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  2. INTRODUCTION TO LEVERAGE: Leverage or financial leverage is basically an investment where borrowed money or debt is used to maximise the returns of an investment, acquire additional assets or raise funds for the company. Individuals or businesses create debt by borrowing money or capital from lenders and promising to pay this debt off with the added interest. Thus, leverage can also mean trading equities. Whenever a company or an individual business is termed as highly leveraged, it means that the debt on them is more than the equity. Knowing this helps investors to make the right decisions before investing in any property, firm, or company.
  3. DEFINITION: In the words of J. E. Walter, ‘Leverage may be defined as percentage return on equity and the net rate of return on total capitalization’. According to James C. Van Home, ‘Leverage refers to the use of fixed cost in an attempt to increase (or lever up) profitability’. CHARACTERISTICS OF LEVERAGE: •Those borrowings which lead to fixed annual liabilities such as interest or even fixed dividend in the case of preference shares, fall under this category.
  4. It is the use of borrowings for capital expenditures and net operating expenditure. The choice of financial leverage arises when the company expects that the returns generated from the asset so purchased will be greater than the cost of borrowing or more commonly known as the interest expense. Interest expense is mandatory even if the company doesn’t earn profits, however, interest expense is tax- deductible so provides a tax shield, which is a lucrative feature of the leverage financing As the borrowings are used to purchase fixed assets, these are generally for a long term period There are several ratios that measure the financial leverage, such as the Debt ratio, Debt to equity ratio, Coverage ratios, etc.
  6. OPERATING LEVERAGE: When a company uses debt financing, its financial leverage increases. More capital is available to boost returns, at the cost of interest payments, which affect net earnings. PROVISION AND COMPUTATION OF OPERATING LEVERAGE: A company can calculate its degree of operating leverage by taking its earnings before interest and tax (EBIT) and then dividing that number by the company’s percentage change in sales output. The operating leverage formula is as follows: Degree of operating leverage = [number of units x (price per unit - variable cost per unit)] / number of units x (price per unit - variable cost per unit) - fixed operating costs To calculate operating leverage, note the number of units (or products) that your company is selling, the price per unit, the variable cost per unit, and the fixed operating costs. You can find many of these numbers on your company’s income statement, cash-flow projections, or other financial statements
  7. 1. Calculate the earnings before interest and tax. First, subtract the variable cost per unit from the price per unit. Then, multiply this number by the number of units sold. The result is your percentage earnings before interest and tax. 2. Calculate the percentage change in sales output. Next, subtract the variable cost per unit from the price per unit. Multiply this number by the number of units sold. Then subtract the fixed operating costs from that number. This is your percentage change in sales output. 3. Divide to determine the operating leverage. Divide the percentage earnings before interest and taxes that you calculated in step one by the percentage change in sales output you calculated in step two: This number is your degree of operating leverage.
  8. FINANCIALLEVERAGE: Financial leverage is mainly related to the mix of debt and equity in the capital structure of a firm. It exists due to the existence of fixed financial charges that do not depend on the operating profits of the firm. PROVISION AND COMPUTATION OF FINANCIAL LEVERAGE: Financial Leverage can be calculated as follows: Financial Leverage = EBIT/ EBT Financial Leverage = EBIT/ (EBIT-Interest) Where, •EBIT: Earnings Before Interest and Tax •EBT: Earnings Before Tax
  9. COMBINED LEVERAGE: Combined leverage (OL + FL) represents a company’s total risk related to operating leverage, financial leverage, and the net effect on the EPS.
  10. COMPUTATION OF DEGREE OF OPERATING LEVERAGE(DOL): 1. Calculate your percent change in EBIT To calculate your EBIT for a given year, you need to know your sales for that year as well as your operating expenses. Subtract your operating expenses from your sales to get your EBIT. For example, if your sales were $250,000 and your operating expenses were $50,000, your EBIT would be $200,000. To calculate a percent change in your EBIT -- say, from year one to year two of your business -- you would use the following formula: % Change in EBIT = ((EBIT Y2 / EBIT Y1) - 1) x 100 2. Calculate your percent change in sales You can calculate your percentage change in sales from one year to the next with this formula: % Change in Sales = (Sales Y2 / Sales Y1) - 1) x 100 3. Divide your percent change in EBIT by your percent change in sales Once you have your results from the two steps above, calculating your DOL is simple division: DOL = % Change in EBIT / % Change in Sales
  11. COMPUTATION OF DEGREE FINANCIALLEVERAGE (DFL): 1. DFL = (% of change in net income) / (% of change in the EBIT) In this formula, the percent change in a company's earnings before interest and taxes (EBIT) divides into the percent change of the company's net income. 2. DFL = (EBIT) / (EBT) The second DFL formula is useful for calculating the DFL based on a business's earnings before taxes (EBT). This formula akes a company's EBT and divides it into the company's EBIT.
