Leverage

Leverage, in the context of finance, refers to the use of borrowed funds or debt to finance
investments or operations. It involves utilizing debt financing alongside equity financing to
increase the potential returns and risk exposure of an investment or business.

Leverage can be classified into two types: financial leverage and operating leverage.

1. Financial Leverage: Financial leverage refers to the use of debt to finance an investment
or business operations. By taking on debt, a company can increase its potential returns on
equity investment. Financial leverage is commonly measured using the debt-to-equity
ratio or the debt ratio.

Advantages of financial leverage:

 Increased potential returns: By using borrowed funds, a company can amplify its profits
if the return on investment exceeds the cost of debt.
 Tax benefits: Interest payments on debt are usually tax-deductible, providing potential tax
advantages for leveraged companies.
 Asset acquisition: Debt financing allows companies to acquire assets or make
investments that would otherwise be unaffordable with equity alone.

Disadvantages of financial leverage:

 Increased financial risk: High debt levels increase the financial risk of a company,
especially if the return on investment falls short of the cost of debt, potentially leading to
financial distress.
 Higher interest costs: Interest payments on debt can reduce a company's profitability and
cash flow, especially if interest rates rise.
 Limited flexibility: Debt obligations come with fixed repayment schedules and covenants
that may restrict a company's financial flexibility.

Calculations of Financial Leverage

Financial leverage can be calculated using the following formula:

Financial Leverage = Total Assets / Total Equity

Total assets represent the total value of a company's assets, including both tangible and
intangible assets. Total equity, also known as shareholders' equity or net worth, represents the
residual interest in the assets after deducting liabilities.
To calculate financial leverage, follow these steps:

1. Determine the total assets from the company's balance sheet.

2. Determine the total equity from the company's balance sheet, which is typically
calculated as total assets minus total liabilities.
3. Calculate the financial leverage using the formula: Financial Leverage = Total Assets /
Total Equity

The resulting value of financial leverage represents the proportion of a company's assets that are
financed by debt compared to equity. A higher financial leverage indicates a higher proportion of
debt financing, meaning that a company relies more on borrowed funds. Conversely, a lower
financial leverage indicates a higher proportion of equity financing.

Financial leverage magnifies the potential returns and risks for equity investors. When a
company generates returns higher than the cost of debt, financial leverage can lead to increased
profitability and return on equity. However, if the company's returns fall short of the cost of debt,
financial leverage can amplify losses and increase the risk of financial distress.

It's important for companies to carefully manage their financial leverage and assess the trade-off
between the potential benefits of debt financing (such as tax advantages and increased returns)
and the risks associated with higher debt levels (such as interest expenses and potential financial
instability). The optimal level of financial leverage may vary depending on the company's
industry, growth prospects, profitability, and risk tolerance.

2. Operating Leverage: Operating leverage refers to the relationship between a company's

fixed costs and its variable costs. It measures the extent to which fixed costs are present
in the cost structure of a business. A higher proportion of fixed costs leads to higher
operating leverage.

Advantages of operating leverage:

 Increased profitability: When revenue increases, companies with high operating leverage
can experience significant profit growth due to the relatively lower increase in variable
costs.
 Economies of scale: Operating leverage can allow companies to benefit from economies
of scale, as fixed costs are spread over a larger output.

Disadvantages of operating leverage:

 Higher risk of losses: If revenue declines, companies with high operating leverage may
experience significant losses due to the relatively higher fixed costs that must still be
covered.
  Limited flexibility: Fixed costs can make it more challenging for a company to adjust its
operations in response to changes in demand or market conditions.
 Sensitivity to business cycles: Companies with high operating leverage are more sensitive
to economic downturns, as fixed costs must still be covered even if sales decline.

Calculation of Operating Leverage

Operating leverage can be calculated using the following formula:

Operating Leverage = Contribution Margin / Operating Income

The contribution margin is the difference between sales revenue and variable costs. It represents
the portion of each sales dollar that contributes towards covering fixed costs and generating
profit.

