FM CH 14 PDF

FINANCIAL AND OPERATING LEVERAGE
CHAPTER 14
LEARNING OBJECTIVES
2
 Explainthe concept of financial leverage

 Discuss the alternative measures of financial leverage
 Understand the risk and return implications of financial
leverage
 Analyze the combined effect of financial and operating
leverage
 Highlight the difference between operating risk and
financial risk
Capital Structure Defined
3
 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.
4
The capital structure decision process

While making the Financing Decision...
5
 How should the investment project be financed?

 Does the way in which the investment projects are
financed matter?
 How does financing affect the shareholders’ risk, return
and value?
 Does there exist an optimum financing mix in terms of the
maximum value to the firm’s shareholders?
 Can the optimum financing mix be determined in practice
for a company?
 What factors in practice should a company consider in
designing its financing policy?
Meaning of Financial Leverage
6
 The use of the fixed-charges sources of funds, such as debt and

preference capital along with the owners’ equity in the capital
structure, is described as financial leverage or gearing or trading
on equity.
 The financial leverage employed by a company is intended to earn
more return on the fixed-charge funds than their costs. The surplus
(or deficit) will increase (or decrease) the return on the owners’
equity. The rate of return on the owners’ equity is levered above or
below the rate of return on total assets.
Measures of Financial Leverage
7
1. Debt ratio
2. Debt–equity ratio
3. Interest coverage
 The first two measures of financial leverage can be
expressed either in terms of book values or market values.
These two measures are also known as measures of
capital gearing.
 The third measure of financial leverage, commonly known
as coverage ratio. The reciprocal of interest coverage is a
measure of the firm’s income gearing.
8
Financial Leverage of Ten Largest Indian

Companies, 2008
Financial Leverage and the Shareholders’
9
Return
 The primary motive of a company in using financial leverage is
to magnify the shareholders’ return under favourable economic
conditions. 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 banks or debentures) can be obtained at a cost lower than
the firm’s rate of return on net assets (RONA or ROI).
 EPS, ROE and ROI are the important figures for analysing the
impact of financial leverage.
EPS and ROE Calculations
10
 For calculating ROE either the book value or the market

value equity may be used.
Analyzing Alternative Financial Plans:
11
Constant EBIT
Effect of Financial Plan on EPS and ROE:
 The firm is considering two Constant EBIT
alternative financial plans:
 (i) either to raise the entire
funds by issuing 50,000
ordinary shares at Rs 10 per
share, or
 (ii) to raise Rs 250,000 by
issuing 25,000 ordinary
shares at Rs 10 per share and
borrow Rs 250,000 at 15 per
cent rate of interest.
 The tax rate is 50 per cent.
Interest Tax Shield
12
 The interest charges are tax deductible and,

therefore, provide tax shield, which increases the
earnings of the shareholders.
Effect of Leverage on ROE and EPS
13
Favourable ROI > i
Unfavourable ROI < i
Neutral ROI = i
14
Varing EBIT
15
Varing EBIT
EBIT–EPS chart-Example
16
Calculation of indifference point
17
 The EPS formula under all-equity plan is
 The EPS formula under debt–equity plan is:
 Setting the two formulae equal, we have:

Calculation of indifference point
18
 Sometimes a firm may like to make a choice between two

levels of debt. Then, the indifference point formula will be:
 The firm may compare between an all-equity plan and an

equity-and-preference share plan. Then, the indifference point
formula will be:
Operating Leverage
19
 Operating leverage affects

a firm’s operating profit
(EBIT).
 The degree of operating % Change in EBIT
leverage (DOL) is defined DOL 
% Change in Sales
as the percentage change in
 EBIT/EBIT
the earnings before interest DOL 
and taxes relative to a  Sales/Sales
given percentage change in
sales.
Degree of Financial Leverage
20
 The degree of financial leverage (DFL) is defined

as the percentage change in EPS due to a given
percentage change in EBIT:
Combining Financial and Operating Leverages
21
 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
22
 The degree of combined leverage (DCL) is given

by the following equation:
% Change in EBIT % Change in EPS % Change in EPS
  
% Change in Sales % Change in EBIT % Change in Sales
 Anotherway of expressing the degree of

combined leverage is as follows:
Q( s  v) Q( s  v)  F Q( s  v)
DCL   
Q( s  v)  F Q( s  v)  F  INT Q( s  v)  F  INT
Financial Leverage and the Shareholders’
23
Risk
 The variability of EBIT and EPS distinguish between two
types of risk—operating risk and financial risk.
 Operating risk can be defined as the variability of EBIT
(or return on total assets). The environment—internal and
external—in which a firm operates determines the
variability of EBIT
 The variability of EBIT has two components:
• variability of sales
• variability of expenses
 The variability of EPS caused by the use of financial
leverage is called financial risk. Financial risk is an
avoidable risk if the firm decides not to use any debt in its
capital structure.
Measuring Operating and Financial Risk
24
 We can use two measures of risk:

 Standard deviation
 Coefficient of variation
 2 (EPS)  [EPS1  E (EPS)] 2 P1  [EPS2  E (EPS)] 2 P2    [EPS j  E(EPS)] 2 Pj
n
  [EPS
j 1
j  E (EPS)] 2 Pj
n
E (EPS)  EPS1  P1  EPS 2  P2    EPS j Pj   EPS P
j 1
j j
Risk-Return Trade-off
25
 If the firm wants higher return (EPS or ROE) for the

shareholders for a given level of EBIT, it will have to employ
more debt and will also be exposed to greater risk (as
measured by standard deviation or coefficient of variation).
 In fact, the firm faces a trade-off between risk and return.
 Financial leverage increases the chance or probability of

insolvency.

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FINANCIAL AND OPERATING LEVERAGE

 Explainthe concept of financial leverage

 The term capital structure is used to represent the

 The various means of financing represent the financial

The capital structure decision process

 How should the investment project be financed?

 The use of the fixed-charges sources of funds, such as debt and

Financial Leverage of Ten Largest Indian

 For calculating ROE either the book value or the market

 The interest charges are tax deductible and,

Favourable ROI > i

Unfavourable ROI < i

 The EPS formula under all-equity plan is

 The EPS formula under debt–equity plan is:

 Setting the two formulae equal, we have:

 Sometimes a firm may like to make a choice between two

 The firm may compare between an all-equity plan and an

 Operating leverage affects

 The degree of financial leverage (DFL) is defined

 Operating leverage affects a firm’s operating profit

 The degrees of operating and financial leverages

 The degree of combined leverage (DCL) is given

 Anotherway of expressing the degree of

 We can use two measures of risk:

 If the firm wants higher return (EPS or ROE) for the

 In fact, the firm faces a trade-off between risk and return.

 Financial leverage increases the chance or probability of

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