Bba 4 fm u 4 operating and financial leverage
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This document discusses financial and operating leverage. It defines financial leverage as using debt and preference shares in addition to equity in a company's capital structure. This allows earnings from fixed-cost funds like debt to be leveraged to increase returns to shareholders if the cost of debt is lower than returns on assets. However, it also increases risk. The document also defines operating leverage as how much a company's operating profits (EBIT) change with sales. It discusses how financial and operating leverage combine to impact earnings per share and risk.
![17Financial Management, Ninth Edition © I M Pandey
Vikas Publishing House Pvt. Ltd.
Measuring Operating and Financial
Risk
We can use two measures of risk:
Standard deviation and
Coefficient of variation.
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Bba 4 fm u 4 operating and financial leverage
- 1. UNIT-4 Financial and Operating Leverage Course: BBA-4 Subject: FM
- 2. 2Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Chapter Objectives Explain the concept of financial leverage. Discuss the alternative measures of financial leverage. Understand the risk and return implications of financial leverage. Analyse the combined effect of financial and operating leverage. Highlight the difference between operating risk and financial risk.
- 3. 3Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Capital Structure Defined The term capital structure is used to represent the proportionate relationship between debt and equity. The various means of financing represent the financial structure of an enterprise. The left- hand side of the balance sheet (liabilities plus equity) represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firm’s capital expenditure.
- 4. 4Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Questions while Making the Financing Decision How should the investment project be financed? Does the way in which the investment projects are financed matter? How does financing affect the shareholders’ risk, return and value? Does there exist an optimum financing mix in terms of the maximum value to the firm’s shareholders? Can the optimum financing mix be determined in practice for a company? What factors in practice should a company consider in designing its financing policy?
- 5. 5Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Meaning of Financial Leverage The use of the fixed-charges sources of funds, such as debt and preference capital along with the owners’ equity in the capital structure, is described as financial leverage or gearing or trading on equity. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners’ equity. The rate of return on the owners’ equity is levered above or below the rate of return on total assets.
- 6. 6Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Measures of Financial Leverage Debt ratio Debt–equity ratio Interest coverage The first two measures of financial leverage can be expressed either in terms of book values or market values. These two measures are also known as measures of capital gearing. The third measure of financial leverage, commonly known as coverage ratio. The reciprocal of interest coverage is a measure of the firm’s income gearing.
- 7. 7Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Financial Leverage of Ten Largest Indian Companies, 2002 Company Capital Gearing Income Gearing Debt ratio Debt–equity ratio Interest coverage Interest to EBIT ratio 1. Indian Oil 0.556 1.25:1 4.00 0.250 2. HPCL 0.350 0.54:1 5.15 0.194 3. BPCL 0.490 0.96:1 5.38 0.186 4. SAIL 0.858 6.00:1 - ve - ve 5. ONGC 0.106 0.12:1 53.49 0.019 6. TELCO 0.484 0.94:1 0.99 1.007 7. TISCO 0.577 1.37:1 1.62 0.616 8. BHEL 0.132 0.15:1 8.36 0.120 9. Reliance 0.430 0.75:1 3.46 0.289 10. L&T 0.522 1.09:1 2.31 0.433 11. HLL 0.027 0.03:1 264.92 0.004 12. Infosys 0.000 0.00:1 NA* NA* 13. Voltas 0.430 0.72:1 2.64 0.378
- 8. 8Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Financial Leverage and the Shareholders’ Return The primary motive of a company in using financial leverage is to magnify the shareholders’ return under favourable economic conditions. The role of financial leverage in magnifying the return of the shareholders’ is based on the assumptions that the fixed-charges funds (such as the loan from financial institutions and banks or debentures) can be obtained at a cost lower than the firm’s rate of return on net assets (RONA or ROI). EPS, ROE and ROI are the important figures for analysing the impact of financial leverage.