Operating income, also known as operating profit or earnings before interest and taxes (EBIT), is
the profit earned from a company's core operations before deducting interest expenses and taxes.

To calculate operating leverage, follow these steps:

1. Determine the contribution margin: Contribution Margin = (Total Sales - Total Variable
Costs) / Total Sales
2. Calculate the operating income: Operating Income = Total Sales - Total Variable Costs -
Total Fixed Costs
3. Calculate the operating leverage using the formula: Operating Leverage = Contribution
Margin / Operating Income

The resulting value of operating leverage represents the multiplier effect on operating income
resulting from a change in sales revenue. A higher operating leverage indicates a higher
proportion of fixed costs in the cost structure, meaning that a small change in sales can have a
larger impact on operating income. Conversely, a lower operating leverage implies a lower
sensitivity of operating income to changes in sales.

It's important to note that operating leverage is a measure of risk and potential profitability.
While higher operating leverage can lead to increased profits when sales are growing, it can also
amplify losses in the case of declining sales. Therefore, companies should carefully manage their
cost structure and evaluate the trade-off between fixed and variable costs to achieve an optimal
level of operating leverage based on their business model and industry dynamics.

It's important for businesses and investors to carefully consider the appropriate level of leverage
based on their specific circumstances, risk tolerance, and financial objectives. Excessive leverage
can increase financial risk and may have detrimental effects in times of economic uncertainty,
while moderate leverage can provide opportunities for growth and increased profitability.
Combined Leverage

Combined leverage is a concept that combines both financial leverage and operating leverage to
provide a comprehensive view of a company's overall risk and return profile. It represents the
combined effect of a company's fixed costs, variable costs, and debt financing on its profitability
and risk.

Combined leverage can be measured through the concept of the degree of combined leverage
(DCL), which indicates the percentage change in earnings before interest and taxes (EBIT)
resulting from a percentage change in sales. It takes into account both the operating leverage and
financial leverage components.

The formula for calculating the degree of combined leverage (DCL) is:

DCL = Degree of Operating Leverage (DOL) x Degree of Financial Leverage (DFL)

The Degree of Operating Leverage (DOL) measures the percentage change in EBIT resulting
from a percentage change in sales and is calculated as follows:

DOL = % Change in EBIT / % Change in Sales

The Degree of Financial Leverage (DFL) measures the percentage change in earnings per share
(EPS) resulting from a percentage change in EBIT and is calculated as follows:

DFL = % Change in EPS / % Change in EBIT

By multiplying the DOL and DFL, we obtain the DCL, which represents the combined effect of
operating and financial leverage on a company's earnings.

The concept of combined leverage helps in understanding how changes in sales volume can
impact a company's profitability and earnings. A higher DCL indicates a higher sensitivity of
earnings to changes in sales, implying greater risk and potential for increased returns.
Conversely, a lower DCL implies lower sensitivity to sales changes and lower risk.

Understanding combined leverage is essential for assessing a company's financial health, risk
exposure, and decision-making. It enables management and investors to evaluate the potential
impact of changes in sales, costs, and debt financing on the company's overall profitability and
financial performance. By considering both operating and financial leverage, companies can
make more informed decisions about their capital structure, investment strategies, and growth
plans.
Numericals

Operating Leverage

Let's assume a company has fixed costs of ₹500,000 and variable costs of ₹200 per unit. The
selling price per unit is ₹500, and the company expects to sell 2,000 units.

Total Sales Revenue = Selling Price per Unit * Number of Units Sold Total Sales Revenue =
₹500 * 2,000 = ₹1,000,000

Total Variable Costs = Variable Cost per Unit * Number of Units Sold Total Variable Costs =
₹200 * 2,000 = ₹400,000

Contribution Margin = Total Sales Revenue - Total Variable Costs Contribution Margin =
₹1,000,000 - ₹400,000 = ₹600,000

Operating Income = Contribution Margin - Fixed Costs Operating Income = ₹600,000 -

₹500,000 = ₹100,000

Operating Leverage = Contribution Margin / Operating Income Operating Leverage = ₹600,000 /

₹100,000 = 6

In this example, the operating leverage is 6, indicating that a 1% change in sales would lead to a
6% change in operating income.

