5. TABLE OF
CONTENTSR NO. PARTICULARS
1. Introduction and meaning of leverages
2. Debt vs equity financing
3. Business risk and financial risk
4. Types of leverages- operating leverage
5. Financial leverage
6. Trading on equity
7. Combined leverage
8. Break-even point
9. EBIT- EPS Analysis
10. Measures of operating and financial
leverage
11. Importance of leverages
6. INTRODUCTION TO LEVERAGE
LEVER MEANS A BAR RESTING ON A PIVOT WHICH IS
USED TO RAISE A HEAVIER OBJECT.WHEN A LEVER IS
USED PROPERLY , A FORCE APPLIED AT ONE POINT IS
TRANSFORMED , OR MAGNIFIED , INTO ANOTHER
LARGE FORCE OR MOTION AT SOME OTHER POINT. IN
SHORT , THE FUNCTION OF LEVER IS TO RAISE A
HEAVY OBJECT WITH A MINIMUM FORCE
8. DEBT V/S EQUITY FINANCING
• LENDER REUIRE A LOWER RATE OF RETURN THAN
ORDINARY SHAREHOLDER.
• A PROFITABLE BUSINESS LESS PAY FOR DEBT THAN
EQUTY.
• ISSUING AN TRANSACTIONS COST.
16. WHAT DOES IT TELL
US ?
• IF DOL = 2 , THEN 1 % INCREASE IN SALES WILL RESULT IN 2 %
INCREASE
IN OPERATING INCOME ( EBIT)
SALES EBIT
17. EFFECTS OF OPERATING
LEVERAGE
MORE OPERATING LEVERAGE LEADS TO
MORE BUSINESS RISK FOR THAN A SMALL
SCALE DECLINE CAUSES A BIG PROFIT
DECLINE
18. FINANCIAL
LEVERAGE
•IT IS DEFINED AS THE USE OF FUNDS WITH A FIXED
COST IN ORDER TO INCREASE EARNING PER
SHARE
•FINANCIAL LEVERAGE IS A MEASURE OF
FINANCIAL RISK
•AND THERE WILL BE NO FINANCIAL LEVERAGE IF
THERE IS NO FIXED CHARGE FINANCING.
19. DEGREE OF FINANCIAL LEVERAGE (
FORMULA)
STATIC. DYNAMIC
IN EPS
INEBI
T
EBIT
EBT
20. DEGREE OF FINANCIAL LEVERAGE
IF WE HAVE THE DATA, WE CAN USE
FOLLOWING FORMULA
DFL= EBIT
EBIT- INTEREST
HERE, I =AMOUNT OF INTEREST CHARGES
21. WHAT DOES IT TELL US ?
IF DFL = 3, THEN A 1% INCREASE IN OPERATING INCOME WILL RESULT
IN A 3% INCREASE IN EARNING PER SHARE
IF DFL = % CHANGE IN EPS
% CHANGE IN EBIT
SALES EBIT EPS STOCKHOLDER
23. FROM THE EXAMPLE WE COME TO KNOW
THAT
IF INTEREST IS LOW, DFL WILL BE LOW
AND
IF INTEREST IS HIGH, DFL WILL BE HIGH
24. IMPORTANCES OF FINANCIAL
LEVERAGE
•IT IS USE TO FIND EPS AND MARKET VALUE OF
EQUITY SHARE
•IT IS SUPERIOR THAN OPERATING LEVERAGE
•IT IS USE TO MAKE FINANCIAL DECISIONS
25. TRADING ON
EQUITY
EQUITY MEANS EQUITY SHARES
TRADING MEANS ‘TAKING ADVANTAGE OF’.
REFERRED TO AS FINANCIAL LEVERAGE
USE OF OWNER’S FUND AS WELL AS BORROWED FUNDS
WITH A VIEW TO INCREASE THE EPS
COMPANY IS MAKING USE OF FIXED INTEREST AND
DIVIDEND BEARING SECURITIES TO BENEFIT EQUITY
SHAREHOLDERS.
26. CAPITAL STRUCTURE
PARTICULARS DIAMOND
LTD. (AMT.)
GOLD LTD.
(AMT.)
SILVER LTD.
(AMT.)
EQUITY SHARES OF RS. 100 EACH 2,00,000 8,00,000 10,00,000
10% DEBENTURES OF RS.100 EACH 8,00,000 - -
8% PREFERENCE SHARES OF RS. 100
EACH
- 2,00,000 -
TOTAL CAPITAL EMPLOYED 10,00,000 10,00,000 10,00,000
33. TRADING ON EQUITY
GENERATES HIGHER RETURNS TO EQUITY
SHAREHOLDERS, PROVIDED THE COMPANY’S -
ROCE > INTEREST RATE
PRESENTS THE RISKS OF OUTRIGHT BANKRUPTCY
OTHER BENEFITS
34. RELATIONSHIP BETWEEN OPERATING LEVERAGE AND
FINANCIAL LEVERAGE
OPERATING LEVERAGE FINANCIAL LEVERAGE
• Operating leverage is concerned with
investment activities of the firm.
• Financial leverage is concerned with
financing activities of the firm.
• It is determined by the cost structure of the firm. • It is determined by the capital structure of the
firm.
• It is the firm’s ability to use fixed operating costs
to magnify the effects of changes in sales on its
earnings before interest and taxes.
• It is the firm’s ability to use fixed financial
charges to magnify the effects of changes in
EBIT on its earnings per share.
• Degree of operating leverage enables us to
measure the business risk associated with the
firm.
• Degree of financial leverage enables us to
measure the degree of financial risk,
associated with the firm.
• DOL = Contribution
EBIT
• DFL = EBIT
EBT
36. DEGREE OF COMBINED
LEVERAGE
• DEGREE OF COMBINED LEVERAGE:
= DEGREE OF OPERATING LEVERAGE(DOL) * DEGREE OF FINANCIAL
LEVERAGE(DFL)
37. DEGREE OF COMBINED
LEVERAGE
• DEGREE OF COMBINED LEVERAGE (DCL):
OR
DCL =
CONTRIBTION
EBT
DCL = % CHANGE IN EPS
% CHANGE IN SALES
38. COMBINED
LEVERAGE
• WHEN DCL = % CHANGE IN EPS
% CHANGE IN SALES
• THEN IF DCL = 4, THEN A 1% INCREASE IN SALES
WILL RESULT IN A 4% INCREASE IN EARNINGS PER
SHARE
43. EBIT-EPS ANALYSIS
INTRODUCTION
EBIT – EPS ANALYSIS IS AN APPROACH WHICH HELPS IN
DESIGNING THE OPTIMUM CAPITAL STRUCTURE FOR THE
COMPANY OR THE FIRM.
TO DESIGN VARIOUS ALTERNATIVES OF DEBT, EQUITY AND
PREFERENCE TO MAXIMIZE THE EPS .
46. MEASURES OF OPERATING LEVERAGE
FIXED COSTS TO TOTAL
COSTS
PERCENTAGE CHANGE IN OPERATING
INCOME TO THE PERCENTAGE CHANGE IN
SALES
NET INCOME TO FIXED
COSTS
47. MEASURES OF FINANCIAL LEVERAGE
DEBT TO ASSETS RATIO
DEBT TO EQUITY RATIOINTEREST COVERAGE RATIO
48. IMPORTANCE OF OPERATING LEVERAGE & FINANCIAL
LEVERAGE
MEASUREMEN
T OF
OPERATING
RISK
MEASUREMEN
T OF
FINANCIAL
RISK MANAGING
RISK
DESIGNING
APPROPRIATE
CAPITAL STRUCTURE
MIX