CHAPTER 14
FINANCIAL AND OPERATING LEVERAGE
Q.1
Explain the concept of financial leverage. Show the impact of financial leverage
on the earnings per share.
A.1
The use of fixed-charges sources of funds, such as debt and preference capital,
along with owners’ equity in the capital structure is known as financial leverage
(or gearing or trading on equity). The financial leverage employed by a company
is intended to earn more on the fixed charges funds than their costs. The surplus
will increase the return on the owners’ equity.
The role of financial leverage in magnifying the return of the shareholders’ is
based on the assumptions that the fixed-charges funds (such as the loan from
financial institutions and other sources or debentures or bonds) can be obtained at
a cost lower than the firm’s rate of return on net assets. So, when the difference
between the earnings generated by assets financed by the fixed-charges funds and
costs of these funds is distributed to the shareholders, the earnings per share (EPS)
(or return on equity, ROE) increases. EPS is calculated by dividing profits after
tax (PAT) (net of preference dividend) by the number of shares outstanding.
Example:
All-equity
Debt-equity
500,000
500,000
500,000
250,000
0
250,000
120,000
120,000
0
37,500
120,000
82,500
60,000
41,250
------------8.
PAT
60,000
41,250
9.
No. of equity shares
50,000
25,000
10.
EPS (5 ÷ 6)
1.20
1.65
This indicates that EPS increases as debt in introduced in the capital structure.
1.
2.
3.
4
5.
6.
7.
Q.2
Investment
Equity capital
Debt capital @ 15%
EBIT
Less: Interest
PBT
Less: Taxes @ 50%
Does financial leverage always increase the earnings per share? Illustrate your
answer.
Q.2
The earnings per share will increase if return on assets is higher than the interest
cost, and EPS will reduce if return on assets is lower than the interest cost. The
EPS will not be affected by the level of leverage if return on assets just equal to
the interest cost.
Example:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11
12
Q.3
No Debt
50% Debt
75% Debt
(Rs.)
plan (Rs.)
plan (Rs.)
Investment
500,000
500,000
500,000
Equity capital
500,000
250,000
125,000
Debt capital @ 15%
0
250,000
375,000
EBIT
120,000
120,000
120,000
Interest
0
37,500
56,250
PBT
120,000
82,500
63,750
Taxes @ 50%
60,000
41,250
31,875
PAT
60,000
41,250
31,875
No. of equity shares
50,000
25,000
12,500
EPS (8 ÷ 9)
1.20
1.65
2.55
ROI
24%
24%
24%
ROE
12%
16.5%
25.5%
What is financial risk? How does it differ from business risk? How does the use
of financial leverage result in increased financial risk?
A.3
The variability of EBIT and EPS distinguish between two types of risk - operating
risk and financial risk. Operating risk or business risk can be defined as the
variability of EBIT on account of variability of sales and expenses. The
fluctuation of sales happens on account of general economic conditions, events in
related product lines, and boom or recession in industry. The variability of
expenses may include variability in prices of factors of production, technological
changes, etc.
For a given degree of variability of EBIT, the variability of EPS (or ROE)
increases with more financial leverage. The variability of EPS caused by the use
of financial leverage is called financial risk. Firms exposed to same degree of
operating risk can differ with respect to financial risk when they finance their
assets differently. A totally equity financed firm will have no financial risk. But
when debt is used, the firm adds financial risk. The operating risk is unavoidable,
while financial risk is avoidable.
Financial leverage magnifies the shareholders’ earnings. The variability of EBIT
causes EPS to fluctuate within wider ranges with debt in the capital structure.
That is, with more debt, EPS rises and falls faster than the rise and fall in EBIT.
Example:
Situation 1
Situation 2
Situation 3
Rs
Rs
Rs
1.
EBIT
100,000
120,000
80,000
2.
Less Interest
40,000
40,000
40,000
3.
EBT (PBT)
60,000
80,000
40,000
4.
Taxes @ 50%
30,000
40,000
20,000
5.
PAT
30,000
40,000
20,000
6.
No. of equity shares
50,000
50,000
50,000
7.
EPS
0.60
0.80
0.40
Above example indicates that at the same level of debt-equity ratio in the capital
structure of the firm, the EPS rises by increases in EBIT, and falls by decreases in
EBIT.
Q.4
If the use of financial leverage magnifies the earnings per share under favorable
economic conditions, why companies do not employ very large amount of debt in
their capital structures?