Financial Leverage

Let's consider a company with total assets of ₹2,000,000 and total equity of ₹800,000.

Financial Leverage = Total Assets / Total Equity Financial Leverage = ₹2,000,000 / ₹800,000 =
2.5

In this example, the financial leverage is 2.5, meaning that the company has ₹2.5 in assets for
every ₹1 in equity.

Combined Leverage

Let's consider the same company as above, which has an operating leverage of 6 and a financial
leverage of 2.5.

Combined Leverage = Operating Leverage x Financial Leverage Combined Leverage = 6 x 2.5 =

15
In this example, the combined leverage is 15, suggesting that a 1% change in sales would result
in a 15% change in operating income after considering the effects of both operating and financial
leverage.

These numerical examples demonstrate how to calculate and interpret operating leverage,
financial leverage, and combined leverage. They showcase the impact of fixed costs, variable
costs, debt financing, and equity financing on a company's profitability and risk.

Capital Structure

Capital structure refers to the way a company finances its operations and investments by
combining different sources of funds, including debt and equity. It represents the composition of
a company's long-term liabilities and shareholders' equity.

There are two primary components of capital structure:

1. Debt: Debt represents the borrowed funds that a company raises through loans, bonds, or
other forms of borrowing. It includes both short-term and long-term obligations that the
company must repay over a specified period, typically with interest. Debt holders have a
legal claim on the company's assets and are entitled to receive interest payments and
repayment of principal.
2. Equity: Equity represents the ownership stake in a company held by its shareholders. It
includes common stock, preferred stock, retained earnings, and additional paid-in capital.
Equity holders bear the residual risk and reward of the company's performance, and their
returns are primarily in the form of dividends and capital appreciation.

The capital structure decision involves determining the appropriate mix of debt and equity
financing for a company. This decision is influenced by various factors, including the company's
risk profile, profitability, cash flow generation, industry norms, growth prospects, tax
considerations, and the availability and cost of capital.

A company's capital structure affects its financial risk, cost of capital, and the overall value of the
firm. The optimal capital structure is the one that maximizes the value of the company while
balancing the risks and costs associated with each source of financing.

Companies with a higher proportion of debt in their capital structure are said to have a more
leveraged or debt-heavy capital structure. This can provide tax advantages due to the tax
deductibility of interest payments but also increases financial risk and interest expenses. On the
other hand, companies with a higher proportion of equity in their capital structure have lower
financial risk but may face higher costs of equity and dilution of ownership.

Determining the optimal capital structure involves analyzing trade-offs between the benefits and
costs of debt and equity financing, considering the specific characteristics and goals of the
company. It is an ongoing process that may evolve over time as the company's financial position
and market conditions change.

Theories of Capital Structure

Net Income Approach (Traditional Approach)

The Net Income Approach, also known as the Traditional Approach or the Regular Income
Theory, is one of the theories of capital structure. It suggests that the capital structure decisions
of a firm can affect its value by leveraging the tax advantage of debt.

The key idea behind the Net Income Approach is that the interest paid on debt is tax-deductible,
while the dividends paid to equity shareholders are not. As a result, increasing the proportion of
debt in the capital structure can reduce the firm's overall tax liability and increase its net income.
The increase in net income, in turn, leads to an increase in the value of the firm.

According to the Net Income Approach, the optimal capital structure is achieved by finding the
right balance between debt and equity financing. As long as the marginal tax rate is positive, the
cost of debt is lower than the cost of equity due to the tax shield provided by interest payments.
Therefore, increasing the proportion of debt in the capital structure can lower the overall cost of
capital and increase the value of the firm.

The Net Income Approach assumes that the cost of debt is lower than the cost of equity and that
the tax advantage of debt is the primary driver of the value of the firm. However, it does not
consider other factors such as bankruptcy costs, agency costs, or the potential impact of financial
distress.

While the Net Income Approach provides a framework for understanding the potential benefits
of debt financing in terms of the tax advantage, it should be used in conjunction with other
theories and considerations to make informed decisions regarding the capital structure. Factors
such as business risk, financial flexibility, industry norms, and the firm's growth prospects
should also be taken into account when determining the optimal capital structure for a specific
company.

Net Operating Income Approach

The Net Operating Income (NOI) Approach, proposed by David Durand, is a theory of capital
structure that focuses on the operating income of a firm rather than its net income. It suggests
that the capital structure decisions of a company have no impact on its value.

According to the Net Operating Income Approach, the value of a firm is determined by its
operating income, and the financing decisions, including the use of debt or equity, do not affect
the firm's value. The theory suggests that the cost of capital is independent of the capital
structure.

The Net Operating Income Approach assumes that the overall value of a company is determined
by the profitability of its operations and the risk associated with those operations. The use of debt
or equity financing does not change the underlying profitability of the company's operations. As
a result, changes in the capital structure do not affect the value of the firm.

This approach ignores the potential tax advantages of debt and assumes that the market value of
a firm's assets and cash flows is not affected by the capital structure decisions. It implies that
investors are indifferent to the capital structure and that the value of the firm is determined solely
by the operational performance.

While the Net Operating Income Approach provides a perspective that capital structure decisions
are irrelevant, it is important to note that in practice, the cost of capital and the availability of
different sources of financing do influence a firm's value and capital structure decisions. Other
theories, such as the Trade-Off Theory and the Modigliani-Miller (MM) Approach, provide
alternative frameworks that consider the impact of debt and equity financing on the value of a
firm.

It is essential for companies to carefully analyze various theories and considerations, taking into
account factors such as risk, taxation, financial flexibility, and market conditions when
determining their optimal capital structure.

Modigliani-Miller Approach

The Modigliani-Miller (MM) Approach, developed by Franco Modigliani and Merton Miller, is
a theory of capital structure that suggests that, under certain assumptions, the capital structure of
a firm does not affect its value. This theory is also known as the Modigliani-Miller theorem.

The fundamental principle of the MM Approach is that, in a perfect capital market, the value of a
firm is determined by its underlying cash flows and is independent of how the firm is financed.
The theory assumes several key assumptions:

1. Perfect Capital Markets: The MM Approach assumes that capital markets are perfect,
meaning that there are no transaction costs, no taxes, no bankruptcy costs, no agency
costs, and no information asymmetry.
2. Homogeneous Expectations: The theory assumes that all investors have the same
expectations and information, and they make rational investment decisions based on these
common expectations.
3. No Arbitrage Opportunities: The MM Approach assumes that there are no arbitrage
opportunities available in the market, meaning that investors cannot consistently earn
abnormal profits by exploiting price differences.
Based on these assumptions, the Modigliani-Miller theorem states that the value of a firm is
determined by its cash flows generated by its underlying assets and is not affected by the capital
structure. Therefore, changing the proportion of debt or equity in the capital structure should not
impact the overall value of the firm.

The MM Approach implies that the cost of capital for a firm is unaffected by its capital structure.
In other words, the required return for investors (cost of equity) increases proportionally with the
increase in the debt-to-equity ratio, resulting in a constant weighted average cost of capital
(WACC) regardless of the capital structure.

While the MM Approach provides valuable insights into the relationship between capital
structure and firm value, it should be noted that the assumptions underlying the theory are
idealized and may not hold in the real world. Real-world factors such as taxes, bankruptcy costs,
agency costs, and market imperfections can influence a firm's capital structure decisions and
value.

The MM Approach serves as a benchmark for understanding the impact of capital structure
decisions and can guide discussions on the trade-offs between debt and equity financing.
However, in practice, companies need to consider a range of factors, including tax implications,
financial distress costs, and market conditions, to determine their optimal capital structure.

