FINANCIAL LEVERAGE.

The use of fixed charges

sources of funds, such as debt
and preference capital along
with the owners’ equity in the
capital structure is described
as financial leverage or trading
on equity.
Effect of Financial Leverage on the
Shareholder’s earnings:

• Calculating EPS and Return on Equity.

The Earning per share can be calculated by dividing

the earnings after interest and taxes, EAIT (i.e. net
income, NI) by the number of outstanding common
shares.
• EBIT = X (Net operating Income, NOI)
• Less: Interest = R
• EAIBT = X–R
• Tax = t (X – R) (t is the tax rate)
• EAIT (Net Income) = (X – R) – t (X – R)
• NI = (X – R) (1 – t)
• EPS = (X – R) (1 – t) / N -----(1)
•
• If the earnings after interest and taxes, EAIT are
divided by the shareholders’ funds (share capital
plus reserves and surplus), we get return on equity
in percentage. Thus,
• e = (X – R) (I – t) / E ----------(2)
where e represents the common shareholders’ fund
or net worth.
• Favorable and Unfavorable Financial
Leverages
• The effect of the financial leverage may be
favorable or unfavorable. Positive, or
favorable, financial leverage occurs when the
earnings per share increase due to the use of
debt in the capital structure. This happens
when the rate of return on the company’s
assets is more than the cost of debt capital.
 Favorable financial leverage is
illustrated as follows:
• Example: 1.
• Firms A and B are identical, except that Firm B is levered. The
following data relate to them:
• A B
• Assets. Rs. 5,00,000 Rs. 5,00,000
• Debt 0 2,50,000(9% Debenture)
• Equity 5,00,000 2,50,000
• (50,000 Shares) (25,000 Shares)
• Rate of return on Assets. 20% 20%
• Calculate EPS for Firms A and B. Assume a 50% tax rate.
 Table 1: Example of Favorable
Financial leverage
• Firm A Firm B
• EBIT Rs.1,00,000 Rs. 1,00,000
• Less: Interest 0 22,500
•
• EAIBT 1,00,000 77,500
• Less; Taxes @ 50% 50,000 38,750
•
EAIT Rs. 50,000 Rs. 38,750
•
No. of shares 50,000 25,000
• EPS Rs.1.00 Rs.1.55
 Unfavorable Financial Leverage
• Negative, or unfavorable leverage occurs
when the earning per share decreases
because of the use of debt in the capital
structure. The following example explains
the negative effect of financial leverage.

• Except the rate of return on assets, assume

the same data for Firms A and B. If the rate of
return is supposed to be 6 percent, the EPS
will be as shown in the following table.
 Table: 2 Example of Unfavorable
Financial Leverage.
Firm A Firm B
(Rs) (Rs)
EBIT (6% of Rs. 5,00,000) 30,000 30,000
Less: Interest 0 22,500
EAIBT 30,000 7,500
Less: taxes @ 50% 15,000 3,750
EAIT 15,000 3,750
No. of shares 50,000 25,000
EPS 0.30 0.15
• If the rate of return on assets were just
equal to the cost of debt i.e. 9% it can
be seen that financial leverage will
have no impact on the shareholders’
return. (Assume the same data for
Firms A and B except the rate of
return).
 Table: 3: Example of neutral Financial
leverage.
• Firm A Firm B
• EBIT (9%of Rs. 5,00,000) Rs.45,000 Rs.45,000
• Less: Interest 0 22,500
• EAIBT 45,000 22,500
• Less: Taxes @ 50% 22,500 11,250
•
EAIT 22,500 11,250
•
No. of shares. 50,000 25,000
•
EPS Re. 0.45 Re.0.45
 Conclusion:
• We are thus led to an important conclusion:
• (i) the financial leverage will have a favorable impact on EPS
only when the firm’s return on investment (r) exceeds the
interest cost of debt (kd).
• (ii) the impact will be unfavorable if r < kd.
• (iii) The financial leverage will have no impact on EPS, when r =
kd

