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.
In the words of J. E. Walter, ‘Leverage may be defined as percentage return on equity and the net rate of return on
According to James C. Van Home, ‘Leverage refers to the use of fixed cost in an attempt to increase (or lever up)
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.
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.
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
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
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.
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)
•EBIT: Earnings Before Interest and Tax
•EBT: Earnings Before Tax
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
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.
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.
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.
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
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
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.
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.
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
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:
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.
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.
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.
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.
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.
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.
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.
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.
•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.
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.
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.
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
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
It adds credibility.
Your company’s dividend policy communicates the value of your organization and sends a message about your future prospects and
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.
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.
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
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
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
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.
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.
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
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.