Afm session 2
- 3. What is Leverage? RISK
- 4. LEVERAGES • MEANING: Leverage refers to an increased means of achieving some purpose • Leverage allows us to accomplish certain things which are otherwise not possible, namely lifting of heavy objects with the help of leverage.
- 5. Leverages • In corporate finance the term Leverage applies to the use of certain fixed costs that result in a manifold increase in a firm’s profitability. For a business firm, the lever is the fixed operating cost and the fixed financing costs in the cost structure of the firm.
- 6. TYPES OF LEVERAGES Types of leverages Activity Strutural operating Financial combined
- 7. Operating leverage A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. 1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. 2. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged. 3. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability.
- 8. The Operating Leverage can be calculated by using the following Formula:- • Operating Leverage = Contribution Net Operating Income • Degree of Operating Leverage = Percentage Change in NOI Percentage Change in Sales Operating leverage deals with: – Business risk – Unavoidable risk – Uncontrollable risk
- 9. FINANCIAL LEVERAGE • Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share. • Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; • They may also be unable to find new lenders in the future. Financial leverage is not always bad. • It emphasizes the use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).
- 10. The Financial Leverage can be calculated by using the following Formula:- • Financial Leverage = EBIT EBT • Degree of Financial Leverage = Percentage Change in EPS Percentage Change in EBIT • Operating leverage deals with: o Financial risk o Avoidable risk o Controllable risk
- 11. Financial Leverage of Ten Largest Indian Companies, 2008
- 12. COMBINED LEVERAGE • Combined leverage is a leverage which refers to high profits due to fixed costs. • Competitive firms choose high level of degree of combined leverage whereas conservative firms choose lower level of degree of combined leverage. • Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share.
- 13. The Combined Leverage can be calculated by using the following Formula • Combined Leverage = Operating Leverage X Financial Leverage or, Contribution / EBT • Degree of Combined Leverage = Percentage Change in EPS Percentage Change in SALES
- 14. SALES EBIT EPS
- 15. SALES EBIT EPS
- 16. SALES EBIT EPS
- 17. EXAMPLE • Based on the following information on Levered Company, answer these questions: 1. Calculate operating leverage. 2. Calculate financial leverage. 3. Calculate combined leverage.
- 18. LEVERED COMPANY Sales (100,000 units) Rs.1,400,000 Variable Costs Rs.800,000 Fixed Costs Rs.250,000 Interest paid Rs.125,000 Tax rate 34% Common shares outstanding 100,000
- 19. OPERATING LEVERAGE 1,400,000 - 800,000 350,000 = 1.714 OLs = = Sales - Variable Costs EBIT
- 20. FINANCIAL LEVERAGE DFL = EBIT EBIT - I = 350,000 225,000 = 1.556
- 21. COMBINED LEVERAGE DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667 =
- 22. Question 1: A firm sells its products for Rs. 50 per unit, has variable operating cost of Rs. 30 per unit and fixed operating cost of Rs. 5000 per year. Its current level of sales is 300 units. • Determine the operating leverage. • What will happen to EBIT if sales change (a) Increase by 16.67% (b) Decrease by 16.67%
- 23. Solution Units: 300 units Particulars Amount (Rs.) Sales 15000 Less: Variable Cost 9000 Contribution 6000 Fixed Cost 5000 EBIT 1000 Contribution = 6000 EBIT 1000 = 6 (a)
- 24. Units: 250 units Units:350 units Particulars Amount (Rs.) Amount (Rs.) Sales 12500 17500 Less: Variable Cost 7500 10500 Contribution 5000 7000 Fixed Cost 5000 5000 EBIT 0 2000 (b)
- 25. • Lets practice some more examples…..
- 26. Question 2: A firm selling price of its product is Rs.100 per unit. The variable cost per unit is Rs.50 and the fixed operating costs are Rs.50,000 per year. The fixed interest expenses (non-operating) are Rs.25,000 and the firm has 10,000 shares outstanding. Tax rate = 35%. Evaluate the EBIT/EPS resulting from sale of (a) 2000 units (b) 3000 units.