• Effect of leverage
• Favorable r > kd
• Unfavorable r < kd
• Neutral r = kd
 EBIT–EPS ANALYSIS
• One useful way of examining the effect of financial
leverage is to analyze the behavior of EPS with
varying levels of EBIT under alternative financing
plans. As noted earlier, the formula to calculate EPS
is:
• EPS = (X –R) (1 – t) / N

• This equation can be rewritten as:

• EPS = {(1-t)X – (1-t)R} / N = (1-t)X /N - (1-t)R / N
• Or EPS = - (1-t)R / N + (1-t)X /N -----------(3)
• If the level of leverage and tax rate are
constant, the 1st part of Eq (3) is a
constant. The constant part of the
equation may be represented by a.
EBIT is a changing variable and is
represented by X. Thus,
• EPS = a + bx ,
• Where, a = - (1 – t) R/ N and b = (1-t) / N
• From the following data calculate EPS for the three alternative
plans, if the levels of EBIT (X) are assumed to be Rs. 20 Rs. 40,
Rs. 60, Rs. 80, Rs. 100, Rs. 120, Rs.140, Rs150.

F. Plan – I F. Plan – II F. Plan- III

• (D = 0) (D = 50%) (D = 80%)
• Assets Rs.1,000 Rs.1,000 Rs.1,000
• Financed by
• Debt at 6% 0 500 800
• Equity 1,000 500 200
• (10 Shares) (5 shares) (2 shares)
• Tax Rate 50% 50% 50%
• We know, EPS = a + bx
• where a = - (1 – t) R/N
• b = (1 – t) /N
• F. Plan – I
• a = - (1 - .5) 0 /10 = 0,
• b = (1 – t)/ N = (1 – 0.5)/10 = 0.05
•
• F. Plan – II
• a = - (1 - .5) 30/5 = - 0.5 x 6 = - 3
• b = (1 – t) /N = (1 – 0.5) / 5 = 0.5/5 = 0.1
• F. Plan – III
• a = - (1 - .5) x 48 / 2 = - 12
• b = (1 - .5) /2 = .5 /2 = 0.25
Table – 4: EPS Calculation for Financial Plan - I

a bx EPS = a + bx
0 (0. 05) (Rs. 20) = Rs. 1 Rs 1
0 (0. 05) (Rs. 40) = Rs. 2 Rs 2
0 (0. 05) (Rs. 60) = Rs. 3 Rs 3
0 (0. 05) (Rs. 80) = Rs. 4 Rs 4
0 (0.05) (Rs. 100)= Rs. 5 Rs 5
0 (0.05) (Rs. 120)= Rs. 6 Rs 6
0 (0.05) (Rs.140) = Rs. 7 Rs 7
0 (0.05) (Rs.150) = Rs. 7.5 Rs 7.5
 Table 5: EPS Calculation for Financial Plan - II

a bx EPS=a+bx
-3 (0. 1) (Rs. 20) = Rs. 2 Rs(-)1
-3 (0. 1) (Rs, 40) = Rs. 4 Rs 1
-3 (0. 1) (Rs. 60) = Rs. 6 Rs 3
-3 (0. 1) (Rs. 80) = Rs. 8 Rs 5
-3 (0.1) (Rs.100) = Rs.10 Rs 7
-3 (0.1) (Rs.120) = Rs.12 Rs 9
-3 (0.1) (Rs.140) = Rs.14 Rs 11
-3 (0.1) (Rs.150) = Rs.15 Rs 12
Table 6: EPS Calculation for Financial Plan - III

a bx EPS=a+bx
-12 (0. 25) (Rs. 20) = Rs. 5 Rs(-)7
-12 (0. 25) (Rs, 40) = Rs. 10 Rs (-)2
-12 (0. 25) (Rs. 60) = Rs. 15 Rs 3
-12 (0. 25) (Rs. 80) = Rs. 20 Rs 8
-12 (0. 25) (Rs.100) = Rs.25 Rs 13
-12 (0. 25) (Rs.120) = Rs.30 Rs 18
-12 (0. 25) (Rs.140) = Rs.35 Rs 23
-12 (0. 25) (Rs.150) = Rs.37.5 Rs 25.5
• A comparison of tables 4, 5 and 6
indicates that EPS of Financial Plan
which employs more financial leverage,
increases at a faster rate than that of
financial plan which employs less
financial leverage. But at low level of
EBIT the danger of reduced EPS is
more in case of financial plans
employing more leverage.
 GRAPHIC PRESENTATION OF
EBIT – EPS ANALYSIS
• As noted earlier:
• EPS = -(1 – t) R/N + (1 – t) X/N
• = a + bx

• The EPS equations under three financial plans are as follow:

• Financial Plan – I EPS = 0 + 0.05 x -------(4)
• Financial Plan – II EPS = -3 + 0.1 x -------(5)
• Financial Plan – III EPS = -12 + 0.25x -------(6)
• The EBIT – EPS analysis can be presented graphically. The
effects of varying levels of EBIT on EPS under alternative
financial plans are shown in Fig. 1. In the figure, the
horizontal line is used to represent EBIT, while the vertical
line represents EPS.

• Conclusion:
1. Shareholders will benefit by the use of Financial leverage if r
> kd
2. Shareholders will reduce EPS if r < kd.
3. Their earnings will not be affected by the level of leverage if
r = kd.
 Figure 1

• EPS III (D=80%)

• II (D=50%)

• I (D=0)

• 30 48 60 80 100 X
• 3% 4.8% 6% 8% 10%

• r<k r=k r>k

Degree of Financial leverage:
• We have seen in the earlier example that financial leverage
affects the earning per share. When the firm’s 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:

• DFL = % Change in EPS / % Change in EBIT

• Or DFL = (∆ EPS / EPS) / (∆ EBIT/ EBIT) -------- (1)

• The following formula can also be used to calculate

Degree of Fin. Leverage
• DFL = EBIT / ( EBIT –R)
 The above formula is derived as follows:

• DFL = (∆ EPS / EPS) / (∆ EBIT/ EBIT)

• = (∆ EPS / ∆ EBIT) . (EBIT / EPS)
• = {(1-t) / N}. (EBIT /EPS)
• = EBIT / {N. EPS / (1-t)}
• = EBIT / (EBIT –R)

• Since we know that EPS = - (1 – t) R/ N + {(1 – t) / N }EBIT

• Or, d (EPS) / d (EBIT) = (1 – t) / N
• Again EPS= (EBIT – R) (1 – t) / N
• Or , N (EPS) / (1-t) = EBIT -R
In Tables 4, 5, and 6 we have calculated different EPSs
for varying levels of EBIT under three alternative
financial plans. These are summarized in Table 7.
Table: 7

r EBIT when D = 0, D = 50%, D = 80% ,

(Rs) EPS EPS EPS
(Rs) (Rs) (Rs)
2% 20 1 -1 -7
4% 40 2 1 -2
6% 60 3 3 3
8% 80 4 5 8
10 % 100 5 7 13
12 % 120 6 9 18
14 % 140 7 11 23
15 % 150 7.5 12 25.5
• When EBIT increase from 120 to 140
• EPS increase from
• Rs. 6 to 7 Financial Plan – I
• Rs. 9 to 11 Financial Plan – II
• Rs. 18 to 23 Financial Plan – III

• The DFL at EBIT = 120 is

• DFL (I) = {(7-6) / 6} / {(140 – 120) / 120} = 1

• Or, EBIT / (EBIT – R) = 120 / (120-0) = 1

• DFL (II) = {(11-9) / 9} / {(140-120) / 120}
• = (2/9) (20/120) = 1.33
• Or, EBIT / (EBIT – R) = 120 / (120 -30)
• = 120 / 90 = 1.33

• DFL (III) = {(23-18)/18} / {(140-120)/120}

• = (5/18) (120/20) = 1.67
• Or, EBIT/(EBIT-R) = 120/(120-48)
• =120/72=1.67
• This implies that for a given change in EBIT,
EPS will change by 1 time, 1.33 times and
1.67 times for the three alternative financial
plans respectively. That is the more the debt
capital used in the capital structure, the more
the EPS changes for a given change in EBIT.
The change in EPS due to the use of debt
capital is called the financial risk.
 OPERATING LEVERAGE:
• Operating leverage refers to the use of fixed
costs in the operation of a firm. A firm will not
have operating leverage if its ratio of fixed costs
to total costs is nil. For such a firm, a given
change in sales would produce the same
percentage change in the operating profit or
EBIT. If the firm has fixed costs, it would have
operating leverage and the percentage change
in the operating profit would be more for a given
change in sales.
• The Break – Even Analysis can help us to
understand the impact of operating
leverage on the operating profit.
• The Break – Even Analysis establishes a
relationship between revenue and costs
with respect to volume. The Break – Even
point is that point of sales at which total
revenue is equal to total costs.
 Break–Even Analysis

• Assumption:
• Total costs = Total Fixed cost + Total Variable cost.
• When a cost changes in direct proportion to changes in volume, it is
called variable cost. Variable costs vary in a proportionate manner
with volume. Mathematically, a liner relationship exists between a
variable cost and volume.
•
• cost
• Total variable cost

• volume
• When a cost does not change with change in volume, it is called
fixed cost. Fixed costs remain at the same level irrespective of the
changes in volume. It is the total fixed cost which is constant.

• cost

• Fixed cost

• volume
• cost
• &
• revenue
 How to calculate Break – Even Quantity (QBE)?
• We know,
• Total Cost = T. Variable Cost + T. Fixed Cost
• Or T.C = T.VC + F = V.Q + F
• where, V is variable cost per unit, Q is quantity, and F is total fixed
cost.

• Op. Profit (EBIT) =Total Revenue – Total Cost = P.Q – (V.Q + F)

• { P= Price per quantity}
• Or EBIT = P.Q – V.Q – F = Q (P – V) – F.
• { (P- V) = contribution margin per unit}.
• At the break–even point (QBE), EBIT is zero
•
• 0 = QBE (P – V) – F
• or QBE (P – V) = F

• Or, QBE = F / (P-V)

• = Total Fixed Cost / Contribution margin per unit
• Example:
• The following illustration shows the impact of operating leverage on
the operating profit.
• Consider the following information of the same firm under two
different situations:

Situation – I Situation – II
Low Automation High Automation
Price per product Rs 8 Rs 8
(Unit) P

V. Cost per Unit Rs 4 Rs 2

Fixed Cost (F) Rs 280 Rs 480

• What are the B/E points for the firm under two situations? How
much profits are earned by the firm if the sale ranges between Q =
70 units to 105 units.

• Situation I: QBE = F / (P-V) = 280 / (8-4) = 70 units

• Situation II: QBE = F / (P-V) = 480 / (8-2) = 80 units
Table 8a: Profit to be made by the firm at different sales volume under:
Situation – 1 (Low Automation)

Units Sales VC F TC EBIT r

70 560 280 280 560 0 0%

75 600 300 280 580 20 2%
80 640 320 280 600 40 4%
85 680 340 280 620 60 6%
90 720 360 280 640 80 8%
95 760 380 280 660 100 10 %
100 800 400 280 680 120 12 %
105 840 420 280 700 140 14 %
Table 8b: Profit to be made by the firm at different sales volume under:
Situation – II (High Automation)

Units Sales VC F TC EBIT r

70 560 140 480 620 -60 -6%

75 600 150 480 630 -30 -3 %
80 640 160 480 640 0 0%
85 680 170 480 650 30 3%
90 720 180 480 660 60 6%
95 760 190 480 670 90 9%
100 800 200 480 680 120 12 %
105 840 210 480 690 150 15 %
 Degree of Operating Leverage

