Leverage

2. Leverage

3. • Firms ability to use fixed costs assets and funds to magnify the
return
• Leverage is the employment of an asset or funds for which the firm
pays a fixed cost – James Horne
• No leverage- if firm not required to pay fixed cost
• Fixed cost is something which has to be paid irrespective of the
volume of production or sales and it has considerable effect on the
firms profit which is available to shareholders
Leverage
Operating
leverage
Financial
Leverage
Combined
Leverage

4. Operating Leverage

5. Operating leverage
• Use of fixed cost in the operation of the firm
• Irrespective of volume of sales firm has to bear fixed cost
• It remains constant
• A small change in sales will bring a proportionate change in operating
profit- operating leverage
• It’s the firms ability to use fixed operating cost to magnify the effect
of changes in sales pm its earning before interest and tax
• OL= Contribution/EBIT

6. Particulars Per unit Total
Sales
- Variable cost
a)Direct Labour
b)Direct Expense
c)Variable factory overhead
d)Variable administrative overhead
e)Variable Selling and distribution expenses
Contribution
- Fixed cost
Operating Profit (EBIT)

7. OL can be favourable or unfavourable
Favourable- contribution exceeds fixed cost
Unfavourable –opposite
Problem 1:
Output 20000 units
Selling price per unit Rs.12
Direct materials per unit Rs.5
Direct Labour per unit Rs.2
Variable overhears per unit Rs.1
Fixed cost per year Rs.60000

8. Questions??
• A firm sells its only product at Rs.12 per unit . Its variable cost is Rs 8
per unit.Present sales are 1000 units. Calculate the operating leverage
in each of the following
a) Fixed cost is 1000 Rs
b) Fixed cost is 1200 Rs
c) Fixed cost is 1500 Rs
Observe how fixed cost is related to operating leverage

9. • Calculate Operating leverage for Maruti Ltd, from the following
information
No of units produced 50,000
Selling price per unit Rs 50
Variable cost per unit Rs 20
Fixed cost per unit at current level of sales is Rs 15. What will be the new
operating leverage if the variable cost is Rs 30/unit
The installed capacity of a factory is 600 units. Actual capacity used is 400
units. Selling price per unit is Rs 10, variable cost Rs 6/per unit. Calculate
operating leverage in each of the three situations
Fixed cost is Rs 400
Fixed cost 1000 Rs
Fixed cost Rs 1200

10. • No of units produced and sold :30,000
Selling price per unit Rs 20
Variable cost per unit Rs 10
Fixed cost per unit at current level of Sales is Rs 5 /unit. What will be the new operating leverage
if variable cost is Rs12
Determine operating leverage
Company A
Sales 50,00,000Rs
Fixed cost 15,00,000Rs
Variable cost 50% of sales
Company B
Sales 60,00,000Rs
Fixed cost 30,00,000Rs
Variable cost 25% of sales

11. • Find operating leverage
Sales 50,000 Rs
Variable cost 60%
Fixed cost 12,000 Rs

12. • Degree of Leverage:
Percentage change in operating profit resulting from percentage
change in sales
DOL= % change in EBIT / %change in sales
Higher operating leverage for the firm which uses greater amount of
fixed cost and smaller amount of variable cost
Opposite gives lower operating leverage
X ltd sells 1000 units @ 20 per unit. The cost of production is Rs 14
per unit. The firm has a fixed cost of Rs 1000. Assume that the sales
of X ltd increased by 10%
Find the DOL

13. Find degree of leverage :
EBIT (2008) – Rs 50,000
Sales (2008) – 20,000 units
EBIT (2009) –Rs 60,000
Sales (2009) -28,000 units
Find DOL
EBIT(2005) – 40,000/-
Sales (2005)- 20,000 units
EBIT(2006)- 50,000
Sales (2006)- 28000 units

14. The firm will have no operating leverage if it doesn’t have fixed cost
Consider the following:
Solve and Analyse:
Present Expected
Sales
- Variable cost
20,000
14,000
30,000
21,000
EBIT/Profit 6000 9000