- 27. Solution CASE I CASE II Units: 2000 Units: 3000 Particulars Amount (Rs.) Amount (Rs.) Sales 200000 300000 Less: Variable Cost -100000 -150000 Contribution 100000 150000 Fixed Cost -50000 -50000 EBIT 50000 100000 Less: Interest -25000 -25000 EBT 25000 75000 Less: Tax (35%) -8750 -26250 PAT 16250 48750 No. of Outstanding Equity Shares 10000 10000 Earnings Per Share 1.625 4.875
- 28. • Percentage change in EPS = (4.875-1 .625) x 100 = 200% 1.625 • Percentage change in EBIT = (100000-50000) x 100 = 100% 50000 • Degree of Financial Leverage: Percentage change in EPS = 200 = 2 Percentage change in EBIT 100
- 29. Question 3: Consider the following information for Kaunark Enterprise (a) Calculate all the leverages (b) Calculate the % change in EPS, if the sales increased by 5% Rs in Lakh Particulars Amount (Rs.) EBIT 1120 PBT 320 Fixed Cost 700
- 30. Solution Operating Leverage: = Contribution EBIT = 1120+700 = 1.625 1120 Financial leverage = EBIT PBT = 1120 = 3.5 320 Combined Leverage = Contribution EBT = 1120+700 = 5.6875 320
- 31. Calculation of the % change in EPS, if the sales increased by 5% Degree of Combined leverage = % Change in EPS % Change in Sales 5.687 = % Change in EPS 5 % Change in EPS = 5.687*5 = 28.44%
- 32. Question 4 If the combined leverage and operating leverage figures of a company are 2.5 and 1.25 respectively, find the financial leverage and P/V ratio, given that: the • Equity dividend per share is Rs. 2 • Interest payable per year is Rs. 1 lakh • Total Fixed cost Rs. 0.5 lakhs • Sales Rs. 10 lakhs
- 33. Solution Combined Leverage = Operating leverage * financial leverage 2.5 = 1.25 * financial leverage Financial Leverage = 2.5 = 2 1.25 Financial Leverage = EBIT EBT = EBT + Interest EBT 2 = EBT + 1,00,000 EBT EBT = 1,00,000 Therefore EBIT = EBT + 1,00,000 =1,00,000 + 1,00,000 = 2,00,000
- 34. Operating leverage = Contribution EBIT 1.25 = Contribution 2,00,000 Therefore, Contribution is Rs. 2,50,000 Therefore P.V. Ratio = Contribution * 100 Sales = 2,50,000 * 100 = 25% 10,00,000
- 35. Question 5 Well established company’s balance sheet is as follows Liablities Amount(Rs.) Assets Amount(Rs.) Equty Capital( Rs 10 per share) 60000 Net Fixed Assets 150000 10% long term debt 80000 Current Assets 50000 Retained Earnings 20000 Current liablities 40000 200000 200000
- 36. • Company’s total asset turnover ratio is 3; its fixed asset operating cost are Rs. 1,00,000 and the variable operating costs ratio is 40 per cent. The income tax rate is 35% a) Calculate all types of leverages b) Determine the likely level of EBIT if EPS is Rs.1 Rs. 3 Zero
- 37. Solution Particulars Amount (Rs.) Sales 600000 Less: Variable Cost 240000 Contribution 360000 Fixed Cost 100000 EBIT 260000 Less: Interest 8000 EBT 252000 Less: Tax 88200 PAT 163800
- 38. Operating Leverage = Contribution EBIT = 600000-240000 = 1.38 260000 Financial leverage = EBIT PBT = 260000 = 1.03 252000 Combined Leverage : Contribution EBT = 1.38 * 1.03 = 1.42
- 39. • EPS = ( EBIT – I ) (1 – t) N Rs. 1 = ( EBIT – 8000 ) (1 – 0.35) 6000 EBIT = Rs. 17,231 Rs. 3 = ( EBIT – 8000 ) (1 – 0.35) 6000 EBIT = Rs. 35,692 Rs. 0= ( EBIT – 8000 ) (1 – 0.35) 6000 EBIT = Rs. 8,000
- 40. Particulars Amount (Rs.) Amount (Rs.) Amount (Rs.) EBIT 8000 17231 35692 Less: Interest 8000 8000 8000 EBT 0 9231 27692 Less: Tax 0 3231 9692 PAT 0 6000 18000 Number of shares 6000 6000 6000 EPS (NI+ N) 0 1 3
- 41. Question 6 The selected financial data for A, B & C companies for the current year ended 31st March are as follows : PARTICULARS A B C Variable expenses as a percentage of sales 66.67 75 50 Interest expenses(Rs.) 200 300 1000 Degree of operating leverage 5 6 2 Degree of financial leverage 3 4 2 Income tax rate 0.35 0.35 0.35 a) Prepare income statements for A, B & C companies. b) Comment on the finanacial position and structure of these companies.