• The degree of operating leverage may be defined as the percentage

change in operating profits resulting from a percentage changes in
sales. Thus,
• DOL = % Change in Operating profit / % Change in Sales
• = {∆EBIT / EBIT}/ {∆ Sales / Sales}
• = {∆ EBIT / EBIT}/ {∆Q/Q}
• = (P – V)Q /EBIT = (P – V)Q /{ Q(P-V) – F}
• = contribution / (contribution – fixed cost)
• = contribution / PBIT
• [ since EBIT = Q(P-V) – F , or d(EBIT)/dQ = (P-V) ]
• In table 8, when Q changes from 100 units to 105 units
• EBIT Changes from Rs. 120 to 140 (Low Automation Situation- I)
• And, EBIT Changes from Rs. 120 to 150 (High Automation Situation
– II)
• Thus, at Q = 100 Units
• DOL (Low Automation) = {(140-120) / 120} / {(105-100)/100}
• = (20/120) x (100/5) = 3.33
• Or, DOL= Q (P – V) / {Q (P – V) – F } = 100(8-4)/{100(8-4)-280}
• = 400/120 = 10/3=3.33
• And DOL (High Automation)
• = {(150-120) /120} / {(105-100)/100}
• = (30/120) x (100/5) = 5.0

• Or, DOL = Q (P – V) / {Q (P – V)-F} = 100(8-2) / {100(8-

2)-480 = 600/120 = 5.0
 Combined Effect of operating and Financial leverage

• Degree of Financial Leverage

• DFL = EBIT / (EBIT-R) = {Q (P – V) – F} / Q (P –V)- F – R

• Degree of operating Leverage

• DOL = Q (P-V) / {Q (P-V) –F}

• The degree of operating and financial leverage can be combined to see the effect of
total leverage on EPS associated with a given change in sales.

• The degree of combined leverage

• = DFL x DOL= [{Q (P – V) – F} / Q (P –V)- F – R] x [Q (P-V) / {Q (P-V) –F}]
• = Q (P – V) / {Q (P –V)- F – R}
• Under Situation – I, (low- automation), when Q changes from 100
unit to 105 unit EBIT change from Rs. 120 to Rs. 140. And at Q =
100, DOL = 3.33

• Again when Q changes from 100 unit to 105 units, EBIT changes
from Rs. 120 to Rs. 140, and EPS changes from;
• Rs. 6 to Rs. 7 (Fin. Plan – I, when D = 0)
• Rs. 9 to Rs. 11 (Fin. Plan – II, when D = 50%)
• Rs. 18 to Rs. 23 (Fin. Plan – III, When D = 80%).

• And at that point

• DFL = 1 (FP – I)
• DFL = 1.33 (FP – II)
• DFL = 1.67 (FP – III)
• Thus, when the firm uses low automation, the combined leverage at
different financial plans are given below (when sales are Q = 100
Units).

• DCL = Q(P-V) / {Q(P-V)-F-R} = 100(8-4)/ {100(8-4)-280-0}=3.33 (FP – I)

• DCL= Q(P-V) / {Q(P-V)-F-R} = 100(8-4)/ {100(8-4)-280-30}=4.44 (FP – II)
• DCL= Q(P-V) / {Q(P-V)-F-R} = 100(8-4)/ {100(8-4)-280-48}=5.55 (FP – III)

• Alternatively we can calculate DCL = DFL x DOL

• thus,
• DCL = (10/3) x 1 = 3.33 (FP – I)
• DCL = (10/3) x (4/3) = 4.44 (FP – II)
• DCL = (10/3) x (5/3) = 5.55 (FP – III)
 Combinations of operating and financial leverage.

Low Automation High Automation

DFLx DOL = DCL DFLx DOL = DCL
1 X (10/3) =3.33 1 X 5 =5
(4/3) X(10/3) =4.44 (4/3) X5 = 6.67
(5/3) X (10/3)=5.55 (5/3) X5 = 8.33
• Under High Automation.

• If Q change from 100 to 105 units (5%),

•
• EBIT change from Rs. 120 to 150.
•
• And table 6 shows that when EBIT changes from Rs. 120 to Rs.
150 , EPS changes from Rs. 18 to Rs. 25.5 i.e., a change of
41.67 % which is equal to [5 % x 8.33(DCL)].