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1. Advanced Financial Management

2. Session -2
LEVERAGES

3. What is Leverage?
RISK

4. LEVERAGES
• MEANING: Leverage refers to an increased
means of achieving some purpose
• Leverage allows us to accomplish certain
things which are otherwise not possible,
namely lifting of heavy objects with the
help of leverage.

5. Leverages
• In corporate finance the term Leverage applies
to the use of certain fixed costs that result in a
manifold increase in a firm’s profitability. For a
business firm, the lever is the fixed operating
cost and the fixed financing costs in the cost
structure of the firm.

6. TYPES OF LEVERAGES
Types of
leverages
Activity
Strutural
operating Financial combined

7. Operating leverage
A measurement of the degree to which a firm or project incurs a
combination of fixed and variable costs.
1. A business that makes few sales, with each sale providing a very
high gross margin, is said to be highly leveraged.
2. A business that makes many sales, with each sale contributing a
very slight margin, is said to be less leveraged.
3. As the volume of sales in a business increases, each new sale
contributes less to fixed costs and more to profitability.

8. The Operating Leverage can be calculated by
using the following Formula:-
• Operating Leverage = Contribution
Net Operating Income
• Degree of Operating Leverage =
Percentage Change in NOI
Percentage Change in Sales
Operating leverage deals with:
– Business risk
– Unavoidable risk
– Uncontrollable risk

9. FINANCIAL LEVERAGE
• Financial leverage: by using fixed cost financing, a small
change in operating income is magnified into a larger change
in earnings per share.
• Companies that are highly leveraged may be at risk of
bankruptcy if they are unable to make payments on their
debt;
• They may also be unable to find new lenders in the future.
Financial leverage is not always bad.
• It emphasizes the use of fixed-cost sources of financing (debt,
preferred stock) rather than variable-cost sources (common
stock).

10. The Financial Leverage can be calculated by
using the following Formula:-
• Financial Leverage = EBIT
EBT
• Degree of Financial Leverage =
Percentage Change in EPS
Percentage Change in EBIT
• Operating leverage deals with:
o Financial risk
o Avoidable risk
o Controllable risk

11. Financial Leverage of Ten Largest Indian
Companies, 2008

12. COMBINED LEVERAGE
• Combined leverage is a leverage which refers to high profits
due to fixed costs.
• Competitive firms choose high level of degree of combined
leverage whereas conservative firms choose lower level of
degree of combined leverage.
• Combined leverage: by using operating leverage and financial
leverage, a small change in sales is magnified into a larger
change in earnings per share.

13. The Combined Leverage can be calculated by
using the following Formula
• Combined Leverage =
Operating Leverage X Financial Leverage or,
Contribution / EBT
• Degree of Combined Leverage =
Percentage Change in EPS
Percentage Change in SALES

14. SALES EBIT EPS

15. SALES EBIT EPS

16. SALES EBIT EPS

17. EXAMPLE
• Based on the following information on Levered
Company, answer these questions:
1. Calculate operating leverage.
2. Calculate financial leverage.
3. Calculate combined leverage.

18. LEVERED COMPANY
Sales (100,000 units) Rs.1,400,000
Variable Costs Rs.800,000
Fixed Costs Rs.250,000
Interest paid Rs.125,000
Tax rate 34%
Common shares outstanding 100,000

19. OPERATING LEVERAGE
1,400,000 - 800,000
350,000
= 1.714
OLs =
=
Sales - Variable Costs
EBIT

20. FINANCIAL LEVERAGE
DFL =
EBIT
EBIT - I
=
350,000
225,000
= 1.556

21. COMBINED LEVERAGE
DCL =
Sales - Variable Costs
EBIT - I
1,400,000 - 800,000
225,000
= 2.667
=

22. Question 1:
A firm sells its products for Rs. 50 per unit, has
variable operating cost of Rs. 30 per unit and fixed
operating cost of Rs. 5000 per year. Its current level
of sales is 300 units.
• Determine the operating leverage.
• What will happen to EBIT if sales change
(a) Increase by 16.67%
(b) Decrease by 16.67%

23. Solution
Units: 300 units
Particulars Amount (Rs.)
Sales 15000
Less: Variable Cost 9000
Contribution 6000
Fixed Cost 5000
EBIT 1000
Contribution = 6000
EBIT 1000
= 6
(a)

24. Units: 250 units Units:350 units
Particulars Amount (Rs.) Amount (Rs.)
Sales 12500 17500
Less: Variable Cost 7500 10500
Contribution 5000 7000
Fixed Cost 5000 5000
EBIT 0 2000
(b)

25. • Lets practice some more examples…..

26. Question 2:
A firm selling price of its product is Rs.100 per
unit. The variable cost per unit is Rs.50 and the
fixed operating costs are Rs.50,000 per year. The
fixed interest expenses (non-operating) are
Rs.25,000 and the firm has 10,000 shares
outstanding. Tax rate = 35%.
Evaluate the EBIT/EPS resulting from sale of
(a) 2000 units
(b) 3000 units.