  12. DIFFERENCES: BASIS FOR COMPARISON OPERATING LEVERAGE FINANCIAL LEVERAGE Meaning Use of such assets in the company's operations for which it has to pay fixed costs is known as Operating Leverage. Use of debt in a company's capital structure for which it has to pay interest expenses is known as Financial Leverage. Measures Effect of Fixed operating costs. Effect of Interest expenses Relates Sales and EBIT EBIT and EPS Ascertained by Company's Cost Structure Company's Capital Structure Preferable Low High, only when ROCE is higher Formula DOL = Contribution / EBIT DFL = EBIT / EBT Risk It give rise to business risk. It give rise to financial risk.
  13. INDIFFERENCE POINT: The indifference point, often called as a breakeven point, is highly important in financial planning because, at EBIT amounts in excess of the EBIT indifference level, the more heavily levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below the EBIT indifference points the financing plan involving less leverage will generate a higher EPS. Indifference points refer to the EBIT level at which the EPS is same for two alternative financial plans. According to J. C. Van Home, ‘Indifference point refers to that EBIT level at which EPS remains the same irrespective of debt equity mix’. The management is indifferent in choosing any of the alternative financial plans at this level because all the financial plans are equally desirable. The indifference point is the cut-off level of EBIT below which financial leverage is disadvantageous. Beyond the indifference point level of EBIT the benefit of financial leverage with respect to EPS starts operating. The indifference level of EBIT is significant because the financial planner may decide to take the debt advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will be able to magnify the effect of increase in EBIT on the EPS.
  14. EARNINGS BEFORE INTERESTAND TAX (EBIT): Earnings before interest and taxes (EBIT) is an indicator of a company's profitability. EBIT can be calculated as revenue minus expenses excluding tax and interest. EBIT is also referred to as operating earnings, operating profit, and profit before interest and taxes. •EBIT is used to analyze the performance of a company's core operations without the costs of the capital structure and tax expenses impacting profit. •EBIT is also known as operating income since they both exclude interest expenses and taxes from their calculations.
  15. Formula and Calculation for Earnings Before Interest and Taxes (EBIT): EBIT = Revenue − COGS − Operating Expenses Or EBIT = Net Income + Interest + Taxes where: COGS = Cost of goods sold​ The EBIT calculation takes a company's cost of manufacturing including raw materials and total operating expenses, which include employee wages. These items are then subtracted from revenue. The steps are outlined below: 1.Take the value for revenue or sales from the top of the income statement. 2.Subtract the cost of goods sold from revenue or sales, which gives you gross profit. 3.Subtract the operating expenses from the gross profit figure to achieve EBIT.
  16. EARNINGS PER SHARE (EPS): Earning per share (EPS), also called net income per share, is a market prospect ratio that measures the amount of net income earned per share of stock outstanding. In other words, this is the amount of money each share of stock would receive if all of the profits were distributed to the outstanding shares at the end of the year. Earnings per share is also a calculation that shows how profitable a company is on a shareholder basis. So, a larger company’s profits per share can be compared to smaller company’s profits per share. Obviously, this calculation is heavily influenced on how many shares are outstanding. Thus, a larger company will have to split its earning amongst many more shares of stock compared to a smaller company.
  17. ANALYSIS OF EPS: Earning per share is the same as any profitability or market prospect ratio. Higher earnings per share is always better than a lower ratio because this means the company is more profitable and the company has more profits to distribute to its shareholders. Although many investors don’t pay much attention to the EPS, a higher earnings per share ratio often makes the stock price of a company rise. Since so many things can manipulate this ratio, investors tend to look at it but don’t let it influence their decisions drastically. EPS = (Net Income – Preferred Dividends) / End of period Shares Outstanding EPS = (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding
  18. DIVIDEND POLICY: A dividend policy is a strategy that a company uses to decide how much money it will give out as a dividend. It can be important for a company to have a diverse set of dividends so that the corporation’s shareholders are not allocating the same percentage of their income to different investments. A dividend policy also helps ensure that taxable distributions are distributed at the correct rate to shareholders. FACTORS DETERMINING DIVIDEND POLICY: Several factors could be applicable in individuality or in a combination of two or more factors that decide a company’s dividend policy. Let’s have a quick look at them in the following paragraphs: Liquidity For paying the dividend, a firm will require access to funds. Even extremely prosperous firms can occasionally have difficulties in paying dividends if the resources are locked up in other types of assets. In summary, firms with higher liquidity pay dividends more frequently than companies with cash locked up in fixed assets or inventory. Repayment of Debt Companies having a high load of interest-bearing debts may be hesitant to pay dividends. Dividend payout may be made difficult if the debt is due for repayment. Because paying interest on interest-bearing assets is a necessity in virtually all nations. Shareholders acquire whatever remains after discharging liabilities of debt-holders. It is also conceivable that the firm is not left with any distributable earnings after paying interest on loans.
