Financial and Operating Leverage

Capital Structure Defined The term capital structure is used to represent the proportionate relationship between debt and equity. The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firm’s capital expenditure.

Meaning of Financial Leverage The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure, is described as financial leverage or gearing or trading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners’ equity. The rate of return on the owners’ equity is levered above or below the rate of return on total assets.

The relationship between EBIT and EPS ABC company has currently an ordinary share capital of Rs25.lac,consisting of 25,000 shares of Rs.100 each. The management is planning to raise another Rs20 lac to finance a major programme of expansion through one of four possible financial plans. The options are : Entirely through ordinary shares Rs.10lac through ordinary shares and Rs 10 lac through long-term borrowing at 8%interest pa. Rs.5lac through ordinary shares and Rs 15 lac through long-term borrowing at 9%interest pa. Rs.10lac through ordinary shares and Rs 10 lac through Preference shares at 5% dividend. The company’s expected EBIT will be Rs8 lac. Assuming a corporate tax rate of 50%, determine the EPS in each alternative, and comment on the implication of financial leverage.

particulars proposal1 propoasl2 proposal3 proposal4 EBIT 8,00,000 Less:Interest - 80,000 1,35,000 EBT 7,20,000 6,65,000 Less: Tax 50% 4,00,000 3,60,000 3,33,000 EAT 3,32,000 Less: Prefer. Dividend 50,000 Earnings to Equity holders 4,40,000 4,67,500 3,50,000 No. of Eq.shares 45,000 35,000 30,000 EPS Rs.8.88 Rs.12.57 Rs.15.58 Rs.10.00

Proposal 3 gives highest EPS Proposal 3 gives highest EPS. Because interest is exempted from tax and borrowers are not owners, they will not interfere in the management decisions

The company is in the 35% tax bracket Determine the firms EPS. Determine the EPS of a textile company which has EBIT of Rs.1,60,000. Its capital structure consists of the following securities. The company is in the 35% tax bracket Determine the firms EPS. Determine the % change in EPS with 30% increase and 30% decrease in EBIT. Securities Amount 10% Debenture 5,00,000 12% Preference shares 1,00,000 Equity shares(Rs.100 each) 4,00,000

-------*100 = -------------- *100 = 28.49% EPS 27.37 For 30% increase: ∆EPS 35.17-27.37 -------*100 = -------------- *100 = 28.49% EPS 27.37

Operating Leverage Operating leverage affects a firm’s operating profit (EBIT). The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales.

Operating Leverage Calculate operating leverage from the following information. Interest Rs.5,000, Sales Rs.50,000, Variable cost Rs.25,000, Fixed cost Rs.15,000 sales-VC DOL = ------------- EBIT

EBIT = Sales-VC-FC(other than interest) 50,000-25,000-10,000 = 15,000 50,000-25,000-10,000 = 15,000 Contribution DOL = ---------------- EBIT 50,000-25,000 DOL = ----------------------- =1.67 15,000

The installed capacity of a factory is 600 units The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling price per unit is Rs.10. Variable cost is Rs.6 per unit. Calculate the Operating leverage in each of the following three situations. When F.C are Rs.400 When F.C are Rs.1000 When F.C are Rs.1200

Statement showing operating leverage Particulars Situation 1 Situation 2 Situation 3 SALES 4,000 Less : VC 2,400 CONTRIBUTION 1,600 Less: FC 400 1,000 1,200 OPERATING PROFIT 600 OPERATING LEVERAGE 1,600/1,200 =1.33 1600/600 =2.67 1600/400 =4 Degree of operating leverage increases with increase in share of fixed cost in the total structure of the firm.

Financial Leverage It is also known as trading on equity. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earning per share. Walter defines “FL may be defined as percentage return on equity to the percentage return on capitalization”.

Degree of Financial Leverage A company has the following capital structure: The present EBIT is Rs.50,000. Calculate the financial leverage assuming the company is in 50% tax bracket. Equity share capital 1,00,000 10% preference share 1.00,000 8% debt 1,25,000

Solution EBIT Financial leverage = ---------- PBT 50,000 30,000 Particulars Rs. EBIT 50,000 Less: Interest on debt 10,000 40,000 Less: Preference dividend 30,000

Problem 2 A company has a choice of the following three financial plans. You are required to calculate the financial leverage in each case and interpret. Particulars X Y Z Equity 2,000 1,000 3,000 Debt EBIT 400 Interest @ 10 on Debt in all cases

The financial leverage will be computed as follows in case of each of these financial plans.hat It indicates the change that will take place in the taxable income as a result of change in the operating income. Particulars X Y Z EBIT 400 Less: Interest 200 300 100 PBT FL=EBIT/PBT 400/200 = 2 400/100 = 4 400/300 = 1.33

Combining Financial and Operating Leverages Operating leverage affects a firm’s operating profit (EBIT), while financial leverage affects profit after tax or the earnings per share. The degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales.

Combined or composite leverage CL = Operating Leverage * Financial Leverage. Calculate DOL, DFL, Combined leverage. Particulars X Y Z Output(units) 60,000 15,000 10,000 FC 7,000 14,000 1,500 VC per unit .20 1.50 .02 Interest on Borrowed funds 4,000 8,000 - Selling price per unit .60 5 .10

Calculate Financial, operating and combined leverage Sales: Rs.50,000 VC: Rs.25,000 Interest: Rs.5,000 FC: 15,000

Calculate Financial, operating and combined leverage Units sold: 30,000 Unit sale price: Rs.10 FC: Rs.40,000 VC per unit Rs.6 10% debt capital Rs. 1,00,000 Tax rate:50%

OL:1.5 FL:1.14 CL: 1.71