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1 UNIT 13 LEVERAGES Structure 13.0 Objectives 13.1 Introduction 13.2 Concept an

1 UNIT 13 LEVERAGES Structure 13.0 Objectives 13.1 Introduction 13.2 Concept and Types of Leverage 13.3 Operating Leverage 13.3.1 Meaning 13.3.2 Computation of OL 13.3.3 Behaviour of Operating Leverage 13.3.4 Applications 13.4 Financial Leverage 13.4.1 Meaning 13.4.2 Computation of Financial Leverage 13.4.3 Behaviour 13.4.4 Applications 13.5 Composite Leverage 13.6 EBIT-EPS Analysis 13.7 Importance of Leverage 13.8 Practical Problems 13.9 Let us sum up 13.10 Key words 13.11 Answers to check your progress 13.12 Terminal Questions 13.13 Selected References 2 13.0 OBJECTIVES After studying this unit, you should be able to • understand the concepts of financial leverage, operating leverage and total leverage • explain the computation process of leverages • assess the behaviour and applications of leverages • analysis the relationship between EBIT and EPS • discuss the importance of leverages • Illustrate various practical problems of leverage 13.1 INTRODUCTION In the arena of financing decisions, the capital structure decision assumes greater significance. As it deals with debt equity composition of the organization, the resultant risk and return for shareholders is of utmost concern for finance managers. If the borrowed funds are more than owners’ funds, it results in increase in shareholders’ earnings. At the same time, it also increases the risk of the organization. In a situation where the proportion of the equity funds is more than the proportion of the borrowed funds, the return as well as risk of the shareholders will be very low. This underlines the importance of having an optimal capital structure where risk and return to shareholders be matched. The effect of capital structure where risk and return to shareholders may judiciously help the finance managers to decide their short term and long term strategies. The behaviour and application of leverage helps in examining the whole issue in right perspective. 3 13.2 CONCEPT AND TYPES OF LEVERAGES The dictionary meaning of the term leverage refers to : an increased means for accomplishing some purpose”. It helps us in lifting heavy objects by the magnification of force when a lever is applied to a function. James Horne has defined leverage as the employment of an asset or funds for which the firm pays a fixed cost or fixed return. Christy and Roder defines leverage as the tendency for profits to change at a faster rate than sales. A few essential characteristics of leverage are as follows : (a) Leverage is applied to the employment of an asset or funds. (b) Profits tend to change at a faster rate than sales. (c) There is risk return relationship which is basically found in the same direction. (d) If higher is t he leverage, higher will be the risk and higher will be the expected returns. A brief review of various types of leverage is as follows : Return on Investment Leverage is an index of operational efficiency. It is calculated as follows : EBIT --------------- Total Assets 4 Asset Leverage is the part of ROI leverage. It is like assets turnover. It is calculated as follows : Sales --------------- Total Assets A firm with a relatively high turnover is said to have a high degree of asset leverage. Operating Leverage is related to fixed cost. It indicates the impact of changes in sales on operating income. It is calculated as follows : Contribution --------------- EBIT Financial Leverage depends upon the ratio of debt and preferred stock together to common shares. It is calculated with the help of EBIT and EBT as below : EBIT --------------- EBT Combined Leverage is the multiplication of operating leverage and financial leverage. 5 Activity 1 1. Explain the following : (i) Combined Leverage (ii) Asset Leverage (iii) ROI Leverage 2. Explain the concept of leverage. State its essentials. 13.3 OPERATING LEVERAGE It takes place when a change in revenue produces a greater change in EBIT. It is related to fixed costs. A firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs. 6 13.3.1 Meaning It refers to heavy usage of fixed assets. A few definitions are as follows : “The use of fixed operating costs to magnify a change in profits relative to a given change in Sales” Walker & Petty “If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage. E F Brigham It is a function of three factors : § Fixed costs § Contribution § Volume of Sales A few specific characteristics of operating leverage are as follows : § It affects assets side of Balance sheet § It is related to composition of fixed assets § It is related in fluctuations in business risk § It affects capital structure and return on total assets. 