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Information about leverage

Published on April 21, 2009

Author: prachigupta787

Source: authorstream.com

UNIT -2 : UNIT -2 Leverage Leverage analysis : Leverage analysis The dictionary meaning of the firm leverages refers to “an increase means of accomplishing purpose ”. In machines , leverages means the instrument that helps us in lifting heavy objects, which may not be other wise possible. This concept of leverage is valid in business too. In financial management , it is used to describe the firms ability to use fixed assets costs funds to satisfy to magnify to return of its owners. DEFINATION : DEFINATION “Leverage is the ratio of the net rate of return on shareholder’s equity and net rate of return on total capitalization.” Types of leverage : Types of leverage There are three types of leverages- 1 . Financial leverage 2 . Operating leverage 3 . Composite leverage Financial leverage : Financial leverage A firm needs funds so run and manage its activities. The funds are first needs to set up an enterprise and then to implement expansion , diversification and other plans . A decision has to be made regarding the composition of funds. The funds may be raised through two sources., owners, called owners equity , and outsiders, called creditors equity. Slide 6: “financial leverage exists whenever a firm has debts other sources of funds that carry fixed charges. ” Computation of financial leverage : Computation of financial leverage Where capital structure consists of equity shares and debts- financial leverage- EBIT or EBIT EBIT-INT EBT or OP EBT or PBT Where the capital structure consists of preference share and equity shares : Where the capital structure consists of preference share and equity shares F.L- EBIT EBIT-(PDx1 ) 1-t When the capital structure consists of equity shares ,preference shares and debts : When the capital structure consists of equity shares ,preference shares and debts FL- EBIT EBIT-INT-(PDx 1 ) 1-t Degree of financial leverage : Degree of financial leverage DFL- %change in EPS % change in OP or EBIT Importance of financial leverage : Importance of financial leverage Capital structure management Maximization of EPS and market value of shares Measurement of Risk Operating leverage : Operating leverage This leverage is associated with the employment of fixed cost assets. It is calculated to know income of the company on different levels of sales. It is measure of effect on operating profit of the concern on change in sales. According to Solomon Ezra : According to Solomon Ezra “operating leverage is the tendency of the operating profit to vary disproportionately with sales. ” Operating leverage : Operating leverage OL= C OP or EBIT contribution= Sales-Variable cost operating profit=contribution-fixed cost Degree of operating leverage : Degree of operating leverage DOL= % change in OP or EBIT % change in Sales Composite leverage : Composite leverage Composite leverage is calculated to determine the combined effect of operating and financial leverages. CL=Financial leverage x operating Leverage or C PBT Degree of combined leverage : Degree of combined leverage DCL= % change in EBT % change in Sales Example-1 : Example-1 Calculate operating leverage, financial leverage and combined leverage from the follow data- Sales 100000 units @ Rs 2 pu Variable cost per unit @ Rs 0.70 p.u. fixed costs 100000 Interest charges on debt 3668 Indifference point : Indifference point The indifference point refers to that level of EBIT at which EPS are the regardless of leverage in alternative financial plans. At this, all financial plans are equally desirable and the management is indifferent between alternative financial plans as far as EPS is concerned . Slide 20: (x - i) (1- T ) = (x – i2) ( 1-T ) N1 N 2 N1- no of equity shares in first alternative N2- No of equity shares in second alternative i- interest on debentures

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