A.4
Financial leverage works both ways. It accelerates EPS (and ROE) under
favorable economic conditions, but depresses EPS (and ROE) when the going are
not good for the firm. The favorable effect of the increasing financial leverage
during normal and good years is on account of the fact that the rates of return on
assets exceed the cost of debt. From, the table explained in A. 3 above, it is clear
that favorable economic condition (i.e., increase in EBIT in situation 2)
accelerated EPS, while unfavorable economic condition (i.e., decrease in EBIT in
situation 3) depressed EPS. Generally, companies do not employ very large
amount of debt on account of business risk i.e., variability in sales and expenses,
which is unpredictable with accuracy.
Q.5
What is an EBIT-EPS analysis? Illustrate your answer.
A.5
In practice, EBIT for any firm is subject to various influences on account of
fluctuations in the economic conditions, sales, expenses, etc. The EBIT-EPS
analysis helps to find out the impact of financial leverage on EPS (and ROE) for
possible fluctuations in EBIT.
Example: (A) Debt 60%, Equity 40%
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
EBIT
Capital Employed
Debt Capital @ 15%
Interest
P.B.T (1-4)
Taxes @ 50%
PAT
No. of equity shares
EPS (7 ÷ 8)
R.O.I (EBIT/CE)
Situation
1 (poor)
50,000
500,000
300,000
45,000
5,000
2,500
2,500
20,000
0.125
.10.0%
Situation
2 (Normal)
75,000
500,000
300,000
45,000
30,000
15,000
15,000
20,000
0.75
15.0%
B:
Assume Debt 90%, and Equity 10%
1.
EBIT
50,000
75,000
2.
Interest @ 15%
67,500
67,500
3.
PBT
(17,500)
67,500
4.
Taxes @ 50%
8,750*
3,750
5.
PAT
(8,750)
3,750
6.
No. of equity shares
5,000
5,000
7.
E.P.S.
(1.75)
0.75
8.
R.O.I (EBIT/CE)
10.0%
15.0%
*Assumed that losses will be set off against other profits
Situation
3 (Good)
100,000
500,000
300,000
45,000
55,000
27,500
27,500
20,000
1.375
20.0%
100,000
67,500
32,500
16,250
16,250
5,000
3.25
20.0%
Above two financial plans, indicates that higher financial leverage works
adversely when firm face the unfavorable economic conditions.
Q.6
What is an indifference point in the EBIT-EPS analysis? How would you compute
it?
A.6
The relationship between EBIT and EPS for the alternative financial plans can be
depicted in graphical way, in the form of EBIT-EPS chart. The chart is easy to
prepare since, for any given level of financial leverage, EPS is linearly related to
EBIT. In the chart, EBIT is shown on a horizontal line and EPS on vertical line.
We can draw EBIT-EPS line for all different financial plans. The point of
intersection of all financial plans lines in short indicates the ‘Indifference point’ at
which EPS is same regardless of the level of financial leverage.
The firm wants to know the level of EBIT at which EPS would be same under two
alternative plans. It can be worked out by using following formula:
EBIT(1 − T) (EBIT − INT)(1 − T)
=
N1
N2
where N1 is the number of equity share under first plan and N2 is the number of
equity shares under second plan.
Example:
The firm is considering two financial plans, viz. an all equity plan, and a plan with
1:3 debt-equity ratio. Assume total finance need is Rs. 500,000 and debt interest
@ 10%. Using the above values, we can determine the level of EBIT at which
EPS of both plan is same. Also, assume tax rate 50% and FV of share Rs. 10.
EBIT (1 − 0.50) (EBIT − 12500)(1 − 0.50)
=
50,000
37,500
 37500 
∴ 0.50EBIT
 = 0.50EBIT − 6250
 50000 
∴ 0.375EBIT − 0.50EBIT = −6,250
EBIT = 50,000
Verify: At EBIT of Rs. 50,000. The EPS of each plan:
∴
50,000(1 − 0.50) (50,000 − 12500)(1 − 0.50)
=
50,000
37,500
0.50 = 0.50
Q.7
Explain the merits and demerits of the various measures of financial leverage.