Determinants of Capital Structure

Determinants of capital structure are the factors that influence a company's decisions regarding
the mix of debt and equity financing in its capital structure. These determinants can vary across
companies and industries and may change over time. Here are some key determinants of capital
structure:

1. Business Risk: The level of business risk associated with a company's operations is a
significant determinant of its capital structure. Companies operating in industries with
higher business risk, such as technology or biotechnology, may prefer to have a lower
proportion of debt to reduce financial risk. Conversely, companies in stable and less risky
industries may be more inclined to use debt financing.
2. Financial Flexibility: Companies with strong financial flexibility, including sufficient
cash reserves and access to capital markets, may have more flexibility in choosing their
capital structure. They may be able to utilize debt financing to take advantage of tax
benefits and enhance shareholder returns.
 3. Profitability and Cash Flow: Companies with higher profitability and consistent cash
flows are often in a better position to service debt obligations. Strong profitability and
cash flow generation provide lenders with confidence in the company's ability to meet
interest and principal payments, enabling the company to have a higher proportion of
debt in its capital structure.
4. Growth Opportunities: Companies with significant growth opportunities may choose to
retain earnings and rely on internal funds for financing expansion projects, leading to a
lower debt-to-equity ratio. High-growth companies may prefer equity financing to avoid
the burden of interest payments and maintain financial flexibility.
5. Tax Considerations: The tax environment plays a role in determining the optimal capital
structure. Debt financing provides the advantage of tax deductibility of interest payments,
reducing the company's overall tax liability. Thus, companies operating in higher tax
jurisdictions may be more inclined to use debt financing to benefit from the tax shield.
6. Market Conditions: The prevailing market conditions, including interest rates and the
availability and cost of debt and equity financing, can influence capital structure
decisions. Favorable borrowing conditions, such as low interest rates, may encourage
companies to take on more debt. Conversely, unfavorable market conditions may lead to
a conservative approach with less debt.
7. Company Size: Company size can impact capital structure decisions. Larger, more
established companies may have easier access to debt markets and can benefit from
economies of scale, enabling them to take advantage of debt financing. Smaller
companies may rely more on equity financing due to limited access to debt markets.
8. Industry Norms: Capital structure decisions are also influenced by industry norms and
practices. Industries with established patterns of capital structure, such as regulated
utilities with higher levels of debt, may influence the capital structure decisions of
companies operating within those industries.

It is important to note that these determinants interact with each other, and the optimal capital
structure varies for each company based on its specific circumstances, objectives, and risk
appetite. Companies need to carefully analyze these determinants and strike a balance between
debt and equity financing to optimize their capital structure and maximize shareholder value.

Numericals

Net Income Approach

Suppose Company XYZ is considering two capital structure options:

Option A: All-equity financing with 100,000 shares outstanding Option B: A combination of

equity and debt with 80,000 shares outstanding and ₹200,000 in debt at an interest rate of 5%

The company's net income before interest and taxes (EBIT) is ₹500,000, and the tax rate is 30%.
To calculate the net income and compare the two options, we need to consider the interest
expense and the tax shield provided by the interest expense.

Option A: Since Option A is an all-equity financing option, there is no interest expense. Net
Income Option A = EBIT * (1 - Tax Rate) Net Income Option A = ₹500,000 * (1 - 0.30) Net
Income Option A = ₹350,000

Option B: Interest Expense = Debt * Interest Rate Interest Expense = ₹200,000 * 0.05 Interest
Expense = ₹10,000

Tax Shield = Interest Expense * Tax Rate Tax Shield = ₹10,000 * 0.30 Tax Shield = ₹3,000

Net Income Option B = EBIT - Interest Expense + Tax Shield Net Income Option B = ₹500,000
- ₹10,000 + ₹3,000 Net Income Option B = ₹493,000

In this numerical example, the net income for Option A (all-equity financing) is ₹350,000, while
the net income for Option B (combination of equity and debt) is ₹493,000. The tax shield
provided by the interest expense in Option B increases the net income compared to Option A,
demonstrating the potential benefit of debt financing in reducing the tax burden and increasing
net income under the Net Income Approach.