27. Solution
CASE I CASE II
Units: 2000 Units: 3000
Particulars Amount (Rs.) Amount (Rs.)
Sales 200000 300000
Less: Variable Cost -100000 -150000
Contribution 100000 150000
Fixed Cost -50000 -50000
EBIT 50000 100000
Less: Interest -25000 -25000
EBT 25000 75000
Less: Tax (35%) -8750 -26250
PAT 16250 48750
No. of Outstanding Equity Shares 10000 10000
Earnings Per Share 1.625 4.875

28. • Percentage change in EPS =
(4.875-1 .625) x 100 = 200%
1.625
• Percentage change in EBIT =
(100000-50000) x 100 = 100%
50000
• Degree of Financial Leverage:
Percentage change in EPS = 200 = 2
Percentage change in EBIT 100

29. Question 3:
Consider the following information for
Kaunark Enterprise
(a) Calculate all the leverages
(b) Calculate the % change in EPS, if the sales
increased by 5%
Rs in Lakh
Particulars Amount (Rs.)
EBIT 1120
PBT 320
Fixed Cost 700

30. Solution
Operating Leverage: = Contribution
EBIT
= 1120+700 = 1.625
1120
Financial leverage = EBIT
PBT
= 1120 = 3.5
320
Combined Leverage = Contribution
EBT
= 1120+700 = 5.6875
320

31. Calculation of the % change in EPS, if the
sales increased by 5%
Degree of Combined leverage =
% Change in EPS
% Change in Sales
5.687 = % Change in EPS
5
% Change in EPS = 5.687*5 = 28.44%

32. Question 4
If the combined leverage and operating leverage
figures of a company are 2.5 and 1.25 respectively,
find the financial leverage and P/V ratio, given that:
the
• Equity dividend per share is Rs. 2
• Interest payable per year is Rs. 1 lakh
• Total Fixed cost Rs. 0.5 lakhs
• Sales Rs. 10 lakhs

33. Solution
Combined Leverage = Operating leverage * financial
leverage
2.5 = 1.25 * financial leverage
Financial Leverage = 2.5 = 2
1.25
Financial Leverage = EBIT
EBT
= EBT + Interest
EBT
2 = EBT + 1,00,000
EBT
EBT = 1,00,000
Therefore EBIT = EBT + 1,00,000
=1,00,000 + 1,00,000 = 2,00,000

34. Operating leverage = Contribution
EBIT
1.25 = Contribution
2,00,000
Therefore, Contribution is Rs. 2,50,000
Therefore P.V. Ratio = Contribution * 100
Sales
= 2,50,000 * 100 = 25%
10,00,000

35. Question 5
Well established company’s balance sheet is as
follows
Liablities Amount(Rs.) Assets Amount(Rs.)
Equty Capital( Rs 10 per share) 60000 Net Fixed Assets 150000
10% long term debt 80000 Current Assets 50000
Retained Earnings 20000
Current liablities 40000
200000 200000

36. • Company’s total asset turnover ratio is 3; its
fixed asset operating cost are Rs. 1,00,000 and
the variable operating costs ratio is 40 per
cent. The income tax rate is 35%
a) Calculate all types of leverages
b) Determine the likely level of EBIT if EPS is
 Rs.1
 Rs. 3
 Zero

37. Solution
Particulars Amount (Rs.)
Sales 600000
Less: Variable Cost 240000
Contribution 360000
Fixed Cost 100000
EBIT 260000
Less: Interest 8000
EBT 252000
Less: Tax 88200
PAT 163800

38. Operating Leverage = Contribution
EBIT
= 600000-240000 = 1.38
260000
Financial leverage = EBIT
PBT
= 260000 = 1.03
252000
Combined Leverage : Contribution
EBT
= 1.38 * 1.03 = 1.42

39. • EPS = ( EBIT – I ) (1 – t)
N
 Rs. 1 = ( EBIT – 8000 ) (1 – 0.35)
6000
EBIT = Rs. 17,231
 Rs. 3 = ( EBIT – 8000 ) (1 – 0.35)
6000
EBIT = Rs. 35,692
 Rs. 0= ( EBIT – 8000 ) (1 – 0.35)
6000
EBIT = Rs. 8,000

40. Particulars Amount (Rs.) Amount (Rs.) Amount (Rs.)
EBIT 8000 17231 35692
Less: Interest 8000 8000 8000
EBT 0 9231 27692
Less: Tax 0 3231 9692
PAT 0 6000 18000
Number of shares 6000 6000 6000
EPS (NI+ N) 0 1 3

41. Question 6
The selected financial data for A, B & C companies for the
current year ended 31st March are as follows :
PARTICULARS A B C
Variable expenses as a percentage of sales 66.67 75 50
Interest expenses(Rs.) 200 300 1000
Degree of operating leverage 5 6 2
Degree of financial leverage 3 4 2
Income tax rate 0.35 0.35 0.35
a) Prepare income statements for A, B & C companies.
b) Comment on the finanacial position and structure of
these companies.

