Operating & Financial Leverage Analysis .ppt

Definition
“ Capital structure of a company refers to the
composition of its capitalisation and it includes all
long term capital sources i.e., loans, reserves, shares
and bonds”. –gerestenbeg
“ the Capital structure of business can be measured by
the ratio of various kinds of permanent loan and
equity capital to total capital”. - Schwarty

Optimal capital structure
 The OCM can be defined as “ that capital structure
or combination of debt and equity that leads to the
maximum value of the firm”
 OCM maximises the value of the company and
hence the wealth of its owners and minimise the
company’s cost of capital.
 the following consideration should be kept in mind
while maximising the value of the firm in achieving
the goal of the optimal capital structure:

Leverage
 Leverage-an Increased means of accomplishing some
purpose
 In financial management, it is the firms ability to use fixed
cost assets or funds to increase the returns to its owners;
 Financial leverage- the use of long term fixed income bearing
debt and preference share capital along with the equity share
capital is called financial leverage or trading on equity
 A Firm is known to have a favourable leverage if its earnings
are more than what debt would cost. On the contrary, if it
does not earn as much as the debt costs then it will be known
as an unfavourable leverage.

© 2012 Pearson Prentice Hall. All rights reserved.
12-5
Leverage: Operating Leverage
Operating leverage is the use of fixed operating costs to
magnify the effects of changes in sales on the firm’s earnings
before interest and taxes.
The degree of operating leverage (DOL) is the numerical
measure of the firm’s operating leverage.
As long as DOL is greater than 1, there is operating leverage.

Operating leverage
 Operating leverage results from the presence of fixed
costs the help in magnifying net operating income
fluctuations flowing from small variations in revenue.
 The changes in sales are related to changes in the
revenue. The fixed costs do not change with the
changes in sales, any increase in sales, FC remaining
the same, will magnify operating revenue
 OL shows the ability of a firm to use fixed operating
cost to increase the effect of change in sales and the
charges in fixed operating income.

If a 10 percent increase in sales causes EBIT to
increase from $1mn to $1.50 mn,
what is its degree of operating leverage?
a. 3.6
b. 4.2
c. 4.7
d. 5.0
e. 5.5

12-8
Financial Leverage
Financial leverage is the use of fixed financial costs to
magnify the effects of changes in earnings before interest and
taxes on the firm’s earnings per share.
The two most common fixed financial costs are (1) interest on
debt and (2) preferred stock dividends.
The degree of financial leverage (DFL) is the numerical measure of
the firm’s financial leverage.
Whenever DFL is greater than 1, there is financial leverage.

Impact of financial leverage
 When the difference b/w the earnings from assets
financed by fixed cost funds and cost of these funds are
distributed to the equity stockholders, they will get
additional earnings without increasing their own
investment. Consequently, the EPS and the Rate of
return will go up.
 On the contrary, if the firm acquires fixed cost funds at
a higher cost than the earnings from those assets then
the EPS and return on equity capital will decrease.

Significance of financial leverage
 Planning of capital structure
 Profit planning
Limitations of FL/ trading on equity
 Double-edged weapon
 Beneficial only to companies having stability in
earnings
 Increases risk and rate of interest
 Restriction from financial instruments

12-11
General Income Statement Format and
Types of Leverage

12-12
Leverage: Breakeven Analysis
 Breakeven analysis is used to indicate the level of operations
necessary to cover all costs and to evaluate the profitability
associated with various levels of sales; also called cost-volume-
profit analysis.
 The operating breakeven point is the level of sales necessary to
cover all operating costs; the point at which EBIT = $0.
 The first step in finding the operating breakeven point is to divide the cost
of goods sold and operating expenses into fixed or variable operating costs.
 Fixed costs are costs that the firm must pay in a given period regardless of
the sales volume achieved during that period.
 Variable costs vary directly with sales volume.