It's important to note that this is a simplified numerical example, and in practice, several other
factors and considerations, such as bankruptcy costs, agency costs, and market conditions, need
to be taken into account to determine the optimal capital structure based on the Net Income
Approach.

Net Operating Income Approach

Company XYZ has an EBIT (Earnings Before Interest and Taxes) of ₹500,000 per year. The
company is considering two capital structure options:

Option A: All-equity financing with no debt. Option B: A combination of equity and debt with
₹1,000,000 in debt and an interest expense of ₹100,000 per year.

Under the Net Operating Income Approach, the value of the firm is determined solely by its
operating income. Therefore, the capital structure decision should not impact the value of the
firm.

Option A: Net Operating Income (NOI) = EBIT - 0 (no interest expense) NOI Option A =
₹500,000 - ₹0 NOI Option A = ₹500,000
Option B: Net Operating Income (NOI) = EBIT - Interest Expense NOI Option B = ₹500,000 -
₹100,000 NOI Option B = ₹400,000

According to the Net Operating Income Approach, the capital structure decision does not affect
the value of the firm. In this example, both Option A and Option B result in the same net
operating income of ₹500,000.

It's important to note that the Net Operating Income Approach does not consider the tax
implications or the impact of debt on the overall risk of the firm. Other theories and
considerations, such as the tax advantage of debt and the trade-off between financial risk and tax
benefits, should be taken into account when making capital structure decisions in practice.

Modigliani-Miller Approach

Assumptions:

 Earnings Before Interest and Taxes (EBIT): ₹1,000,000

 Cost of Equity: 10%
 Cost of Debt: 5%
 Tax Rate: 30%

1. Modigliani-Miller Approach without Taxation:

Option A: All-equity financing with no debt. Option B: A combination of equity and debt.

Under the Modigliani-Miller Approach without taxation, the value of the firm will be the same
for both options.

Option A: Value of the Firm (Option A) = EBIT / Cost of Equity Value of the Firm (Option A) =
₹1,000,000 / 0.10 Value of the Firm (Option A) = ₹10,000,000

Option B: Value of the Firm (Option B) = EBIT / Cost of Equity Value of the Firm (Option B) =
₹1,000,000 / 0.10 Value of the Firm (Option B) = ₹10,000,000

In this example, both Option A and Option B result in the same value of the firm, which is
₹10,000,000, under the Modigliani-Miller Approach without taxation.

2. Modigliani-Miller Approach with Taxation:

Option A: All-equity financing with no debt. Option B: A combination of equity and debt with
₹2,000,000 in debt and an interest expense of ₹100,000 per year (5% interest rate).
Under the Modigliani-Miller Approach with taxation, assuming a tax rate of 30%, the tax shield
provided by the interest expense can affect the value of the firm.

Option A: Value of the Firm (Option A) = (EBIT - Interest Expense) / (Cost of Equity × (1 - Tax
Rate)) Value of the Firm (Option A) = (₹1,000,000 - 0) / (0.10 × (1 - 0.30)) Value of the Firm
(Option A) = ₹1,000,000 / 0.07 Value of the Firm (Option A) = ₹14,285,714.29

Option B: Value of the Firm (Option B) = (EBIT - Interest Expense) / (Cost of Equity × (1 - Tax
Rate)) Value of the Firm (Option B) = (₹1,000,000 - ₹100,000) / (0.10 × (1 - 0.30)) Value of the
Firm (Option B) = ₹900,000 / 0.07 Value of the Firm (Option B) = ₹12,857,142.86

In this example, with taxation considered, the value of the firm is ₹14,285,714.29 for Option A
(all-equity) and ₹12,857,142.86 for Option B (combination of equity and debt).

