1. Leverages and Sharia Law
Department of Post Graduate Studies in Commerce,
Besant College, Mangalore
March 1, 2013

2. Leverage
• Leverage was a later name given to cost-
volume-profit analysis
• Costs were divided into fixed costs and
variable costs-the behaviour to the changes in
volume of production or sale
• Economists derived the concept called Break
Even Point contributing managerial decision-
making tool

3. BEP Chart

4. Limitation of the Analysis
• Relevant Range of Activity
• The classification of costs hold good upto a
given volume
• Beyond that, the fixed cost also becomes
variable
• Supervisor’s salary/Foremen’s Salary,
Depreciation on Machines, Factory Rent,
Project Cost itself

5. Different Analysis
• For economists, the cost and sales figures
represented by curves (curvy-linear) leading to
qualitative analysis
• For developing quantitative analysis, we treat
them as linear represented by straight lines
• In the early 1940s, many physics professors
tried to contribute to conversion of economic
laws into the precision of physics equations

6. CVP Analysis becomes Operating Leverage
• The physicists called the benefit derived
through the presence of fixed cost as leverage
• Leverage can be in operation or in the
sourcing of finance
• The benefit is an increase in sale resulting in a
higher increase in net operating income or
EBIT (operating leverage) and the higher net
income (EBIT) results in still higher Earning per
Share (EPS)

7. Significance of Operating Leverage
• Sales-Operating Profit (EBIT) Relation
• Role of Fixed Cost
• Measurement of Operating Risk

8. Statement of Income
Amount
Rs.
• Sales.... --------
• (-) Variable Cost.. ___________
Contribution....
• (-) Fixed Cost.... _____________
Operating Profit/Earning Before Interest
• And Tax (EBIT)
(-) Interest on Debt Securities Like
• Debentures, Bonds, Long Term Loans _____________
Earning Before Tax (EBT)
• (-) Tax ______________
Earning After Tax (EAT)
• (-) Preference Dividend ______________
Surplus Profit ______________

9. Computation of Operating Leverage
Contribution
Operating Leverage =----------------------
EBIT
%ofChangeinEBIT
DegreeofOp .Leverage
%ofChangeinSales

10. Calculation of Operating Leverage
• Calculate the operating leverage from the
following details:
Sales 10,000 units; Variable Cost Rs.7 per unit;
Price per unit Rs.10 and Fixed Cost –Rs.20,000.
With the help of operating leverage, calculate
the percentage of increase in EBIT for an increase
of 10% in sales

11. Financial Leverage
• Fixed cost in the operation creates a magnified impact
of change in sales on the operating profit (EBIT).
• In the same way, there is also a fixed factor on the
capital structure of the company.
• All the debt securities and preference shares are to be
paid the interest / dividend at a fixed rate.
• when EBIT increases, interest and dividend on
preference shares do not change consequently.
• The Earning per share (EPS) changes to a greater extent
for a given change in the operating profit (EBIT). This is
called Financial Leverage

12. Leverages
↑ Sales > ↑EBIT > ↑ EPS

13. Calculation of Financial Leverage
EBIT
FinancialLeverage
EBT
%ofchangeinEPS
DegreeofFL
%ofChamgeinEBIT

14. Computation of Financial Leverage
• Murthy Valves Ltd manufactures polyurethane
valves for industrial usage.
Utilized capacity 1,000 units; Selling prices Rs.
116 per unit; Variable Cost Rs. 56 per unit;
Fixed Cost Rs. 30,000; Interest on loan Rs.
10,000; Tax rate 50%
When the sales increases by 20%, 40% or 50%,
what will be the impact on Operating Profit
and EPS?

15. Leverages & Revisiting Equity Culture
• No Impact on Zero Debt Companies
• Irrelevant for Cash Rich Companies
• Recapitalisation of PSU Banks by Government in the
light of Basel Norms Compliance
• Debt is resorted as a Last Resort
• Loses significance in the light of Restructuring of
Companies
• Entry of Venture Capital, Private Equity and Angel
Investment
• Benefit of Listed Companies

16. Distortions in Financial Management
• Preference Shares form the first Distortion
• Comparison of Equity Shares and Debt on the basis
of cost of capital
• Ignorance of Adverse Impact of Leverages in case of
Losses
• Long-Term Debt
• Debt is not a source of finance, but a toxic element
of finance
• Asset Financing, oblivious of income
• Limited Liability Partnership

17. Sharia Law
• Holds that borrowing and lending form an immoral
practice
• Allows profit sharing and not interest payment
• Contributes to the principle of financial
management
• Basel Norms prescribe what is preached by Sharia
• Mutual Funds introduce Schemes based on Islamic
Investment principle
• RBI rejected Islamic Banking

18. Significance of Sharia Principles
• Avoidance of Risk Management and its Cost
• Absorbing the Risk
• In the long-run, avoidance of derivatives
• Saving the Banking System from Excesses
• Avoidance of Bankruptcy of Corporates
• Saving People from the Culture of Borrowing
• Accepting the Principle of losses borne by a
large number of shoulders

19. THANK YOU