University 18 Lessons Financial
Management
Unit 7: Financial and Operating
Leverage
Approaches to Determine
Appropriate Capital Structure
What is Capital Structure
• 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.
Capital Structure Decision
• In theory there is an optimal capital structure which depends
on the tax advantage of debt, the financial distress costs and
agency costs associated with debt, and the degree of
informational asymmetry.
• How can the optimal capital structure be determined in
practice?
• There does not appear to be any single method. Different
types of analysis include:
• EBIT-EPS analysis
• ROI-ROE analysis
• Ratio analysis
• Cash flow analysis to assess firm’s debt servicing ability
EBIT-EPS analysis
• In general, the relationship between EBIT and EPS is
as follows:
(EBIT – I) (1 – t)
• EPS = ------------------------ , where
n
EPS = earning per share
EBIT = earnings before interest and taxes
I = interest burden
t = tax rate
n = number of equity shares
Example: EBIT-EPS analysis
• ABC Limited has an existing capital structure of 1 million
shares of Rs.10 each and is subject to a tax rate of 50%.
• ABC Limited plans to raise additional capital of Rs.10 million
for financing an expansion project.
• In this context ABC Limited is evaluating two alternative
financing plans: (i) issue of equity shares (1 million equity
shares of Rs.10 per share), and (ii) issue of debentures
carrying 14% interest.
• What will be the EPS under the two alternative financing
plans for two levels of EBIT, say Rs.4 million and Rs.2 million?
Example: EBIT-EPS analysis
Equity Financing
Debt Financing
EBIT: 2,000,000 EBIT: 4,000,000
Interest
EBIT: 2,000,000
EBIT:
4,000,000
1,400,000
1,400,000
-
-
Profit before
taxes
2,000,000
4,000,000
600,000
2,600,000
Taxes
1,000,000
2,000,000
300,000
1,300,000
Profit after tax
1,000,000
2,000,000
300,000
1,300,000
No. of equity
shares
2,000,000
2,000,000
1,000,000
1,000,000
0.50
1.00
0.30
1.30
EPS
Break-even EBIT Level or Indifference Point
• The EBIT indifference point between the two alternative plans
can be obtained by solving the following equation for EBIT:
(EBIT* - I1)(1-t)
(EBIT* - I2)(1-t)
--------------------- = --------------------- . Taking the ABC case
n1
n2
(EBIT* - 0)(0.5)
(EBIT* - 1,400,000)(0.5)
--------------------- = -------------------------------2,000,000
1,000,000
Or EBIT* = Rs. 2,800,000
This break-even level of EBIT at Rs.2.80 million means that if
EBIT is below Rs.2.8 million, equity financing is preferable to
debenture financing; while if EBIT is higher than Rs.2.8
million, then it is the other way around.
ROI-ROE Analysis
• We now look at the relationship between return on
investment (ROI) and return on equity (ROE) at
different levels of financial leverage.
• Suppose a firm, which requires an investment outlay
of Rs.100 million, is considering two capital
structures: Capital Structure A (only funded by Equity
of Rs.100 million), and Structure B (funded by Equity
of Rs.50 million and Debt of Rs.50 million).
• While the average cost of debt is fixed (say 10%), the
ROI (as defined by EBIT divided by total assets) may
vary widely.
ROI-ROE Analysis
Rs. In million
Capital Structure A
Capital Structure B
ROI
5%
10%
15%
20%
25%
5%
10%
15%
20%
25%
EBIT
5
10
15
20
25
5
10
15
20
25
Interest
0
0
0
0
0
5
5
5
5
5
Profit Before Tax
5
10
15
20
25
0
5
10
15
20
Tax (50%)
2.5
5
7.5
10
12.5
0
2.5
5
7.5
10
Profit After Tax
2.5
5
7.5
10
12.5
0
2.5
5
7.5
10
Return of Equity
2.5%
5%
7.5%
10%
12.5%
0%
5%
10%
15%
20%
ROI-ROE Analysis
• The ROE under capital structure A is higher than the
ROE under capital structure B when ROI is less than
the cost of debt
• The ROE under the two capital structures is the same
when ROI is equal to the cost of debt. Hence the
indifference (or break-even) value of ROI is equal to
the cost of debt.
• The ROE under capital structure B is higher than the
ROE under capital structure A when ROI is more than
the cost of debt.
Effect of Leverage on ROE and EPS
Favourable
ROI > i
Unfavourable
ROI < i
Neutral
ROI = i
Financial & Operating Leverage
Operating Leverage
• The operating costs are categorised into three:
• One - fixed costs, which do not vary with the level of
production, they must be paid regardless of the
amount of revenue available. Example, depreciation
of plant and machinery, buildings, insurance
• Second - variable costs that varies directly with the
level of production. Example, raw materials, direct
labour costs, etc.