The Modigliani-Miller Approach with taxation recognizes the tax shield benefit provided by the
interest expense, which can impact the value of the firm.

EBIT-EPS Relationship

The EBIT-EPS relationship theory, also known as the Indifference Point Theory or the
Breakeven Point Theory, examines the impact of different capital structures on a company's
earnings per share (EPS) at various levels of Earnings Before Interest and Taxes (EBIT). The
theory suggests that the capital structure decision affects the risk and profitability of a firm, and
there exists an optimal capital structure that maximizes EPS.

The key idea behind the EBIT-EPS relationship theory is that higher financial leverage (more
debt) leads to higher fixed interest expenses, which can magnify the impact of changes in EBIT
on EPS. The theory assumes a constant tax rate and the absence of other costs, such as
bankruptcy costs or financial distress.

Here are two numerical examples to illustrate the EBIT-EPS relationship:

Example 1: Company ABC has two capital structure options:

Option A: All-equity financing with no debt. Option B: A combination of equity and debt with
₹500,000 in debt and an annual interest expense of ₹50,000.

Assumptions:

 Tax rate: 30%

 Number of shares outstanding: 100,000
Option A (All-Equity Financing): EBIT = ₹500,000

Net Income (Option A) = EBIT × (1 - Tax Rate) Net Income (Option A) = ₹500,000 × (1 - 0.30)
Net Income (Option A) = ₹350,000

EPS (Option A) = Net Income (Option A) / Number of Shares Outstanding EPS (Option A) =
₹350,000 / 100,000 EPS (Option A) = ₹3.50

Option B (Equity and Debt Financing): EBIT = ₹500,000

Net Income (Option B) = EBIT - Interest Expense × (1 - Tax Rate) Net Income (Option B) =
₹500,000 - ₹50,000 × (1 - 0.30) Net Income (Option B) = ₹535,000

EPS (Option B) = Net Income (Option B) / Number of Shares Outstanding EPS (Option B) =
₹535,000 / 100,000 EPS (Option B) = ₹5.35

In this example, with an EBIT of ₹500,000, Option B (equity and debt financing) has a higher
EPS of ₹5.35 compared to Option A (all-equity financing) with an EPS of ₹3.50. This
demonstrates the impact of financial leverage on EPS under the EBIT-EPS relationship theory.

Example 2: Let's consider a different numerical example with the same capital structure options:

Assumptions:

 EBIT: ₹1,000,000
 Interest Expense: ₹100,000
 Tax rate: 30%
 Number of shares outstanding: 200,000

Option A (All-Equity Financing): Net Income (Option A) = EBIT × (1 - Tax Rate) Net Income
(Option A) = ₹1,000,000 × (1 - 0.30) Net Income (Option A) = ₹700,000

EPS (Option A) = Net Income (Option A) / Number of Shares Outstanding EPS (Option A) =
₹700,000 / 200,000 EPS (Option A) = ₹3.50

Option B (Equity and Debt Financing): Net Income (Option B) = EBIT - Interest Expense × (1 -
Tax Rate) Net Income (Option B) = ₹1,000,000 - ₹100,000 × (1 - 0.30) Net Income (Option B) =
₹730,000

EPS (Option B) = Net Income (Option B) / Number of Shares Outstanding EPS (Option B) =
₹730,000 / 200,000 EPS (Option B) = ₹3.65
In this example, with an EBIT of ₹1,000,000, Option B (equity and debt financing) has a higher
EPS of ₹3.65 compared to Option A (all-equity financing) with an EPS of ₹3.50. Again, this
demonstrates the impact of financial leverage on EPS under the EBIT-EPS relationship theory.

These numerical examples highlight the EBIT-EPS relationship, showing how the inclusion of
debt financing can increase EPS at different levels of EBIT. The theory suggests that as EBIT
increases, the impact of financial leverage on EPS becomes more significant. However, it's
important to consider other factors, such as risk, cost of debt, and potential bankruptcy costs,
when making capital structure decisions in practice.

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