OPERATING, FINANCIAL &

COMBINED LEVERAGE

Company has EBIT of Rs 1,00,000 and faces a tax rate of 30%
Think of 2 scenarios for capital structure:

Scenario 1 Companys capital structure has only Equity
Capital of 20,000 shares of Rs 10 each
Scenario 2 Company has 10,000 ordinary shares of Rs 10
each and a loan of Rs 1,00,000 @ 15% rate of interest
How is taking Debt better for
shareholders ?
CASE I CASE II
EBIT 1,00,000 1,00,000
Less: Interest on debt - 15,000
EBT 1,00,000 85,000
Less: Tax @ 30% 30,000 25,500
EAT 70,000 59,500
Less: Preference Dividend - -
Earnings available to Equity
Shareholders
70,000 59,500
No. of Ordinary Equity
Shares
20,000 10,000
Earning Per Share 3.5 5.95
LEVERAGES
Degree of Operating Leverage
The DOL is a measure of the
business/operating risk of the firm.
Operating risk is the risk of the firm not
being able to cover its fixed operating
costs.
The larger is the magnitude of such costs,
the larger is the volume of sales required
to recover them.
Degree of operating leverage (DOL) is
computed in two ways:
1. Percentage change in EBIT/Percentage
change in sales and
2. (Sales Variable costs)/EBIT.

Proof for DOL
2)
level) base (at EBIT
level) base (at on Contributi Total
F V) Q(S
V) Q(S
Q
Q
F - V) - Q(S
V) - Q(S
DOL
costs. fixed Total F
unit per cost Variable V
unit per price Selling S
units in quantity Sales Q
Where
V) - Q(S EBIT F, V) Q(S EBIT
Q Q
EBIT EBIT
DOL ely, Alternativ
1) 1
sales in change Percentage
EBIT in change Percentage
DOL
(
(
=


= =
=
=
=
=
= =

=
> =
Interesting Fact
DOL only exists if Fixed cost is present
Financial Leverage
Financial leverage is related to the financing
activities of a firm.
It results from the presence of fixed financial
charges (such as interest on debt and
dividend on preference shares).
Since such financial expenses do not vary
with the operating profits, financial leverage is
concerned with the effect of changes in EBIT
on the earnings available to equity-holders.
Degree of financial leverage (DFL) is computed
in two ways:
1. Percentage change in EPS/Percentage change
in EBIT
2. EBIT/(EBIT I )

Proof to DFL
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) 4 (
t 1 / D I EBIT
EBIT
t 1 / D I F V S Q
F V S Q
V S Q
F V S Q
t 1 / D I F V S Q
V S Q
DFL
t 1 / D I F V S Q
V S Q
t 1 by r denominato and numerator Dividing
D t 1 I F V S Q
t 1 V S Q
EPS
EPS
/N t 1 V S Q EPS
constants, are D and F,I Since,
N
D t 1 I F V S Q
N
D t 1 I EBIT
EPS
EBIT EBIT
EPS EPS
DFL ely, Alternativ
(3) 1
EBIT in change Percentage
EPS in change Percentage
DFL
p P
P
p
P
p
P
p

=


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=

=

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> =
Combined Leverage:
The operating leverage and the financial
leverage are both closely concerned with
ascertaining the ability to cover fixed charges
(fixed operating costs in the case of operating
leverage and fixed financial costs in the case of
financial leverage). If they are combined, the
result is total leverage and risk associated
with combined leverage is known as total risk.
Company
The capital structure of a company is as
follows:
Equity Share Capital (Par Value Rs 10) Rs. 60,000
10% Debentures Rs. 80,000
Retained Earnings Rs. 20,000
Sales of the company are Rs.6 , 00,000. Its
variable operating expense is 40% of sales and
fixed operating cost is Rs.1, 00,000. Tax rate is
50%. Calculate the different types of
leverages.
Following figures relate to the two companies-
(in Rs. Lakhs)
A B
Sales 500 1000
Variable Cost 200 300
Fixed Cost 150 400
Interest 50 100
Calculate the degree of operating leverage,
degree of financial leverage and degree of
combined leverage.

Calculate operating leverage and financial
leverage for financing plans A and B
respectively. Installed Capacity is 2000 units
but actual production and sales is 50% of
installed capacity.
Selling price per unit is Rs.20 and variable cost
is Rs.10. Fixed costs are Rs.4000.
Under financing plan A equity is of Rs 5000
and 10% debt is Rs 15000, Under financing
plan B equity is Rs. 15,000 and 10% DEBT IS
Rs. 5000.