2. Introduction
• Leverage provides the Framework for
Financing Décisions of a Firm.
• It May Be définie as the Employment of an
Assest or Source of Funds for which the
Firm has to pay a Fixed Cost , or Fixed
Return.
• Deleveraging is the action of reducing
borrowings.
• A key measure of leverage is the debt to
GDP ratio.
3.
4. Break-Even (BE) Point
• Quantity where Total Revenue equals Total
Cost
• Company has no Profit or Loss
• BE = FC / P – VC
• A leveraged firm has a high BE point
• A non-leveraged firm has a low BE point
5. Risk in the Context of
Leverage
• Leverage influences stock price
Alters the risk/return relationship in an equity
investment
• Measures of performance
Operating income (EBIT or Earnings Before Interest
and Taxes)
• Unaf f ect ed by leverage because it is
calculat ed prior t o t he deduct ion f or
int erest
Return on Equity (ROE) is Earnings after Taxes ÷
Stockholders’ Equity
Earnings per Share (EPS) is Earnings after Taxes ÷
number of shares
• I nvest ors regard EPS as an import ant
indicat or of f ut ure prof it abilit y
6. Risk in the Context of
Leverage
• Redefining Risk for Leverage-Related Issues
• Leverage-related risk is variation in ROE and
EPS:
1. Business risk—variation in EBIT
2. Financial risk—additional variation in ROE
and EPS brought about by financial leverage.
• An aggressive or highly leveraged firm has high
fixed costs (and a relatively high break-even
point)
• A conservative or non-leveraged firm has low
fixed costs (and a relatively low break-even
point)
8. Operating Leverage
• It is associated with asset acquisition or investment
activities.
• It may be defined as the ability to use fixed operating costs
to magnify the effect of changes in sales on its operating
profits(EBIT).
• Refers to the amount of fixed costs in the cost structure.
• Fixed and Variable Costs and Cost Structure.
• Fixed costs don’t change with the level of sales, while
variable costs do
– Fixed costs include rent, depreciation, utilities,
salaries
– Variable costs include direct labor, direct
materials, sales commissions
• The mix of fixed and variable costs in a firm’s operations is
its cost structure
9. The Effect of Operating
Leverage
• As volume moves away from Breakeven(Used t o
det ermine t he level of act ivit y a f irm must
achieve t o st ay in business in t he long run),
profit or loss increases faster with more operating leverage
• The Risk Effect
More operating leverage leads to larger variations in
EBIT, or business risk
• The Effect on Expected EBIT
• Thus, when a firm is operating above breakeven, more
operating leverage implies higher operating profit
I f a f irm is relat ively sure of it s operat ing
level, it is in t he f irm’s best int erest s t o
t rade variable cost s f or f ixed cost
(assuming t he f irm is operat ing above
11. The Degree of Operating
Leverage (DOL)—A
Measurement
• Operating leverage amplifies changes in sales volume
into larger changes in EBIT
• DOL relates relative changes in volume (Q) to relative
changes in EBIT.
DOL = %change in EBT %change in Sales
DOL = Sales – Variable Costs EBIT
12. example
A company is perfectly selling 5000 units of a
product @ Rs 20 per unit. If variable cost is Rs 6
per unit & fixed operational cost are Rs 80000.
Find DOL
sol :- sales = 20*5000 = 100000
VC = 30000
contribution = 70000
(-) FC = 80000
EBIT = 10000
therefore, DOL = 70000/10000 = 7%
13. Financial Leverage
• Measure of the amount of debt used by a firm.
• a in EBIT (or OI) → a larger in EPS.
• Financial Leverage measures the sensitivity of a firm’s
earnings per share to a in operating income.
• Used as a means of increasing the return to common
shareholders.
• Financial leverage magnifies changes in EBIT into larger
changes in ROE and EPS
• The degree of financial leverage (DFL) relates relative
changes in EBIT to relative changes in EPS.
• An easier method of calculating DFL is:-
EBIT
DFL =
EBIT - Interest
14. Degree of Financial Leverage
(DFL)
• Degree of Financial Leverage -- The percentage
change in a firm’s earnings per share (EPS) resulting from a
1 percent change in operating profit.
DFLDFL =
Percentage change in
earnings per share (EPS)
Percentage change in
operating profit (EBIT)
% EPS
DFL = or % EPS = DFL % EBIT
% EBIT
∆
∆ × ∆
∆
15. Financial Risk
• Financial Risk ---- The added variability in earnings
per share (EPS) -- plus the risk of possible insolvency --
that is induced by the use of financial leverage.
• Debt increases the probability of cash insolvency over an
all-equity-financed firm.
18. example
Ques :- a company’s EBIT= 10000 & it has 5%
bonds for Rs 40000 & preference shares =
20000. Calculate DFL
Sol:- EBIT = 10000
(-) Interest = 2000
EBT = 8000
Therefore DFL = 10000/8000 = 1.25
19. Example
Ques :-A co. having a total capital of Rs 10 lacs
with 60% as bonds @10% as equity. The
expected sales of firm = 20000 units @20
per unit, VC = 10 per period, fixed
operational cost = Rs 50000, calcualte DOL,
DFL & DCL
Sol:- Sales = 400000
VC = 200000
Contri = 200000
(-) FC = 50000
