leverage.pptx
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Leverage refers to a firm's use of fixed costs, whether operating costs or financial costs like interest, to magnify the effect of changes in sales or operating profits on profits. There are three main types of leverage: 1) Operating leverage is the use of fixed operating costs, which do not vary with sales. Higher operating leverage means profits are more sensitive to changes in sales. 2) Financial leverage is the use of fixed financing charges like interest on debt. It magnifies the effect of changes in operating profits on net profits. 3) Combined leverage considers the interaction of operating and financial leverage and their combined effect on profits and earnings per share. Firms seek an optimal level of leverage to maximize
leverage.pptx
- 2. Leverage
- 3. • Firms ability to use fixed costs assets and funds to magnify the return • Leverage is the employment of an asset or funds for which the firm pays a fixed cost – James Horne • No leverage- if firm not required to pay fixed cost • Fixed cost is something which has to be paid irrespective of the volume of production or sales and it has considerable effect on the firms profit which is available to shareholders Leverage Operating leverage Financial Leverage Combined Leverage
- 5. Operating leverage • Use of fixed cost in the operation of the firm • Irrespective of volume of sales firm has to bear fixed cost • It remains constant • A small change in sales will bring a proportionate change in operating profit- operating leverage • It’s the firms ability to use fixed operating cost to magnify the effect of changes in sales pm its earning before interest and tax • OL= Contribution/EBIT
- 6. Particulars Per unit Total Sales - Variable cost a)Direct Labour b)Direct Expense c)Variable factory overhead d)Variable administrative overhead e)Variable Selling and distribution expenses Contribution - Fixed cost Operating Profit (EBIT)
- 7. OL can be favourable or unfavourable Favourable- contribution exceeds fixed cost Unfavourable –opposite Problem 1: Output 20000 units Selling price per unit Rs.12 Direct materials per unit Rs.5 Direct Labour per unit Rs.2 Variable overhears per unit Rs.1 Fixed cost per year Rs.60000
- 8. Questions?? • A firm sells its only product at Rs.12 per unit . Its variable cost is Rs 8 per unit.Present sales are 1000 units. Calculate the operating leverage in each of the following a) Fixed cost is 1000 Rs b) Fixed cost is 1200 Rs c) Fixed cost is 1500 Rs Observe how fixed cost is related to operating leverage
- 9. • Calculate Operating leverage for Maruti Ltd, from the following information No of units produced 50,000 Selling price per unit Rs 50 Variable cost per unit Rs 20 Fixed cost per unit at current level of sales is Rs 15. What will be the new operating leverage if the variable cost is Rs 30/unit The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Selling price per unit is Rs 10, variable cost Rs 6/per unit. Calculate operating leverage in each of the three situations Fixed cost is Rs 400 Fixed cost 1000 Rs Fixed cost Rs 1200
- 10. • No of units produced and sold :30,000 Selling price per unit Rs 20 Variable cost per unit Rs 10 Fixed cost per unit at current level of Sales is Rs 5 /unit. What will be the new operating leverage if variable cost is Rs12 Determine operating leverage Company A Sales 50,00,000Rs Fixed cost 15,00,000Rs Variable cost 50% of sales Company B Sales 60,00,000Rs Fixed cost 30,00,000Rs Variable cost 25% of sales
- 11. • Find operating leverage Sales 50,000 Rs Variable cost 60% Fixed cost 12,000 Rs
