Financing Decision

In this chapter… Sources of finance… Debt, Preference and Equity Capitals… Operating and financial Leverage…

Sources of Finance… Owned Capital:

Share Capital Equity Share Capital Preference Share Capital

Retained Earnings. Debt Capital:

Debentures. Institutional Loans. Public Deposits.

Leverage… Leverage means the action of a lever and

mathematical advantage gained by it. Firm’s ability to use fixed costs assets or sources

of funds to magnify the returns to its owners. According to James Home, ‘ leverage is the

employment of an asset or sources of funds for which the firm has to pay a fixed costs or fixed return.

Types of Leverage… Operating Leverage. Financial Leverage.

Operating Leverage… The firm’s ability to use operating cost to

magnify the effects of changes in sales on its EBIT.

The degree of operating leverage may be defined as the change in the percentage of EBIT, for a given change in percentage of sales revenue.

Symbolically…

Degree of Operating Leverage (DOL)

=

Percentage change in EBIT

OrPercentage change in Sales

When the data is given only for one year, then we have to compute operating leverage, by the following formula.

Operating Leverage

= Contribution

Operating Profit (EBIT)

Application of the Operating Leverage…

It is helpful to know how operating profit would change with a given change in units produced.

It will be helpful in measuring business risk.

Financial Leverage… Ability of the firm to use fixed financial charges to

magnify the effect of changes in EBIT on firm’s EPS.

 

Financial Leverage =

EBIT (Operating profit)

Or 

  EBT (Taxable income)  

Degree of Financial Leverage (DFL)

Percentage change in EPS

Percentage change in EBIT=

Application of the Financial Leverage…

It is helpful to know how EPS would change with a operating profit.

It is helpful for measuring financial risk.

Combined Leverage… The percentage change in EPS due to the

percentage changes in sales.

% Change in EBITX

% Change in EPS

=

% Change in EPS

% Change in Sales % Change in EBIT % Change in Sales

Contribution X

EBIT

=

Contribution

EBIT EBT EBT

Or

Effect of Leverage…OperatingLeverage

FinancialLeverage

Combined Effect

High High This combination is very dangerous policy, which should be avoided.

Low Low This combination is very cautious policy and not assuming risk.

High Low This combination have adverse effects of operating leverage were taken care of by having low financial leverage.

Low High This combination is an ideal situation. The company can follow aggressive debt policy.