• Third - Semi-variable costs, which partly vary and is
partly fixed.
Operating Leverage
• Operating Leverage is present at any time. This is
because a firm has operating costs regardless of the
level of production. These fixed costs do not vary
with sales. They must be paid regardless of the
amount of revenue available.
• Hence, operating leverage may be defined as the
firm's ability to use operating costs to magnify the
effects of changes in sales on its earnings before
interest and taxes.
• Operating leverage is associated with investment
(assets acquisition) activities. Hence, operating
leverage results from the present fixed operating
expenses within firm's income stream.
Operating Leverage
Operating Leverage
• Illustration : XYZ Ltd., produced and sold 1,00,000
units of a product at the rate of Rs.100. For
production of 1,00,000 units, it has spend a variable
cost of Rs. 6,00,000 at the rate of Rs. 6 per unit and a
fixed cost of Rs. 2,50,000. The firm has paid interest
Rs. 50,000 at the rate of 5 per cent and Rs. 10,00,000
debt. Calculate operating leverage.
Operating Leverage
Operating Leverage
Operating Leverage
Financial Leverage
• A firm needs long-term funds for long-term activities like
expansion, diversification, modernization etc. The required
funds may be raised by two sources: equity and debt. Use of
various sources to compose capital is known as financial
structure. The use of fixed charges, sources of funds such as
debt and preference share capital, along with the equity share
capital in capital structure is described as financial leverage.
• Financial leverage is the ability of the firm to use fixed
financial charges to magnify the effects of changes in EBIT on
the firm's earnings per share. In other words, financial
leverage may be defined as the payment of fixed rate of
interest for the use of fixed interest bearing securities, to
magnify the rate of return on equity shares. It is also known as
"trading on equity".
Financial Leverage
• Hence, financial leverage results from the presence
of fixed financial charges in the income statement.
Financial leverage is associated with financing
activities. The fixed charges do not vary with firm's
EBIT. They must be paid regardless of the amount of
EBIT available to the firm. It indicates the effect on
EBIT created by the use of fixed charge securities in
the capital structure of a firm.
• Financial leverage is computed by the following
formula:
Financial Leverage
Financial Leverage
• A Financial leverage may be positive or negative.
Favourable leverage occurs when the firm earns
more on the assets purchased with the funds, than
the fixed cost of their use and vice versa.
• High degree of financial leverage leads to high
financial risk. The financial risk refers to the risk of
the firm not being able to cover its fixed financial
costs.
• Hence, the financial manager should take into
consideration, the level of EBIT and fixed charges
while preparing the firm's financial plan.
Financial Leverage
• Illustration: A firm has sales of 1,00,000 units at Rs.
10 per unit. Variable cost of the produced products is
60 per cent of the total sales revenue. Fixed cost is
Rs. 2,00,000. The firm has used a debt of Rs.
5,00,000 at 20 per cent interest. Calculate the
operating leverage and financial leverage.
• Operating leverage = Contribution/ EBIT = 4,00,000/
2,00,000 = 2
• Financial leverage = EBIT/EBT = 2,00,000/ 1,00,000 =
2
Financial Leverage
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.
Combining Financial and Operating
Leverages
• The degree of combined leverage (DCL) is given by the
following equation:
Combining Financial and Operating
Leverages
• The combined leverage can work in both directions. It is
favourable if sales increase and unfavourable when sales
decrease. This is because the change in sales results in more
than proportionate returns in the form of EPS. Financial
leverage and operating leverage are something like a doubleedged sword. They have tremendous acceleration or
deceleration effects on EBIT and EPS.
• Illustration: VST Corporation has sales of Rs. 40 lakh, variable
cost is 70 per cent of the sales and fixed cost is Rs.8,00,000.
The firm has raised Rs.20 lakh funds by issue of debentures at
the rate of 10 per cent. Compute operating, financial and
combined leverages.
Combining Financial and Operating
Leverages
Combining Financial and Operating
Leverages
• Illustration: From the following particulars of PQR Company,
calculate operating and financial leverages. The company's
current sales revenue is Rs. 15,00,000 lakh and sales are
expected to increase by 25 per cent. Rs. 9,00,000 is incurred
on variable expenses for generating Rs.15 lakh sales revenue.
The fixed cost is Rs. 2,50,000. The company has Rs. 20 lakh
equity shares capital and Rs. 20 lakh, 10 per cent debt capital.
Calculate operating leverage and financial leverage. Each
equity share is of Rs. 10 face value and 50 per cent tax rate.
• Ans: A % change in EPS is 100% while % change in sales is
25%, the combined leverage is 4.
Combining Financial and Operating
Leverages