42. Solution
Income statement of companies A, B & C for
the current year, ended March 31
Particulars A B C
Sales 4500 9600 24000
Less: Variable Cost 3000 7200 12000
Contribution 1500 2400 12000
Fixed Cost 1200 2000 10000
EBIT 300 400 2000
Less: Interest 200 300 1000
EBT 100 100 1000
Less: Tax 35 35 350
PAT 65 65 650

43. • DFL = 3, DFL = EBIT
EBIT - 1
• Company A:
3= EBIT
EBIT – 200
EBIT = 300
DOL = Sales – Variable Costs
EBIT
5= S – 0.667S
300
S = Sales = Rs. 4500
VC = 0.667 x 4500 = Rs. 3000

44. • Company B:
4= EBIT
EBIT – 300
EBIT = 400
DOL = Sales – Variable Costs
EBIT
6= S – 0.75S
400
S= Sales = Rs. 9600
VC = 0.75 x 9600 = Rs. 7200

45. • Company C:
2= EBIT
EBIT – 1000
EBIT = 2000
DOL = Sales – Variable Costs
EBIT
6= S – 0.50S
2000
S= Sales = Rs. 24000
VC = 0.50 x 24000 = Rs. 12000

46. • Financial position of Company C can be regarded as
better than other companies.
• Least financial risk as minimum degree of financial
leverage.
• Company C is better placed from DCL point of view.
Total risk of Company C is lowest.
• Ability of Company C to meet its interest liability is
better.
Company EBIT/Interes t Value
A 2000/1000 2
B 300/200 1.5
C 400/300 1.33

47. Question 7
• Mr. Nitesh is an entrepreneur and has recently
set up manufacturing unit of pens. He currently
sells 1million pens in a year at Rs 5 each. His
variable cost is Rs. 3 per pen and he has Rs. 15
lakhs in fixed costs. His sales to assets ratio is
5times and 40% of his assets are financed with
8%debt with the balance being financed by
ordinary shares of Rs. 10 per share. Tax rate is
35%.

48. His newly appointed finance manager Mr.
Vinit Shah thinks that Mr. Nitesh is doing
it all wrong. By reducing his price to Rs.
4.50 per pen he could increase his sales
volume by 40%. Fixed costs would remain
constant and variable costs at Rs. 3 per
unit. His sales to asset ratio would be 6.3
times. Furthermore he could increase his
debt to asset ratio to 50%, with the
balance in shares. It is assumed that
interest rate would be up by 1% and that
price of shares would remain constant.

49. A. Compute the EPS under the Nitesh and
Vinit plans. Is Mr. Vinit’s perception right?
B. Mr. Nitesh’s partner Miss Hemanti does not
think that fixed costs would remain
constant under Vinit’s plan but they would
go up by 15% . If this is the case should Mr
Nitesh shift to Vinit’s plan, based on EPS?
C. What is the effect of total risk on the firm
on switching from one plan to another?

50. Solution
Particulars Amount(Rs.)
Nitesh’s Plan:
Sales Revenue(1 million * Rs 5) 5000000
Less: Variable Cost(1 million* Rs.3) 3000000
Contribution 2000000
Less: Fixed Cost 1500000
EBIT 500000
Less: Interest 32000
PBT 468000
Less : Tax(0.35) 163800
PAT 304200
N( numbers of Shares) 60000
EPS 5.07

51. Particulars Amount(Rs.)
Vinit’s Plan:
Sales Revenue(1million * 1.4* Rs 4.5) 6300000
Less: Variable Cost(1million * 1.4* Rs.3) 4200000
Contribution 2100000
Less: Fixed Cost 1500000
EBIT 600000
Less: Interest 45000
PBT 555000
Less: Tax(0.35) 194250
PAT 360750
N( numbers of Shares) 50000
EPS 7.215

52. Working note 1 :
Sales / Assets = 5
Rs 50 lakh/ Assets =5 or Assets Rs.10 Lakhs
40% of assets financed by 8% debt= Rs. 4 lakh
Interest (0.08* Rs.4 lakh)= Rs.32000
Number of shares (Rs. 6 lakh/Rs. 10 each share)=60,000
Working Note 2:
Total Assets =Rs.10 lakh
Debt/Assets = 50%
Debt = Rs. 5 lakh at 8% + 1% =9%
Interest = 0.09 * Rs.5 lakh = Rs. 45,000
Number of shares (Rs.5 lakh / Rs.10) = 50,000
Yes, Mr Vinit is right in his perceptions. Following his plan
would increase the EPS to Rs.7.22 from Rs.5.07

53. (c) Computation of EPS
The total risk is determined by the combined leverage which in turn is
evaluated by combined operating and financial leverage.
Nitesh’s plan : Vinit’s plan :
DOL = Contribution = 20 L = 4 DOL =Rs. 21 L
EBIT 5 L
DFL = 6 L
DFL =EBIT = 5L 6 L – 0.45L
EBIT-I 5L – 0.32L
DCL = DOL*DFL = 3.78
DCL = DOL * DFL = 4.27
There is decrease in degree in the combined leverage , reflecting a decline in
the total risk of the company. With a lower degree of risk , the market price
of its share is likely to go up.