- 12. • Degree of Leverage: Percentage change in operating profit resulting from percentage change in sales DOL= % change in EBIT / %change in sales Higher operating leverage for the firm which uses greater amount of fixed cost and smaller amount of variable cost Opposite gives lower operating leverage X ltd sells 1000 units @ 20 per unit. The cost of production is Rs 14 per unit. The firm has a fixed cost of Rs 1000. Assume that the sales of X ltd increased by 10% Find the DOL
- 13. Find degree of leverage : EBIT (2008) – Rs 50,000 Sales (2008) – 20,000 units EBIT (2009) –Rs 60,000 Sales (2009) -28,000 units Find DOL EBIT(2005) – 40,000/- Sales (2005)- 20,000 units EBIT(2006)- 50,000 Sales (2006)- 28000 units
- 14. The firm will have no operating leverage if it doesn’t have fixed cost Consider the following: Solve and Analyse: Present Expected Sales - Variable cost 20,000 14,000 30,000 21,000 EBIT/Profit 6000 9000
- 15. FINANCIAL LEVERAGE • When the firm uses fixed interest /dividend bearing securities i.e. debentures and preference shares’ • Along with owners equity to improve return • These fixed financial charges do not vary with operating profit • They are paid regardless of the amount of EBIT • What is remaining after paying the fixed charges is paid to equity shareholders • EBIT/EBT • “ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the firms earning per share”
- 16. X Ltd Y Ltd Equity share capital of Rs 10 each 8,000,000 3,00,000 12% debentures 50,000 5,50,000 Capital Employed 8,50,000 8,50,000 EBIT 2,55,000 2,55,000 EBIT 2,55,000 2,55,000 - Interest on debentures 6000 66,000 EBT 2,49,000 1,89,000 - Tax @ 35% 87,150 66,150 EAT 1,61,850 1,22,850 EPS= EAT/No of Equity shares 1,61,850/80,000 =2.02 1,22,850/30,00 0 =4.095
- 17. Question??? • Buddha Belly Ltd has a choice of the following three financial plans You are requested to ascertain the financial leverage in each case and interpret it. Plan 1 Plan 2 Plan3 Equity share capital 6 lakh 5 lakh 2 lakh 10% Debentures 4 lakh 5 lakh 8 lakh EBIT 2.5 lakh 2.5 lakh 2.5lakh
- 18. • The capital Structure of Tom Gilbert Ltd consists of the following securities 45,000 10% preference shares of 100 each – 45,00,000 5,00,000 equity shares of 10 each ---------------50,00,000 The companys operating profit is Rs 12,00,000 . Find financial leverage What will be the new financial leverage if the operating profit increases to 18,00,000 and interpret • Martin Ltd has the following capital structure: 25,000 Equity shares of Rs 10 each – 2,50,000 2000 9% Pref shares of 100 each –2,00,000 3000 10% Debentures of 100 each- 3,00,000 The company’s EBIT is Rs 1,25,000. Calculate the financial leverage assuming that the company tax bracket is 40%
- 19. • The capital Structure of Tom Gilbert Ltd consists of the following securities 45,000 10% preference shares of 100 each – 45,00,000 5,00,000 equity shares of 10 each ---------------50,00,000 The companys operating profit is Rs 12,00,000 . Tax bracket 40% Find financial leverage
- 20. • Ascertain Financial Leverage Net worth: 20,00,000 Debt/Equity ratio – 3:1 Interest rate 10% Operating Profit -18,00,000 • Calculate financial leverage Profit before depreciation, interest and tax – 80,00,000 Depreciation –12,50,000 Tax rate- 40% EPS- 4 No of equity shares -3,15,000
- 21. • Find financial leverage: Net worth – 25,00,000 Debt/Equity -3:1 Interest rate -12% Operating Profit- 20,00,000
- 22. • Degree of Financial Leverage : % change in taxable profit as a result of % change in operating profit % change in EPS/ % change in EBIT X Ltd Y Ltd Equity share capital of Rs 10 each 8,00,000 3,00,000 12% debentures 50,000 5,50,000 Capital Employed 8,50,000 8,50,000 EBIT 2,55,000 2,55,000 - Interest on debentures 6000 66000 EBT 2,49,000 1,89,000 - Tax @ 35% 87,150 66,150 EAT 1,61,850 1,22,850 EPS= EAT/No of equity shares 1,61,850/80,000 2.02 1,22,850 /30,000 4.095
