CHAPTE R 14

FINANCIAL AND OPERATING LEVERAGE

LEARNING OBJECTIVES
2

Explain

the concept of financial leverage Discuss the alternative measures of financial leverage Understand the risk and return implications of financial leverage Analyze the combined effect of financial and operating leverage Highlight the difference between operating risk and financial risk

Capital Structure Defined

The

term capital structure is used to represent the proportionate relationship between debt and equity. 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, shortterm borrowings are excluded from the list of methods of financing the firms capital expenditure.

The

The capital structure decision process

While making the Financing Decision...

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 firms 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?

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.

Measures of Financial Leverage

ratio Debtequity 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 firms income gearing.

Financial Leverage of Ten Largest Indian Companies, 2008

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 firms rate of return on net assets (RONA or ROI). ROE and ROI are the important figures for analysing the impact of financial leverage.

EPS,

EPS and ROE Calculations

For

calculating ROE either the book value or the market value equity may be used.

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Analyzing Alternative Financial Plans: Constant EBIT Effect of Financial Plan on EPS and ROE:

The firm is considering two alternative financial plans:

Constant EBIT

(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.

Interest Tax Shield

The

interest charges are tax deductible and, therefore, provide tax shield, which increases the earnings of the shareholders.

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Effect of Leverage on ROE and EPS

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Effect of Financial Plan on EPS and ROE: Varing EBIT

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Effect of Financial Plan on EPS and ROE: Varing EBIT

EBITEPS chart-Example
16

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Calculation of indifference point

EPS formula under all-equity plan is

The

EPS formula under debtequity plan is:

Setting

the two formulae equal, we have:

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Calculation of indifference point

a firm may like to make a choice between two levels of debt. Then, the indifference point formula will be:

The

firm may compare between an all-equity plan and an equity-and-preference share plan. Then the indifference point formula will be:

Operating Leverage
19

Operating

leverage affects a firms 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 % Change in Sales EBIT/EBIT DOL Sales/Sales DOL

Degree of Financial Leverage

The

degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT:

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Combining Financial and Operating Leverages

leverage affects a firms operating profit (EBIT), while financial leverage affects profit after tax or the earnings per share. degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales.

The

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Combining Financial and Operating Leverages

degree of combined leverage (DCL) is given by the following equation:

another

way of expressing the degree of combined leverage is as follows:

Financial Leverage and the Shareholders Risk

The

variability of EBIT and EPS distinguish between two types of riskoperating risk and financial risk. Operating risk can be defined as the variability of EBIT (or return on total assets). The environmentinternal and externalin 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. Financial risk is an avoidable risk if the firm decides not to use any debt in its capital structure.

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Measuring Operating and Financial Risk

can use two measures of risk:

Standard deviation and Coefficient of variation.

2 2 (EPS) [EPS1 E (EPS)] 2 P [EPS E (EPS)] P2 1 2

[EPS
j 1

E (EPS)] 2 Pj EPS j Pj

E (EPS) EPS1 P1 EPS 2 P2

EPS P
j 1 j

Risk-Return Trade-off
25

If

the firm wants higher return (EPS or ROE) for the shareholders for a given level of EBIT, it will have to employ more debt and will also be exposed to greater risk (as measured by standard deviation or coefficient of variation).

In

fact, the firm faces a trade-off between risk and return.

Financial

leverage increases the chance or probability of insolvency.