7 13.3.2 COMPUTATION OF OL The operating leverage can be calculated by the following formula Contribution C OL = ------------------ or --------- EBIT EBIT where contribution means sales minus variables costs EBIT means contribution minus fixed costs . If contribution is more than fixed cost, it is favourable financial leverage. In case of vice-versa, it is unfavourable financial leverage. Illustration No. 13.1 The following are the details Selling price per unit Rs. 20 Variable cost per unit Rs. 12 Actual sales 200 units Installed capacity 300 units Calculated operating leverage in each of the following two situations. (i) when fixed costs are Rs. 1000 (ii) when fixed costs are Rs. 800. 8 Solution : Statement showing computation of operating leverage Sales Rs. 4,000 Rs. 4,000 Less Variables Costs Rs. 2,400 Rs. 2,400 ------------ ------------ Contribution Rs. 1,600 Rs. 1,600 Less – Fixed Costs Rs. 1,000 Rs. 800 ------------ ------------ Earning Before Tax Rs. 600 Rs. 800 Operating Leverage Rs. 1,600 Rs. 1,600 ------------ ------------ Rs. 600 Rs. 800 = 2.67 2.0 13.3.3.BEHAVIOUR OF OPERATING LEVERAGE The behaviour of operating leverage may be measured by the degree of operating leverage. The degree of operating leverage is the percentage change in the profits resulting from a percentage change in the sales. It may be put in the form of the following formula : Percentage change in EBIT Degree of Operating Leverage = -------------------------------------- Percentage change in Sales 9 Illustration No. 13.2 The following are the details Selling Price Per Unit Rs. 20 Variable Cost per unit Rs. 12 Actual Sales 200 units Fixed cost 1000 Calculate degree of operating leverage when sales will be (a) 150 units (b) 250 units (c) 300 units Solution : Computation of degree of operating leverage Present (i) (ii) (iii) Items Position Sales in units 200 150 250 300 Sales in Rs. 4000 3000 5000 6000 Less Variable 2400 1800 3000 3600 Costs in Rs. ------- ------- ------- ------- Contribution 1600 1200 2000 2400 Less Fixed 1000 1000 1000 1000 Costs in Rs. ------- ------- ------- ------- EBIT in Rs. 600 200 1000 1400 Degree of Operating 200 67 133 Leverage ------- ------- ------- 25 25 50 - 8 + 2.67 + 2.67 10 If a firm has a high degree of operating leverage, small change in sales will have large effect on operating income. Similarly, the operating profits of such a firm will suffer loss as compared to decrease in its sales. There will not be any operating leverage, if there are no fixed costs. 13.3.4. APPLICATIONS The operating leverage indicates the impact of change in sales on operating income. If a firm has a high degree of operating leverage, small change in sales will have large effect on operating income. A few areas of application are as follows : (1) Operating leverage has an important role in capital budgeting decisions. Infact, this concept was originally developed for use in capital budgeting. (2) Long term profit planning is also possible by looking at quantam of fixed cost investment and its possible effects. (3) Generally, a high degree of operating leverage increases the risk of a firm. For deciding capital structure in favour of debt, the impact of further increase in risk will influence capital structure decision. Activity II 1. Illustrate the concept of operating leverage. 11 2. State the applications of operating leverage in the changed socio-economic Indian scenario. __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ 13.4 FINANCIAL LEVERAGE It refers to usage of debt in capital structure. It is the use of fixed cost capital (debt) in the total capitalization of the firm. Fixed cost capital includes loans, debentures and preferences share capital. 13.4.1 MEANING Financial leverage is expressed as the firm’s ability to use fixed financial cost in such a manner so as to have magnifying impact on the EPS due to any change in EBIT (Earning Before Interest and Taxes). In other words, financial leverage is a process of using debt capital to increase the return on equity. According to Guthman “Financial leverage is the ability of the firm to use fixed financial changes to magnify the effect of changes in EBIT on the firms EPS. The following are the essentials of financial leverage : (1) It relates to liabilities side of balance sheet (2) It is related to uploads/Finance/ blcok-4-mco-7-unit-3.pdf