- 42. Solution Income statement of companies A, B & C for the current year, ended March 31 Particulars A B C Sales 4500 9600 24000 Less: Variable Cost 3000 7200 12000 Contribution 1500 2400 12000 Fixed Cost 1200 2000 10000 EBIT 300 400 2000 Less: Interest 200 300 1000 EBT 100 100 1000 Less: Tax 35 35 350 PAT 65 65 650
- 43. • DFL = 3, DFL = EBIT EBIT - 1 • Company A: 3= EBIT EBIT – 200 EBIT = 300 DOL = Sales – Variable Costs EBIT 5= S – 0.667S 300 S = Sales = Rs. 4500 VC = 0.667 x 4500 = Rs. 3000
- 44. • Company B: 4= EBIT EBIT – 300 EBIT = 400 DOL = Sales – Variable Costs EBIT 6= S – 0.75S 400 S= Sales = Rs. 9600 VC = 0.75 x 9600 = Rs. 7200
- 45. • Company C: 2= EBIT EBIT – 1000 EBIT = 2000 DOL = Sales – Variable Costs EBIT 6= S – 0.50S 2000 S= Sales = Rs. 24000 VC = 0.50 x 24000 = Rs. 12000
- 46. • Financial position of Company C can be regarded as better than other companies. • Least financial risk as minimum degree of financial leverage. • Company C is better placed from DCL point of view. Total risk of Company C is lowest. • Ability of Company C to meet its interest liability is better. Company EBIT/Interes t Value A 2000/1000 2 B 300/200 1.5 C 400/300 1.33
- 47. Question 7 • Mr. Nitesh is an entrepreneur and has recently set up manufacturing unit of pens. He currently sells 1million pens in a year at Rs 5 each. His variable cost is Rs. 3 per pen and he has Rs. 15 lakhs in fixed costs. His sales to assets ratio is 5times and 40% of his assets are financed with 8%debt with the balance being financed by ordinary shares of Rs. 10 per share. Tax rate is 35%.
- 48. His newly appointed finance manager Mr. Vinit Shah thinks that Mr. Nitesh is doing it all wrong. By reducing his price to Rs. 4.50 per pen he could increase his sales volume by 40%. Fixed costs would remain constant and variable costs at Rs. 3 per unit. His sales to asset ratio would be 6.3 times. Furthermore he could increase his debt to asset ratio to 50%, with the balance in shares. It is assumed that interest rate would be up by 1% and that price of shares would remain constant.
- 49. A. Compute the EPS under the Nitesh and Vinit plans. Is Mr. Vinit’s perception right? B. Mr. Nitesh’s partner Miss Hemanti does not think that fixed costs would remain constant under Vinit’s plan but they would go up by 15% . If this is the case should Mr Nitesh shift to Vinit’s plan, based on EPS? C. What is the effect of total risk on the firm on switching from one plan to another?
- 50. Solution Particulars Amount(Rs.) Nitesh’s Plan: Sales Revenue(1 million * Rs 5) 5000000 Less: Variable Cost(1 million* Rs.3) 3000000 Contribution 2000000 Less: Fixed Cost 1500000 EBIT 500000 Less: Interest 32000 PBT 468000 Less : Tax(0.35) 163800 PAT 304200 N( numbers of Shares) 60000 EPS 5.07
- 51. Particulars Amount(Rs.) Vinit’s Plan: Sales Revenue(1million * 1.4* Rs 4.5) 6300000 Less: Variable Cost(1million * 1.4* Rs.3) 4200000 Contribution 2100000 Less: Fixed Cost 1500000 EBIT 600000 Less: Interest 45000 PBT 555000 Less: Tax(0.35) 194250 PAT 360750 N( numbers of Shares) 50000 EPS 7.215
- 52. Working note 1 : Sales / Assets = 5 Rs 50 lakh/ Assets =5 or Assets Rs.10 Lakhs 40% of assets financed by 8% debt= Rs. 4 lakh Interest (0.08* Rs.4 lakh)= Rs.32000 Number of shares (Rs. 6 lakh/Rs. 10 each share)=60,000 Working Note 2: Total Assets =Rs.10 lakh Debt/Assets = 50% Debt = Rs. 5 lakh at 8% + 1% =9% Interest = 0.09 * Rs.5 lakh = Rs. 45,000 Number of shares (Rs.5 lakh / Rs.10) = 50,000 Yes, Mr Vinit is right in his perceptions. Following his plan would increase the EPS to Rs.7.22 from Rs.5.07
- 53. (c) Computation of EPS The total risk is determined by the combined leverage which in turn is evaluated by combined operating and financial leverage. Nitesh’s plan : Vinit’s plan : DOL = Contribution = 20 L = 4 DOL =Rs. 21 L EBIT 5 L DFL = 6 L DFL =EBIT = 5L 6 L – 0.45L EBIT-I 5L – 0.32L DCL = DOL*DFL = 3.78 DCL = DOL * DFL = 4.27 There is decrease in degree in the combined leverage , reflecting a decline in the total risk of the company. With a lower degree of risk , the market price of its share is likely to go up.