12-13
Leverage: Breakeven Analysis
Using an algebraic calculation as a formula for earnings
before interest and taxes yields:
EBIT = (P  Q) – FC – (VC  Q)
Simplifying yields:
EBIT = Q  (P – VC) – FC
Setting EBIT equal to $0 and solving for Q (the firm’s
breakeven point) yields:

12-14
Leverage: Breakeven Analysis (cont.)
Assume that Cheryl’s Posters, a small poster retailer, has
fixed operating costs of $2,500. Its sale price is $10 per
poster, and its variable operating cost is $5 per poster. What
is the firm’s breakeven point?

Combined leverage
 The OL affects the income which is the result of
production. On the other hand, FL is the result of
financial decisions. The CL focuses attention on the
entire income of the concern
 This leverage shows the relationship between a
change in sales and the corresponding variation in
taxable income.
 Working capital leverage
This leverage measures the sensitivity of ROI of
changes in the level of current assets.

12-16
Leverage: Total Leverage (cont.)
The degree of total leverage (DTL) is the numerical
measure of the firm’s total leverage.
As long as the DTL is greater than 1, there is total
leverage.

12-17
Leverage: Relationship of Operating,
Financial, and Total Leverage
 Total leverage reflects the combined impact of operating and
financial leverage on the firm.
 High operating leverage and high financial leverage will cause
total leverage to be high. The opposite will also be true.
 The relationship between operating leverage and financial
leverage is multiplicative rather than additive.
DTL = DOL  DFL

Effect of Leverage on the cost of equity
 If the level of debt increases, the riskiness of the firm
increases.
 The cost of debt will increase because bond rating
will deteriorates with higher debt level.
 Moreover, the riskiness of the firm’s equity also
increases, resulting in a higher ke.

For example
 A company’s expected annual EBIT is Rs. 50000. The
company has Rs 2,00,000, 10% debenture. The cost
of equity of the company is 12.5%. Calculate market
value of Equity and total value of Firm.

Solution
Net Operating Income (EBIT) Rs 50,000
Less: Interest on debentures (I) 20,000
------------------
---------
Earnings available to equity holders (NI) 30,000
Equity Capitalization Rate (ke) 0.125
Market Value of Equity (S) = NI/Ke ------------------
----------
2,40,000
Market Value of Debt (B) 2,00,000
Total Value of the firm (S+B) = V ------------------
------------
4,40,000

Practice Question
 Two firms A and B are identical in all respects except
the degree of leverage. Firm A has 6% debt of £
3,00,000 while firm B has no debt. Both the firms
earning an EBIT of £ 1,20,000 each. The equity
capitalisation rate is 10% and the corporate tax is
60%.
 Compute the market value of the two firms.

Dividend Policies involve the decisions, whether-
To retain earnings for capital investment and other purposes; or
To distribute earnings in the form of dividend among shareholders; or
To retain some earning and to distribute remaining earnings to
shareholders.
The typical dividend policy of most firm is to retain between 1/3 to half
of the net earnings and distribute the remaining amount to share holders.
Companies in India specify dividends in term of a dividend rate which is
percentage of the paid up capital per share.
What is Dividend Policy

CASH DIVIDEND
 Companies mostly pay dividends in cash.
 A company should have enough cash while declaring dividend in
its absences arrangement should be made to borrow fund.
 Same way, when the company follows a stable dividend policy, it
should prepare a cash budget for the coming period to indicate
the necessary funds, which would be needed to meet the regular
dividend payments of the company.
 The cash account and the reserve account of a company will be
reduced when the cash dividend is paid.
 The market price of the shares drops in most cases by the
amount of the cash dividend distributed.

BONUS SHARES
 Bonus shares is the distribution of shares free of cost to the existing
company.
 In India, bonus shares are issued in addition to the cash dividend and
not in lieu of cash dividend. Hence companies in India may supplement
cash dividend by bonus issues.
 The bonus shares are distributed proportionately to the existing
shareholder. Hence there is no dilution of ownership.
 The declaration of bonus shares will increase the paid up share capital
and reduce the reserve and surplus of the company.
 The total net worth (paid up capital + surplus) is not affected by the
bonus issue.
 In fact, a bonus issue represents a recapitalization of reserve and
surplus.
 It is merely an accounting transfer from reserves and surplus to paid-
up capital.