  19. Stability of Profits As there are certain limitations on cash and loan credit given to the company, it has to earn revenue. A company has to generate an income from sales or some other means to earn money for its shareholders. At this point in time, the earning capacity of the company is known, and it can be predicted. This earning capacity is reflected in the company’s earnings and profits. It indicates how much of the total sales and profits of the company can be generated from its operations. In the event that earnings fall, the dividend policy will be lowered accordingly. Control The utilisation of retained earnings to finance a new project maintains the company’s ownership and control. This can be useful in businesses where the existing ownership disposition is relevant. Legal Considerations The legal rules set out parameters within which a business can declare dividends. It is done to safeguard the interests of creditors, lenders, and other parties having a stake in the firm. The court or company law boards can regulate whether or how much the firm can pay dividends.
  20. Risks in the Market As there is always a risk in the market, a company’s dividend policy is determined in accordance with this risk. In the stock market, there are fluctuations. A company has to face this risk while deciding on the dividend policy. Inflation If the company does not have enough cash flow to cover its operating expenses and dividends, it will need to reduce or eliminate its dividend. Inflation can also be a factor in determining a company’s dividend policy Expectations of the Management The dividend policy is also affected by the expectations of a company’s management. If the management is confident about the company’s earnings, the dividend policy is high. In the same way, in case the management is not confident about the earning ability of the company, the dividend policy is lowered. Other Factors Tax considerations and other variables such as dividend policies followed by other companies similarly positioned in the sector, management stance on dilution of existing control over the shares, fear of being branded as inept or inefficient, and cautious policy versus non-aggressive one.
  21. FACTORS DETERMINING DIVIDEND DECISION: The dividend is that portion of the profit that is distributed to the shareholders. The decision involved here is how much of the profit earned by the company after paying the taxes is to be distributed to the shareholders. It also includes the part of the profit that should be retained in the business. There are various factors that affect the dividend decision. These are as follows: •Amount of Earnings: Dividends are paid out of the current and previous year’s earnings. More earnings will ensure greater dividends, whereas fewer earnings will lead to the declaration of a low rate of dividends. •Stability of Earning: A company that is stable and has regular earnings can afford to declare higher dividend as compared to those company which doesn’t have such stability in earnings. •Stability of Dividend: Some companies follow the policy of playing a stable dividend because it satisfies the shareholders and helps in increasing companies reputation. If earning potential is high, it is declared as a high dividend, whereas if the earning is temporary or not increasing, then it is declared as a low or normal dividend.
  22. •Growth Opportunities: Companies with growth opportunities prefer to retain more money out of their earnings to finance the new project. So, companies that have growth prospects in near future will declare fewer dividends as compared to companies that don’t have any growth plan. •Cash flow Position: Payment of dividends is related to the outflow of cash. A company may be profitable, but it may have a shortage of cash. In case the company has surplus cash, then the company can pay more dividends, but during a shortage of cash, the company can declare a low dividend. •Taxation Policy: The rate of dividends also depends on the taxation policy of the government. In the present taxation policy, dividend income is tax-free income to the shareholders, so they prefer higher dividends. However, dividend decision is left to companies. •Stock market reaction: The rate of dividend and market value of a share are directly related to each other. A higher rate of dividends has a positive impact on the market price of the shares. Whereas, a low rate of dividends may hurt the share price in the stock market. So, management should consider the effect on the price of equity shares while deciding the rate of dividend.
  23. ISSUES IN DIVIDEND DECISION: Type of firm Firms with stable earnings can lead to better dividend policies than firms with uneven income flow. This can become an issue for the stakeholders and firm owners too. Types and desires of shareholders Many times, the dividend decision is also affected by the shareholders’ types and desires. If they are financially stable, then you can manage them by paying the dividends accordingly. Still, if they are financially weaker, you will need to pay a dividend at regular timings. Company’s age The old Company does not require a large amount in stabilizing itself and saving for further development and growth so they can afford to pay dividends. On the other hand, newly established companies cannot afford to make such payments. Taxation policy The taxation policy of the government can also create issues in making dividend decisions. This is so because the net earnings somewhat depend upon the taxation policy, which ultimately affects dividend decisions.