- 23. Combined leverage Combined leverage = financial leverage * operating leverage Contribution/EBIT * EBIT/EBT = Contribution/EBT Z ltd has a sales of 4,00,000 . The variable cost is 60% of the sale and fixed cost is Rs 8,00,000. the interest on debentures is Rs 40,000 Compute combined leverage and show the impact of taxable income when sales increases by 5%
- 24. Question??? • The following figures relate to two companies. Calculate all three leverages of the two companies X ltd Y ltd Sales 4,00,000 8,00,000 - Variable cost Contribution - Fixed cost Operating Profit (EBIT) - Interest Profit before tax 1,60,000 2,40,000 1,28,000 1,12,000 48,000 64,000 2,40,000 5,60,000 2,80,000 2,80,000 1,20,000 1,60,000
- 25. • The following projections have been given in respect of Bright co Calculate all three leverages Output 3,00,000 units Fixed cost 3,50,000 Variable cost/unit 1 Interest expenses 25,000 Unit selling Price 3
- 26. • A firm has sales of 15,00,000 , variable cost of 9,00,000 .Fixed cost of 3,00,000 and debt of 8,00,000 at 8% Calculate all leverages • The capital structure of Madan Ltd Consists of equity share capital of 8,00,000 (shares of 100 each) and 8,00,000 of 12% debentures. Sales have increased from 80,000 units to 1,00,000 units . The selling price is Rs 15 per unit , variable cost amounts to 9 per unit and fixed cost amounts to 1,60,000. Tax at 50% Calculate financial and operating leverages at both levels Calculate percentage increase in EPS
- 27. • Calculate leverages under situations A, B, C from the following particulars Installed Capacity -1200 units Actual production and sales – 800 units Selling price per unit – Rs 15 Variable cost per unit – Rs 10 Fixed Cost: A -1000 B -2000 C-3000 Capital structure Plan 1 Plan 2 Plan 3 Equity 5000 7500 2500 Debt (12% 5000 2500 7500
- 28. • Calculate operating and financial leverage Unit sold 5000 Variable cost per unit Rs 20 10% public debt 1,00,000 EBIT Rs 30,000 Selling price per unit Rs 30 • A firm has a sales of Rs. 20,00,000. Variable cost is Rs. 14,00,000 and fixed cost Rs. 4,00,000 and the debt is Rs. 10,00,000 at 10% rate of interest. Find out the leverages. • Calculate leverages from the following : Production (units) 75,000 Fixed expenses 7,00,000 Variable cost (1 unit) 7.50 Interest expenses 40,000 Selling price (1 unit) 25.00
- 29. • The company’s current balance sheet is as follows : The company's total assets turnover ratio is 3.0. its fixed operating costs are Rs. 10,00,000 and variable operating cost 40%. The income tax rate is 50%. Compute for the company all the three types of leverages Liabilities Assets Equity capital 6,00,000 (Rs. 10 per share) Net fixed assets 15,00,000 10% long term loan 8,00,000 Current assets 5,00,000 Profit and loss a/c 2,00,000 Current liabilities 4,00,000
- 30. • The company had the following balance sheet as on 31-03-2006 Additionally, Fixed cost per annum (excluding interest) – 8 cr Variable operating cost ratio :65% Total Asset turnover ratio – 2.5 Income tax rate – 40% Find EPS and levrages Liabilities Amount in Cr Assets Amount in Cr Equity share capital (one crore shares of 10 each) 10 Fixed 25 Reserves and surplus 2 Current 15 15% debentures 20 Current liabilities 8 40 40
- 31. • Calculate the degree of operating leverage degree of financial leverage for the following firms and interpret the results. Particulars P Q R Output (Units) 3,00,000 75,000 5,00,000 Fixed cost (Rs.) 3,50,000 7,00,000 75000 Unit variable cost (Rs.) 1.00 7.50 0.10 Interest expenses (Rs.) 25,000 40,000 nil Unit selling price 3.00 25.00 0.50
- 32. • Calculate the degree of financial leverage for ‘J’ Ltd. Selling price is Rs. 150. Variable cost is Rs. 100. Fixed cost Rs. 1,20,000.Interest on debt Rs. 20,000. Tax 50%. Preference dividend Rs. 10,000, Output 10,000 units.