ADVANTAGES OF BONUS SHARES
For shareholders:
1) Tax benefits
2) Indication of higher future profits.
3) Future dividends may increase
4) Psychological value
For company:
1) Conservation of cash
2) Only means to pay dividends under contractual
restrictions.
3) More attractive share price

LIMITATIONS OF BONUS SHARES
1) Shareholders wealth remains unaffected
2) Costly to administer
3) Problem of adjusting Earning Per Share and Price Earning
Ratio.

 A share split is a method to increase the number of outstanding
shares through a proportional reduction in the par value of the
share and thus shareholders total funds remain unaltered.
REVERSE SPLIT
 When the prices of shares fall, the company may want to reduce
the number of its share outstanding to increase the market price.
 The reduction of the number of outstanding shares by increasing
per share par value is known as a reverse split.
SHARE SPLIT

Dividend
Theories
Relevance
Theories
(i.e. which consider
dividend decision to be
relevant as it affects the
value of the firm)
Irrelevance
Theories
(i.e. which consider
dividend decision to be
irrelevant as it does not
affects the value of the
firm)
Walter’s Model
Gordon’s
Model
Modigliani and
Miller’s Model

Dividends Irrelevance
 The propagators of this school of thought were
France Modigliani and Merton Miller (1961).
 They state that the dividend policy employed by a
firm does not affect the value of the firm. They argue
that the value of the firm is dependent on the firm’s
earnings which result from its investment policy,
such that when the policy is given the dividend policy
is of no consequence.

 Conditions that face a firm operating in a perfect
capital market, either;
1. The firm has sufficient funds to pay dividend
2.The firm does not have sufficient funds to pay
dividend therefore it issues stocks in order to finance
payment of dividends
3.The firm does not pay dividends but the
shareholders need cash.

Assumptions of M-M hypothesis
 Perfect capital markets, i.e. investors behave rationally,
information is freely available to all investors,
transaction and floatation costs do not exist, no investor
is large enough to influence the price of a share.
 Taxes do not exist; or there is no difference in the tax
rates applicable to both dividends and capital gains.
 The firm has a fixed investment policy
 The risk of uncertainty does not exist, i.e. all investors are
able to forecast future prices and dividends with certainty
and one discount rate is appropriate for all securities
over all time periods.

 Under the assumptions the rate of return, r, will be
equal to the discount rate, k. As a result the price of
each share must adjust so that the rate of return,
which is composed of the rate of dividends and
capital gains on every share, will be equal to the
discount rate and be identical for all shares.
 The return is computed as follows:
r = Dividends + Capital gains (loss)
Share price
r = DIV1 + (P1 – P0)
P0

 As hypothesised, r should be equal for all the shares
otherwise the lower yielding securities will be traded
for the higher yielding ones thus reducing the price
of the low yielding ones and increasing the price of
the high yielding ones.
 This arbitraging or switching continues until the
differentials in rates of return are eliminated.

Conclusions of the model
 A firm which pays dividends will have to raise funds
externally in order to finance its investment plans. When
a firm pays dividend therefore, its advantage is offset by
external financing.
 This means that the terminal value of the share declines
when dividends are paid. Thus the wealth of the
shareholders – dividends plus the terminal share price –
remains unchanged.
 Consequently the present value per share after dividends
and external financing is equal to the present value per
share before the payment of dividends.
 Thus the shareholders are indifferent between the
payment of dividends and retention of earnings.

Criticisms
 Presence of Market Imperfections:
 Tax differentials (low-payout clientele)
 Floatation costs
 Transaction and agency cost
 Diversification
 Uncertainty (high-payout clientele)
 Desire for steady income
 No or low taxes on dividends

Operating & Financial Leverage Analysis .ppt

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