A.7
The most commonly used measures of financial leverage are:
1. Debt ratio: The ratio of debt to total capital, i.e.,
L1 =
D
D
=
D+E V
2. Debt–equity ratio: The ratio of debt to equity, i.e.,
L2 =
D
E
3. Interest coverage: The ratio of net operating income to interest
charges,
L3 =
EBIT
Interest
The first two measures of financial leverage can be expressed either in terms of
book values or market values. The market value to financial leverage is
theoretically more appropriate because market values reflect the current attitude
of investors. But it is difficult to get reliable information on market values in
practice. The market values of securities fluctuate quite frequently.
There is no difference between the first two measures of financial leverage in
operational terms. These relationships indicate that both these measures of
financial leverage will rank companies in the same order. However, the first
measure (i.e. D/V) is more specific as its value will range between zero to one.
The value of the second measure (i.e. D/E) may vary from zero to any large
number. The debt-equity ratio, as a measure of financial leverage, is more popular
in practice. There is usually an accepted industry standard to which the
company’s debt–equity ratio is compared.
The first two measures of financial leverage are also measures of capital gearing.
They are static in nature as they show the borrowing position of the company at a
point of time. These measures, thus, fail to reflect the level of financial risk,
which is inherent in the possible failure of the company to pay interest and repay
debt.
The third measure of financial leverage, commonly known as coverage ratio,
indicates the capacity of the company to meet fixed financial charges. The
reciprocal of interest coverage, that is, interest divided by EBIT, is a measure of
the firm’s income gearing. Again by comparing the company’s coverage ratio
with an accepted industry standard, investors can get an idea of financial risk.
However, this measure suffers from certain limitations. First, to determine the
company’s ability to meet fixed financial obligations; it is the cash flow
information, which is relevant, not the reported earnings. During recessionary
economic conditions, there can be wide disparity between the earnings and the net
cash flows generated from operations. Second, this ratio, when calculated on past
earnings, does not provide any guide regarding the future riskiness of the
company. Third, it is only a measure of short-term liquidity than of leverage.
Q.8
Define operating and financial leverage. How can you measure the degree of
operating and financial leverage? Illustrate with an example.
A.8
Operating leverage refers to the use of fixed costs in the operation of a firm, and it
accentuates fluctuations in the firm’s operating profit due to changes in sales.
Thus, the degree of operating leverage may be defined as the percentage change
in operating profit (EBIT) on account of change in sales.
DOL =
∆EBIT Sales
×
EBIT ∆Sales
Or
DOL =
Contribution
EBIT
The financial leverage refers to the use of fixed charges capital like debt with
equity capital in the capital structure. The main reason for using financial leverage
is to increase the shareholders’ wealth/return.
The percentage of change in EPS occurring due to a given percentage change in
EBIT is referred to as degree of financial leverage (DFL).
% Change in EPS
DFL = ------------------% change in EBIT
=
∆EPS EBIT
×
EPS ∆EBIT
DFL =
EBIT
EBIT − INT
For example, the expected sales volume of firm is 100,000 units. The selling price
Rs 8 per unit, the variable cost per unit Rs. 4; fixed operating charges Rs. 280,000
and fixed financial charges Rs. 50,000.
Contribution
-----------EBIT
DOL =
Sales Volume (S.P. – V.C)
---------------------------------------Contribution – Fixed Operating Charges
=
=
1,00,000(8 − 4)
4,00,000
=
= 3.33
4,00,000 − 2,80,000 1,20,000
This indicates that EBIT will change by 3.33 times, for given change in sales.
DFL =
=
EBIT
EBIT − INT
1,20,000
1,20,000
=
= 1.71
1,20,000 − 50,000
70,000
This indicates that EPS will change by 1.71 times, for given change in EBIT.
Q.9
What is the degree of combined leverage? What do you think is the appropriate
combination of operating and financial leverage?
A.9
The degrees of operating and financial leverages can be combined to see the
effects of total leverage on EPS associated with a given change in sales. The
degree of combined leverage can be calculated as under:
DCL =
% of change in EBIT
% of change in EPS
----------------------× --------------------% of change in Sales
% of change in EBIT
% of change in EPS
=
--------------------= DFL × DOL
% of change in Sales
Operating leverage and financial leverage together cause wide fluctuation in EPS
for a given change in sales. If a company employs a high level of operating
leverage and financial leverage, even a small change in the level of sales will have
dramatic effect on EPS.
The appropriate combination should be governed by the behaviour of sales. The
public utilities such as Electricity Companies can afford to combine high
operating leverage with high financial leverage since they generally have stable or
rising sales. A company whose sales fluctuate widely and erratically should avoid
use of high financial leverage since it will be exposed to a very high degree of
risk.