Overall cost of capital
of each firms
 Dividend Theories
• The term dividend refers to that part of the profits of
a company which is distributed amongst its
shareholders.
 Theories of Dividend
Different theories are developed by many
experts regarding dividend decision on the valuation
of the firm. The theories can be grouped into two
heads:
A)Relevance Concept of Dividend
1. James Walter’s Approach
2. Myron Gordon’s Approach
B) Irrelevance Concept of Dividend
1. Modigliani – Miller’s Approach
 Relevance Concept Dividend
1. James Walter’s Approach:
James Walter (1966), has developed a relevance
concept of dividend model and strongly supports that
dividend policies of a firm almost always affect the value of
the firm.
If return on investment is higher than the cost of
Capital (r>k), the firm should retain the earnings. Such firms
referred to as growth firm is able to earn more than what the
shareholders can earn on their investment.
On other hand, if a firm does not have a profitable
investment opportunities (When r<k), the optimum dividend
policy would distribute the entire earnings as dividend. In this
case, the shareholders will be better-off.
Walter’s Model also implied that when normal firm is
r=k, it does not matter whether earnings are retained or
distributed. The value of market price of share will not be
adversely affected with change in the dividend rate.
Assumptions:
1. Retained earnings is the only source of entire financing of a
firm.
2. External sources of funds such as debt or new equity capital
are not used.
3. Return on firm’s investment (r) and cost of capital (k0) of a
firm remain constant.
4. Firm’s business risk does not change with additional
investment undertaken.
5. The firm has an infinite or very long life.
Formula
r
D +------ ( E- D)
ke
P = ------------------
Ke
Where
P = market price of an equity share
D = Dividend per share
r = Internal rate of return on investment
E = Earnings per share
E-D = Retained Earnings per share]
Ke = Cost of Equity Capital (or) Capitalization Rate
2. Gordon’s Model
Mynon J. Gordon (1979), suggested a relevance of
dividend decision for valuation of a firm. This model is also called
as dividend capitalization model. According to this model,
dividend policy of a firm affects its value, and is based on the
following assumptions:
1. The firm is an all equity firm
2. Retained earnings represent the only source of a firm for
financing its investment programmes.
3. The rate of return(r) on the firm’s investment is constant.
4. The cost of capital remains unchanged for all times to come
5. The firm has perpetual life
6. Corporate taxes do not exist.
7. The retention ratio, once decided upon is constant. Thus,
growth rate (g= br) is also constant.
8. Cost of capital is greater than the growth rate (Ko > br)
Valuation Formula

E(1-b)
Po = ----------------
Ko – br
Where,
Po = Price per share at the beginning of the year
E = Earnings per share at the end of the year
B = retention Ratio
1-b = Dividend payout ratio (Percentage of earnings
distributed as dividends)
Ko = Capitalization rate or cost of capital
br = Growth rate of earning and dividends.
r = Rate of return earned on investment made by the
firm
 Irrelevance concept of Dividend
Modigliani and Miller’s Approach
According to them, dividend policy of a firm
does not affect the value of a firm. Thus, the dividend
payout ratio does not affect the wealth of
shareholders.
Assumptions:
1. It assumes that capital markets are perfect
2. Non-existence of brokerage/commission
3. Availability of free information to all investors
4. No transaction costs and floating costs.
5. Investment policy of the firm does not change at
any circumstances.
Proof for MM Hypothesis
According to MM hypothesis, the market value of a
share in the beginning of the periods is equal to the
present value of dividends paid at the end of the period
plus the market price of the share at the end of the
period.
This can be put in the form of the following equation:
D1 + P 1
P = --------------
(1 + Ke )
Where
Po = Prevailing market price of a share
Ke = Cost of equity capital
D1 = Dividend to the received at the end of period one
P1 = Market price of a share at the end of period one.
 From the above equation, the following equation can
be derived for determining the value of P1

P1 = P0 (1+Ke) – D1
Computation of the number of new hares to be issued
The investment programme of a firm in a given period
of time, can be finance either by retained earnings or by
issued of new shares or both. The number of new shares to be
issued can be determined by the following equation.
m x p1 = I – (X – nD1)
Where
m = Number of new shares to be issued
P = Price at which new issue is to be made
I = Amount of investment required
X = Total net profit of the firm during period.
nD1 = Total dividends paid during the period.
 Problem - 1
Following are the details regarding three companies A
ltd., B ltd. and C Ltd.
A Ltd. B Ltd. C Ltd.
r = 15% r = 5% r = 10%
Ke = 10% Ke = 10% Ke = 10%
E = Rs.8 E = Rs.8 E = Rs.8
Calculate the value of an equity share of each of these
companies applying Walter’s formula dividend
payment ratio (D/p) ratio is (a) 50%, (b) 75%, (c)25%
What conclusion do you draw?
 Problem - 2
If K = 11% and earnings per share is Rs.15. calculate
the price per share of Sushma Ltd. For r = 12%, 11%
and 10% for the following levels of D/P ratios.

D/P Ratios Retention Ratio

1 10% 90%
2 30% 70%
3 50% 50%
 Problem 3
The present share capital of A Ltd. consists of 1000
shares selling at Rs.100 each. The company is
contemplating a dividend of Rs.10 per share at the
end of the current financial year. The company
belongs to a risk class for which appropriate
capitalization rte is 20%. The company expects to
have a net income of Rs.25000. what will be the price
of the share at the end of the year (i) dividend is not
declared and (ii) a dividend is declared. Presuming
that the company pays the dividend and has to make
new investment of Rs.48000 in the coming period, how
many new shares be issued to finance the investment
programme? You are required to use the MM model
for this purpose.
 Types of Dividend
1. Cash Dividend
a) Regular Dividend
b) Interim Dividend
2. Stock dividend (bonus Shares)
3. Scrip Dividend
4. Bond Dividend
5. Property Dividend
Factors Affecting Dividend Policy
1. Stability of earnings
2. Liquidity of funds
3. Nature of business
4. Financing policy of the concern
5. Dividend policy of competitive concerns
6. Maintaining effective control
7. Need for expansion
8. Cash position
9. Taxation policy
10. Legal requirements
11. Investment opportunities
12. Legal Requirements
13. Investment opportunities
 Dividend Policy – Stability
Stability of dividends depends on the payout policy
followed by the companies.
Stable Dividend Payout Ratio
According to this policy, the percentage of earning
paid out as dividends remains constant respective of
the level of earnings. Thus, as earnings of a company
fluctuates, dividends paid by it also fluctuates
accordingly. The following figure shows the behaviour
of dividends in case this policy is adopted.
 Stable Dividend Payout Ratio
Earnings

Earnings /
Dividends

Dividends

Time
Stable Dividends/ Steadily Changing Dividends

According to this policy, dividends in rupee

terms mostly remain constant irrespective of the level
of earnings. Most of the times, it is gradually increased
over a period. The following figure shows the profile of
dividend payout according to this policy. Most of the
business firms uses this policy.
 Stable Dividends/ Steadily Changing Dividends
Earnings

Earnings /
Dividends

Dividends

Time
 Practical aspects of Dividend Policy
While deciding on the dividend policy, firm face two
questions:
1.What should be the average pay ratio?
2.How Stable should the dividends be over time?
Firms consider the following factors to determine the
payout ratio
1. Funds requirement
2. Liquidity
3. Availability of external sources of financing
4. Shareholder preference
5. Difference in the cost of external equity and retained
earnings
6. Control
7. Taxes