- 9. 9Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. EPS and ROE Calculations For calculating ROE either the book value or the market value equity may be used. N )T1)(INTEBIT( N PAT =EPS sharesofNumber after taxProfit =shareperEarnings −− = S )TINT)(1(EBIT =ROE equityofValue after taxProfit =equityonReturn −−
- 10. 10Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Effect of Financial Plan on EPS and ROE: Constant EBIT The firm is considering two alternative financial plans: (i) either to raise the entire funds by issuing 50,000 ordinary shares at Rs 10 per share, or (ii) to raise Rs 250,000 by issuing 25,000 ordinary shares at Rs 10 per share and borrow Rs 250,000 at 15 per cent rate of interest. The tax rate is 50 per cent. Financial Plan Debt-equity (Rs) All-equity (Rs) 1. Earnings before interest and taxes, EBIT 120,000 120,000 2. Less: interest, INT 0 37,500 3. Profit before taxes, PBT = EBIT – INT 120,000 82,500 4. Less: Taxes, T (EBIT – INT) 60,000 41,250 5. Profit after taxes, PAT = (EBIT – INT) (1 – T) 60,000 41,250 6. Total earnings of investors, PAT + INT 60,000 78,750 7. Number of ordinary shares, N 50,000 25,000 8. EPS = (EBIT – INT) (1 – T)/N 1.20 1.65 9. ROE = (EBIT – INT) (1 – T)/S 12.0% 16.5%
- 11. 11Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Effect of Leverage on ROE and EPS Favourable ROI > i Unfavourable ROI < i Neutral ROI = i
- 12. 12Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Effect of Financial Plan on EPS and ROE: Varing EBIT Economic Conditions Very poor Poor Normal Good Probability 0.05 0.10 0.15 0.35 0.30 0.05 Sales (Rs) 510 660 710 800 880 1,160 Costs: Variable (Rs) 255 330 355 400 440 580 Fixed (Rs) 280 280 280 280 280 280 Total Costs (Rs) 535 610 635 680 720 860 EBIT (Rs) –25 50 75 120 160 300 ROI (r) –5% 10% 15% 24% 32% 60% Plan I: No debt EBIT –25.00 50.00 75.00 120.00 160.00 300.00 Less: Interest 0.00 0.00 0.00 0.00 0.00 0.00 PBT –25.00 50.00 75.00 120.00 160.00 300.00 Less: tax, 50% –12.50* 25.00 37.50 60.00 80.00 150.00 PAT –12.50 25.00 37.50 60.00 80.00 150.00 No. of shares (000) 50.00 50.00 50.00 50.00 50.00 50.00 EPS (Rs) –0.25 0.50 0.75 1.20 1.60 3.00 ROE (%) –2.50 5.00 7.50 12.00 16.00 30.00 Plan II: 25% debt EBIT –25.00 50.00 75.00 120.00 160.00 300.00 Less: Interest 18.75 18.75 18.75 18.75 18.75 18.75 PBT –43.75 31.25 56.25 101.25 141.25 281.25 Less: tax, 50% –21.88* 15.63 28.13 50.63 70.63 140.63 PAT –21.87 15.62 28.12 50.62 70.62 140.62 No. of share (000) 37.50 37.50 37.50 37.50 37.50 37.50 EPS (Rs) –0.58 0.42 0.75 1.35 1.88 3.75 ROE (%) –5.80 4.20 7.50 13.50 18.80 37.50 Plan III: 50% debt EBIT –25.00 50.00 75.00 120.00 160.00 300.00 Less: Interest 37.50 37.50 37.50 37.50 37.50 37.50 PBT –62.50 12.50 37.50 82.50 122.50 262.50 Less: tax, 50% –31.25* 6.25 18.75 41.25 61.25 131.25 PAT –31.25 6.25 18.75 41.25 61.25 131.25 No. of shares (000) 25.00 25.00 25.00 25.00 25.00 25.00 EPS (Rs) –1.25 0.25 0.75 1.65 2.45 5.25 ROE (%) –12.50 2.50 7.50 16.50 24.50 52.50
- 13. 13Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Operating Leverage Operating leverage affects a firm’s operating profit (EBIT). The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales. % Change in EBIT DOL % Change in Sales EBIT/EBIT DOL Sales/Sales = ∆ = ∆
- 14. 14Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Combining Financial and Operating Leverages Operating leverage affects a firm’s operating profit (EBIT), while financial leverage affects profit after tax or the earnings per share. The degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales.
- 15. 15Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Combining Financial and Operating Leverages The degree of combined leverage (DCL) is given by the following equation: another way of expressing the degree of combined leverage is as follows: % Change in EBIT % Change in EPS % Change in EPS % Change in Sales % Change in EBIT % Change in Sales = × = ( ) ( ) ( ) DCL ( ) ( ) INT ( ) INT Q s v Q s v F Q s v Q s v F Q s v F Q s v F − − − − = × = − − − − − − − −
- 16. 16Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Financial Leverage and the Shareholders’ Risk The variability of EBIT and EPS distinguish between two types of risk—operating risk and financial risk. Operating risk can be defined as the variability of EBIT (or return on total assets). The environment— internal and external—in which a firm operates determines the variability of EBIT The variability of EBIT has two components: variability of sales variability of expenses The variability of EPS caused by the use of financial leverage is called financial risk.
- 17. 17Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Measuring Operating and Financial Risk We can use two measures of risk: Standard deviation and Coefficient of variation. 2 2 2 2 1 1 2 2 2 1 1 1 2 2 1 (EPS) [EPS (EPS)] [EPS (EPS)] [EPS (EPS)] [EPS (EPS)] (EPS) EPS EPS EPS EPS j j n j j j n j j j j j E P E P E P E P E P P P P σ = = = − + − + + − = − = × + × + + = ∑ ∑ L L
- 18. Sourse :- Book : - Financial Management (Ninth Edition) Author I M Panday – Vikas Publication 18Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd.