Leverage

Introduction

Capital Structure

• The assets can be financed either by increasing the owner’s claim or the creditor’s claim.

• Owner’s claim is increase by issuing ordinary shares.• Creditor’s claim is increase by borrowing.• The various means of financing is known as capital

structure.

Result 1. The effect of financial leverage depends on the company’s EBIT. When EBIT

is relatively high, leverage is beneficial.

2. Under the expected scenario, leverage increases the returns to

shareholders, as measured by both ROE and EPS.

3. Shareholders are exposed to more risk under the proposed capital structure

because the EPS and ROE are much more sensitive to changes in EBIT in

this case.

4. Because of the impact that financial leverage has on both the expected

return to stockholders and the riskiness of the stock, capital structure is an

important consideration.

Risks associated with firm

Financial Leverage

Degree of Combined Leverage

Operating leverage and financial leverage together

a wide fluctuation in EPS for a given change in

sales. If a company employs a high level of both

leverages, then a small change in the level of sales

will have a dramatic effect on EPS. This total effect

is called Degree of Combined Leverage.

DCL or Total Leverage: Formula

Example 1 - DCL

• XYZ produced 100,000 units in the latest quarter and

each unit got sold for 20Rs and has a variable cost

15Rs. XYZ has a fixed cost 2,00,000Rs and has to pay

125,000Rs as interest every quarter.

What will be the percentage change on EPS if there

is a 5% change in Sales.

Example 2 – DCL

A company currently has $2 million in sales. Its variable costs

equal 70 percent of its sales, its fixed costs are $100,000, and

its annual interest expense is $50,000.

a. What is the company’s degree of operating leverage?

b. If this company’s operating income (EBIT) rises by 10

percent, how much will its net income increase?

c. If the company’s sales increase 10 percent, how much will

the company’s net income increase?