Investment/

Financing Decisions

S.CLEMENT

LEVERAGES
Financing decisions involve in deciding
capital or financial structure.
It involves mix of capital and debt
Effects of various mix debt & equity on the
share holders return in the capital.
Company can increase or decease the
debt unlike equity .
More capital reduces the return for share
holders.

LEVERAGES
Leverage arises because of presence of
fixed cost . when the firm uses assets or
funds for which it pays fixed cost. It may
be operating or financial.
When a firm uses fixed asset like
machinery, it has a fixed cost which is
fixed operating cost.
Usage of funds for investing in fixed
assets create fixed financial cost (interest)
Proportion between fixed cost and sales
give rise to leverage.

Why leverage
Leverage

indicates relative change in

profits due to change in sales.
Proportionate change in change in
sales may not result same
proportionate change in profits

Operating Leverage

Cost can be fixed or variable

Fixed cost can be operating(manufacturing) or financial
Operating cost arise when a fixed asset is put to use to
produce goods.
When fixed operating cost is more than VC, company
leverage will be high and vice versa.
E.g if sales increase by 25%/ profit may go up by 100 %
(due to high operating leverage) and vice verca.
In absence of any operating cost , there is no leverage.
Profit will increase in direct proportion to increase in sales.
Company should use fixed cost assets to bring about
positive co relation between sales and EBIT and EBIT to
EBT
COMPUTATION OF OperatingLeverage =CONTRIBUTION/
EBIT

Operating Leverage
Production

Planning to modify
cost structure. E.g. installation of
machinery to save labour cost but
increases FC (operating) and
decrease in VC.
Question before finance manager
what will be the probability of
increase in sales?

Operating Leverage
OL relates to implies the use of FA
OL explains the relationship regarding
changes in sales visa--vis profit (EBIT)
It measures a firms ability to use FA to
manage & maximize EBIT
It relates to asset side of the B/S
It is concerned with investing decision
It is a first stage leverage

Operating Leverage
A

company produces & sells 1000

units p.a. SP @ Re 200 and VC @ Re
70 per unit. FC (operating) Re
50,000. What is OL.
OL = Contribution/EBIT

Operating Leverage
Sales

(1000*200)
200000
Less Vc (1000*70)
70000
Contribution (sales VC)130000
Less FC
50000
EBIT
80000
OL
130000/80000 = 1.625

CASE STUDY
A

company sells 80,000 units of a

products. SP per unit Re 8 and VC @
2. FC Re 330000.what wil be the
profit if the company sells
A) 96,000 units
B) 64,000 units

units

80000

96000

64000

Sales
Less VC
Contribution
Less FC

640000
160000
480000
330000

768000
192000
576000
330000

512000
128000
384000
330000

246000
128/640
*100=
20%(+)
96/150
*100=
+64%

54000
128/640
*100 =
20 (-)
96/150*
100 =
-64%

EBIT
150000
% change in
sales
% change in
EBIT

Degree of OL
It measures the ratio of percentage
change in EBIT to percentage change in
sales.
Degree of OL = % of change in EBIT/% of
change in sales
E.g. increase in sales is 20% and profit
@ 64%.
Degree of OL = 64/20 = 3.2.
If sales increase by RE 1,profit will
increase by Re 3.2. & vice versa

Degree of OL
Estimated

BE production is 2000 @
SP of RE 14 per unit. VC Re 9 per
unit. Calculate degree of OL if
A) production @ 2500 units
B) production @ 3000 units
FC - (2000*14) (2000*9)

Re 28000 18000 = 10000

Particulars

2500 units

3000 units

Sales @ 14 p.u. 35000

42000

Less VC
Contribution

22500
12500

27000
15000

Less FC

10000

10000

EBIT
OL

2500
12500/2500 =
5
-

5000
15000/5000 =
3
7000/35000
*100 =20%
2500/2500
*100 = 100%

% change in
sales
% ch.in profits

Degree of OL
% of change in profits 100 % (2500 to
5000)
% of change in sales 20% (35000 to
42000)
OL = % change in EBIT/% change in sales
OL 100/20 = 5
Conclusion 20% increase in sales result
in 100 % in profits. Highly leveraged
company.

Financial Leverage
It relates to fixed financial cost such
as interest on TL/Debentures/Pref.
Dividend etc
It establishes relationship between
EBIT&EBT
It measures firms ability use fixed FC
optimize EBT
It is concerned with financing
decision
It is second stage leverage
FL is favorable when FC < earnings

Financial Leverage
Financial

arises from fixed financial

cost. E.g. Debentures/Term loans
rate of interest is fixed.
FL measures the firms ability to use
fixed FC to bring about changes in
EBIT/EBT .
FL is favorable when earnings is
more than FC and vice versa.