15. FINANCIAL LEVERAGE
• When the firm uses fixed interest /dividend bearing securities i.e.
debentures and preference shares’
• Along with owners equity to improve return
• These fixed financial charges do not vary with operating profit
• They are paid regardless of the amount of EBIT
• What is remaining after paying the fixed charges is paid to equity
shareholders
• EBIT/EBT
• “ability of a firm to use fixed financial charges to magnify the effect of
changes in EBIT on the firms earning per share”

16. X Ltd Y Ltd
Equity share capital of Rs 10 each 8,000,000 3,00,000
12% debentures 50,000 5,50,000
Capital Employed 8,50,000 8,50,000
EBIT 2,55,000 2,55,000
EBIT 2,55,000 2,55,000
- Interest on debentures 6000 66,000
EBT 2,49,000 1,89,000
- Tax @ 35% 87,150 66,150
EAT 1,61,850 1,22,850
EPS= EAT/No of Equity shares 1,61,850/80,000
=2.02
1,22,850/30,00
0
=4.095

17. Question???
• Buddha Belly Ltd has a choice of the following three financial plans
You are requested to ascertain the financial leverage in each case
and interpret it.
Plan 1 Plan 2 Plan3
Equity share capital 6 lakh 5 lakh 2 lakh
10% Debentures 4 lakh 5 lakh 8 lakh
EBIT 2.5 lakh 2.5 lakh 2.5lakh

18. • The capital Structure of Tom Gilbert Ltd consists of the following
securities
45,000 10% preference shares of 100 each – 45,00,000
5,00,000 equity shares of 10 each ---------------50,00,000
The companys operating profit is Rs 12,00,000 .
Find financial leverage
What will be the new financial leverage if the operating profit increases to
18,00,000 and interpret
• Martin Ltd has the following capital structure:
25,000 Equity shares of Rs 10 each – 2,50,000
2000 9% Pref shares of 100 each –2,00,000
3000 10% Debentures of 100 each- 3,00,000
The company’s EBIT is Rs 1,25,000. Calculate the financial leverage
assuming that the company tax bracket is 40%

19. • The capital Structure of Tom Gilbert Ltd consists of the following
securities
45,000 10% preference shares of 100 each – 45,00,000
5,00,000 equity shares of 10 each ---------------50,00,000
The companys operating profit is Rs 12,00,000 . Tax bracket 40%
Find financial leverage

20. • Ascertain Financial Leverage
Net worth: 20,00,000
Debt/Equity ratio – 3:1
Interest rate 10%
Operating Profit -18,00,000
• Calculate financial leverage
Profit before depreciation, interest and tax – 80,00,000
Depreciation –12,50,000
Tax rate- 40%
EPS- 4
No of equity shares -3,15,000

21. • Find financial leverage:
Net worth – 25,00,000
Debt/Equity -3:1
Interest rate -12%
Operating Profit- 20,00,000

22. • Degree of Financial Leverage :
% change in taxable profit as a result of % change in operating profit
% change in EPS/ % change in EBIT
X Ltd Y Ltd
Equity share capital of Rs 10 each 8,00,000 3,00,000
12% debentures 50,000 5,50,000
Capital Employed 8,50,000 8,50,000
EBIT 2,55,000 2,55,000
- Interest on debentures 6000 66000
EBT 2,49,000 1,89,000
- Tax @ 35% 87,150 66,150
EAT 1,61,850 1,22,850
EPS= EAT/No of equity shares
1,61,850/80,000
2.02
1,22,850
/30,000
4.095

23. Combined leverage
Combined leverage = financial leverage * operating leverage
Contribution/EBIT * EBIT/EBT
= Contribution/EBT
Z ltd has a sales of 4,00,000 . The variable cost is 60% of the sale and
fixed cost is Rs 8,00,000. the interest on debentures is Rs 40,000
Compute combined leverage and show the impact of taxable income
when sales increases by 5%