  24. IMPORTANCE OF DIVIDEND POLICY: It informs investors. While it doesn't necessarily affect share price, which is more tied to valuation and market fluctuations, a dividend policy is an important factor that investors consider when deciding what stocks to invest in. It tells them very clearly what they can expect by putting their money into your company and outlines the amount, method, type, and frequency of dividend distributions. It provides internal direction. A dividend policy sets a level of discipline that your company must follow with the use of cash flow. You know where all profits are going and are able to more carefully allocate your profits. It builds trust. A sound dividend policy suggests your company is well managed and profitable, which can help build trust and confidence among your shareholders. It adds credibility. Your company’s dividend policy communicates the value of your organization and sends a message about your future prospects and performance.
  25. TYPES OF DIVIDEND POLICY: Residual Dividend Policy In this policy, a company uses all excess cash to pay for operational needs first (reinvestment), then whatever’s left is paid out to shareholders. This is sometimes used by companies to set the dividend so that it doesn’t hamper its ability to pursue investment opportunities. A business that uses a residual dividend policy will need to constantly justify its payouts and fluctuations with shareholders. On the shareholder side, this policy often attracts investors that are looking for more long term gains and are indifferent to the amount or type of dividends they might receive in the short term. Stable Dividend Policy A stable policy is the most commonly used policy among the four types. With this policy, shareholders receive a certain minimum amount of regular dividend on a scheduled basis, but the amount or rate is not fixed. Investors that are risk-averse and income-oriented typically prefer this policy and consider it a safe bet, even if the company pays low dividends.
  26. Hybrid Dividend Policy The hybrid policy is basically a mix of the stable and residual policies. Companies that use this type of policy aren’t as rigid when it comes to quarterly debt-to-profit metrics as the only basis for the amount of dividend. Industries that focus on nonessential products use this policy the most because they’re more affected by business cycles. As business fluctuates, they pay a modest dividend that can be easily maintained but might also pay a supplemental dividend if business is good. Constant Dividend Policy Of the four policy types, this is considered the riskiest because investors receive fluctuating dividends with changing levels of profits. For this reason, the constant policy is not as ideal for income-oriented investors. However, the advantage of this policy is short or long term growth in dividend amount if the company makes consistent profits. If profits are up investors get a larger payback and vice versa if profits are down. Income retained by a business after dividends are paid to shareholders is known as retained earnings. If you aspire to be in a leadership or management position, understanding these different types of policies can be helpful as it’s likely you’ll have input on your organization’s dividend policy down the road.
  27. THEORIES OF DIVIDEND: Theories of dividend are two types: i) Dividend Relevance theory ii) Dividend Irrelevance theory Relevance and irrelevance of dividend theories Relevance of dividend policy supports the view that the dividend policy has profound impact on the value of a company. There are three theories under this school of thought. a) Traditional view b) Walter model c) Gordon model
  28. WALTER’S MODEL: James Walter also supported the view that the dividend policy of a company has an impact on the share value. The model is based on the following assumptions:  The company is an all – equity financed entity.  It depends on retained earnings only to finance future investment projects.  Return on investment is constant  The company has perpetual life
  29. Gordon’s Theory: Gordon’s theory on dividend policy is one of the dividend theories believing in the ‘relevance of dividends’ concept. It is also called the ‘Bird-in-the-hand’ theory, which states that the current dividends are important in determining the firm’s value. Gordon’s model is one of the most popular mathematical models to calculate the company’s market value using its dividend policy. Gordon’s Model Definition: The Gordon’s Model, given by Myron Gordon, also supports the doctrine that dividends are relevant to the share prices of a firm. Here the Dividend Capitalization Model is used to study the effects of dividend policy on a stock price of the firm. Gordon’s Model assumes that the investors are risk averse i.e., not willing to take risks and prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return and a discount on the uncertain returns. The investors prefer current dividends to avoid risk; here the risk is the possibility of not getting the returns from the investments.
  30. But in case, the company retains the earnings; then the investors can expect a dividend in future. But the future dividends are uncertain with respect to the amount as well as the time, i.e., how much and when the dividends will be received. Thus, an investor would discount the future dividends, i.e., puts less importance on it as compared to the current dividends. According to the Gordon’s Model, the market value of the share is equal to the present value of future dividends. It is represented as: P = [E (1-b)] / Ke-br Where, P = price of a share E = Earnings per share b = retention ratio 1-b = proportion of earnings distributed as dividends Ke = capitalization rate Br = growth rate
  31. MODIGLIANI AND MILLER’S APPROACH (MM Model) • According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affect the value of the firm. • “Under conditions of perfect market, rational investors, absence of tax discrimination its dividend policy may have no influence on the market price of shares”. • MM approach is based on the following important assumptions: • 1. Perfect capital market. • 2. Investors are rational. • 3. There are no tax. • 4. The firm has fixed investment policy. • 5. No risk or uncertainty.