Financial Leverage - Effect

Share holders earnings depends upon
relationship between EBIT and Fixed FC. If
EBIT is more than FC, it will hace positive
imapct on EPS.
Financial Risk more the the proportion of
debt, more the financial risk. E.g. 10%
increase operating profit results in 20%
increase in EPS and 10% drop in OP, will
result in 20% drop in EPS.

Financial Leverage
Company

capital structure
-1000,10% debentures of Re 100
each & 5000 equity shares of RE 10
each.
EBIT 50000,80000 & 20000.
What is the impact on EPS ?

Financial Leverage
FL

= EBIT/EBT
Fixed FC - effect on earnings
EBIT/ EBT (Earnings before Tax but
after Interest)
, Sales Rs 50000,
VC 25000, FC 15000, Int. 5000
10000/5000 FL = 2

CHANGES IN EBIT TO EBT

SALES

50000

60000

40000

VC

25000

30000

20000

CONT.

25000

30000

20000

FC

15000

15000

15000

EBIT
INT.
EBT

10000
5000
5000

15000
5000
10000

5000
5000
0

FL

10/5
=2

2*5000
=2*5000
+10000

2*5000
= -1000

EBIT LEVELS
1

EBIT

50000

80000

20000

Less
interest
EBT

10000

10000

10000

40000

70000

10000

Less
tax(50%)
EAT

20000

35000

5000

20000

35000

5000

EPS

%in EBIT

+60%

-60%

%chg. EPS -

+75%

-75%

EPS for various levels

XYZ

COMPANY EBIT Re
15000,24000& 6000.
8% debentures 25000
10% preference shares 20000
1000 equity of RE 10000
Tax rate 50%
What would be the effect on EPS @
different.

1
EBIT
-INT.
EBT
-TAX
-Pref.divnd.
Ear. For esh
No. of ESH
EPS
%CH.EBIT
% CH.EPS
FL

15000
24000
2000
2000
13000
22000
6500
11000
2000
2000
4500
9000
1000
1000
4.5
9.00
+60%
100%
15/9=1.67 24/18 = 1.33

3
6000
2000
4000
2000
2000
Nil
-

Composite leverage
CL

measures composite effect of all

the fixed cost (operating and
financial)
CL will disclose effect of changes in
sales over cjnage in taxable profit(or
EPS)
FORMULA CONTRIBUTION/EBT

Composite leverage
SALES

Re 1.00 lac
VC (40% of sales) 40 000
Fixed operating cost 30000
Fixed financial cost
10000
Calculate CL.
Calculate CL.IS 5% increase in sales

Sales

100000

105000

VC

40000

42000

Contribution

60000

63000

FC Operating 30000

30000

EBIT

30000

33000

FC- Financial

10000

10000

PBT

20000

23000

CL

60000/20000 =
3

Composite leverage
Sales

@100000 .CL is 3
It indicates 1% increase in sales will
result in 3 in EBT
Sales 1050000 (5% increase)
Profit Re 23000 ( 15% increase)
(23 -20/20 *100)

Composite leverage
Capital

structure of Ever Grow Ltd

Equity Re 3,00,000 (Re 10 each)
10% debentures Re 3,00,000
Increase in sales from 30000 to
36000 units. SP @ Re 10 per unit
FC 50,000. VC Re 6 per unit.
Tax rate 50%
Compute OL,FL & CL.

30000
UNITS
sales@10 300000
- VC@6
180000
Contrib.
120000
-FC
50000
EBIT
70000
Interest
30000
EBT
40000
tax@50% 20000
PAT
20000
No.of ES 30000
EPS
0.67

36000
UNITS
360000
216000
144000
50000
94000
30000
64000
32000
32000
30000
1.07

OL/FL/CL
OL

120/70 =1.72 & 144/94 = 1.53

FL 70/40 = 1.75 & 94/64 =
1.47
CL 120/40 = 3.00 & 144/64= 2.25

OL/FL/CL
%

of change in sales
60000/30000*100 =20%
% of change in EBIT
24000/70000 *100 = 34.29%
%of change in EPS
1.07- .67/.67*100 = 60%`

company

Int.cost ( in
cr)
Escorts
142
India cements 149
BPCL
212
Nagarguna
131
ferti
Arvind mills
130
HPCL
159
Mrpl
188
JSW steel
360
IOC
1022

Int/PBIT
%
78.4
74.9
58.3
54.3

PAT(cr
)r
39
45
130
67

46.8
27.1
23.2
20.8
13.2

127
406
372
857
4915