1. Meaning of leverage:
• Leverage means use of assets and various sources of funds having fixed cost in order to
increase the potential returns to shareholders.
• The term leverage, in general, refers to the relationship between two
interrelated variables. In financial matters, one financial variable influences another
variable. Those financial variables may be cost, sales revenue, earnings before interest
and tax (EBIT), output, earning per share, etc.
Variability of EBIT – Operating Risk: arises due to variability of sales and variability of
expenses.
Variability of EPS – Financial Risk: arises due to the impact of interest charges.
2. Define the term leverage?
• James Horne has defined
leverage as “the employment of
an asset or funds for which the
firm pays a fixed cost or fixed
return”.
3. What are the different kinds of leverages? Explain.
• There are three commonly used measures of leverage in financial analysis.
1. Operating leverage
2. Financial leverage
3. Combined leverage
5. Operating Leverage:
• Operating leverage is defined as the “firm’s ability to use fixed operating costs to magnify effects of
changes in sales on its earnings before interest and taxes”.
• A change in sales will lead to a change in profit i.e. Earnings before Interest and Taxes (EBIT). The
effect of change in sales on EBIT is measured by operating leverage. Since fixed costs remain the
same irrespective of level of output, percentage increase in EBIT will be higher than increase in
Sales. If the contribution is more than the fixed cost, it is said to be favourable one.
• Formula
Contribution
Operating Leverage = -------------------------------
EBIT or Operating Profi
6. CONT…
% Change in EBIT
• Degree of operating leverage (DOL) = ---------------------------
% Change in Sales
•
Contribution = Sales – Variable Cost
Operating profit OR EBIT = Sales – Variable cost – Fixed cost
7. Financial Leverage:
• Financial Leverage is defined as the ability of a firm to use fixed financial charges
(interest) to magnify the effects of changes in EBIT / Operating profits, on the
firm’s Earning per share (EPS).
• Financial Leverage occurs when a company has debt content in its capital structure
and fixed financial charges e.g. interest on debentures. These fixed financial
charges do not vary with the EBIT. They are fixed and are to be paid irrespective of
level of EBIT. Hence an increase in EBIT will lead to a higher percentage increase
in Earnings per share (EPS).
8. CONT….
• This is measured by the Financial Leverage.
EBIT (or) OP
• Financial Leverage = -------------------------------
EBT (or) PBT
% Change in EPS
• Degree of Financial Leverage (DFL) = -------------------------
% Change in EBIT
Earnings before Interest and tax [EBIT] = Sales – Variable cost – Fixed cost
Earnings before tax [EBT] = EBIT - Interest
Earnings per share (EPS) = Profits available to equity shareholders / No. of equity shares
9. Combined Leverage or Composite Leverage:
• Combined Leverage is used to measure the total risk of a firm = Operating risk + Financial risk.
• Effect of fixed operating costs (i.e. Operating Risks) is measured by Operating Leverage
(DOL). Effect of fixed interest charges (i.e. Financial Risks) is measured by Financial Leverage
(DFL). The combined effect of these is measured by Combined Leverage (DCL).
• Combined leverage = Operating leverage × Financial leverage
% Change in earning per share
• Degree of Composite Leverage (DCL) = -----------------------------------
% Change in Sales
10. DIVIDEND DECISION
• The term dividend refers to that part
of the net profits of a company
which is distributed amongst its
shareholders after execution of
retained earnings. It is the reward of
the shareholders for investments
made by them in the shares of the
company.
11. Definition:
• According to the Institute of Chartered
Accountants of India, “ A dividend is a distribution
to shareholder out of profits or reserves available for
this purpose”.
12. What are the sources available for dividends?
1. Earnings from regular operations
2. Earnings accumulated from previous years
3. Income from subsidiaries
4. Profit from the sale of appreciated property
5. Conversion of redundant reserves
6. Surplus from mergers and purchase of subsidiaries
7. Revaluation of assets
8. Surplus earned by reduction in capital stock
9. Donated surplus
10. Sale of securities at a premium
13. What are the forms of Dividend?
• Dividends can be classified in various forms.
Dividends paid in the ordinary course of business are
known as Profit dividends, while dividends paid out
of capital are known as Liquidation dividends.
Dividends may also be classified on the basis of
medium in which they are paid:
14. CONT…
1)On the Basis of Types of Shares
i) Equity Dividend
ii) Preference Dividend
2) On the Basis of Modes of Payment
i) Cash Dividend
ii) Bonus Share/Stock Dividend
iii) Scrip or Bond Dividend
iv) Property Dividend
v) Composite Dividend
15. CONT…
• 3) On the Basis of Time of Payment
i) Interim Dividend
ii) Regular Dividend
iii) Special Dividend
16. DIVIDEND POLICY
• The term dividend policy refers to the
policy concerning quantum of profit
to be distributed as dividend. The
concept of dividend policies implies
that companies through their Board of
Directors evolve a pattern of dividend
payment which has a bearing on
future action.
17. Definition:
• According to Weston and Brigham, "Dividend
policy determines the division of earnings between
payments to shareholders and retained earnings".
18. Nature of Dividend Policy
• Tied-Up with Retained Earnings
• Constitutes Important Areas of
Decision-Making and Problem-
Solving for the Financial Manager
• Impact on Shares
• Optimal Dividend Policy
19. TYPES OR FORMS OF DIVIDEND POLICY
Regular dividend policy
Stable dividend policy
Irregular dividend policy
No dividend policy
20. PRACTICAL CONSIDERATION OR
DIMENSIONS OF DIVIDEND POLICY
• Funds Requirement
• Liquidity
• Access to External Sources of Financing
• Shareholder Preference
• Difference in the Cost of External Equity
and Retained Earnings
• Control
• Taxes
21. FACTORS AFFECTING DIVIDEND POLICY
• Stability of earnings
• Financing policy of the company
• Liquidity of funds
• Dividend policy of competitive concerns
• Past dividend rates
• Debt obligations
• Ability to borrow
• Growth needs of the company
22. CONT…
• Profit rate
• Legal requirements
• Policy of control
• Corporate taxation policy
24. Modigliani and Miller’s Approach
• According to MM, under a perfect market
condition, the dividend policy of the company is
irrelevant and it does not affect the value of the firm.
• “Under conditions of perfect market, rational
investors, absence of tax discrimination between
dividend income and capital appreciation, given the
firm’s investment policy, its dividend policy may
have no influence on the market price of shares”.
25. Relevance of dividend
• According to this concept, dividend policy is
considered to affect the value of the firm. Dividend
relevance implies that shareholders prefer current
dividend and there is no direct relationship between
dividend policy and value of the firm. Relevance of
dividend concept is supported by two eminent
persons like Walter and Gordon.
26. Walter’s Model
• Prof. James E. Walter argues that the dividend
policy almost always affects the value of the firm.
Walter model is based in the relationship between the
following important factors:
Rate of return I
Cost of capital (k)
28. Gordon’s Model
• Myron Gorden suggest one of the popular model which assume
that dividend policy of a firm affects its value, and it is based on the
following important assumptions:
• 1. The firm is an all equity firm.
• 2. The firm has no external finance.
• 3. Cost of capital and return are constant.
• 4. The firm has perpectual life.
• 5. There are no taxes.
• 6. Constant relation ratio (g=br).
• 7. Cost of capital is greater than growth rate (Ke>br).