24. Question???
• The following figures relate to two companies. Calculate all three
leverages of the two companies
X ltd Y ltd
Sales 4,00,000 8,00,000
- Variable cost
Contribution
- Fixed cost
Operating Profit (EBIT)
- Interest
Profit before tax
1,60,000
2,40,000
1,28,000
1,12,000
48,000
64,000
2,40,000
5,60,000
2,80,000
2,80,000
1,20,000
1,60,000

25. • The following projections have been given in respect of Bright co
Calculate all three leverages
Output 3,00,000 units
Fixed cost 3,50,000
Variable cost/unit 1
Interest expenses 25,000
Unit selling Price 3

26. • A firm has sales of 15,00,000 , variable cost of 9,00,000 .Fixed cost
of 3,00,000 and debt of 8,00,000 at 8%
Calculate all leverages
• The capital structure of Madan Ltd Consists of equity share capital
of 8,00,000 (shares of 100 each) and 8,00,000 of 12% debentures.
Sales have increased from 80,000 units to 1,00,000 units . The
selling price is Rs 15 per unit , variable cost amounts to 9 per unit
and fixed cost amounts to 1,60,000. Tax at 50%
Calculate financial and operating leverages at both levels
Calculate percentage increase in EPS

27. • Calculate leverages under situations A, B, C from the following
particulars
Installed Capacity -1200 units
Actual production and sales – 800 units
Selling price per unit – Rs 15
Variable cost per unit – Rs 10
Fixed Cost:
A -1000
B -2000
C-3000
Capital structure Plan 1 Plan 2 Plan 3
Equity 5000 7500 2500
Debt (12% 5000 2500 7500

28. • Calculate operating and financial leverage
Unit sold 5000
Variable cost per unit Rs 20
10% public debt 1,00,000
EBIT Rs 30,000
Selling price per unit Rs 30
• A firm has a sales of Rs. 20,00,000. Variable cost is Rs. 14,00,000 and fixed cost Rs.
4,00,000 and the debt is Rs. 10,00,000 at 10% rate of interest. Find out the leverages.
• Calculate leverages from the following :
Production (units) 75,000
Fixed expenses 7,00,000
Variable cost (1 unit) 7.50
Interest expenses 40,000
Selling price (1 unit) 25.00

29. • The company’s current balance sheet is as follows :
The company's total assets turnover ratio is 3.0. its fixed operating
costs are Rs. 10,00,000 and variable operating cost 40%. The income
tax rate is 50%.
Compute for the company all the three types of leverages
Liabilities Assets
Equity capital 6,00,000 (Rs. 10 per share) Net fixed assets 15,00,000
10% long term loan 8,00,000 Current assets 5,00,000
Profit and loss a/c 2,00,000
Current liabilities 4,00,000

30. • The company had the following balance sheet as on 31-03-2006
Additionally,
Fixed cost per annum (excluding interest) – 8 cr
Variable operating cost ratio :65%
Total Asset turnover ratio – 2.5
Income tax rate – 40%
Find EPS and levrages
Liabilities Amount in Cr Assets Amount in Cr
Equity share
capital
(one crore shares
of 10 each)
10 Fixed 25
Reserves and
surplus
2 Current 15
15% debentures 20
Current liabilities 8
40 40

31. • Calculate the degree of operating leverage degree of financial
leverage for the following firms and interpret the results.
Particulars P Q R
Output (Units) 3,00,000 75,000 5,00,000
Fixed cost (Rs.) 3,50,000 7,00,000 75000
Unit variable cost
(Rs.)
1.00 7.50 0.10
Interest expenses
(Rs.)
25,000 40,000 nil
Unit selling price 3.00 25.00 0.50

32. • Calculate the degree of financial leverage for ‘J’ Ltd. Selling price is
Rs. 150. Variable cost is Rs. 100. Fixed cost Rs. 1,20,000.Interest on
debt Rs. 20,000. Tax 50%. Preference dividend Rs. 10,000, Output
10,000 units.