Chapter 6: Financing Decisions - Leverage from the Financial Management

 Chapter 6: Financing Decisions - Leverage from the Financial Management

 

Question: Explain the concept of leverage and discuss its types.

Answer:

Leverage refers to the use of borrowed funds (debt) to amplify the potential return on equity. Leverage magnifies both the gains and losses a company can experience from its operations, which can lead to higher returns but also introduces higher financial risk. The primary idea is that a company can increase its overall returns by utilizing debt to finance its operations, given that the return on investments exceeds the cost of debt.

Leverage is commonly used in two key forms: operating leverage and financial leverage. Both of these affect the firm's overall risk and return profile.

1. Operating Leverage

  • Definition: Operating leverage refers to the proportion of fixed costs in a company's cost structure. It measures the sensitivity of a firm's operating income (EBIT) to changes in sales. High operating leverage means that a company has a higher proportion of fixed costs relative to variable costs, leading to more significant changes in operating income with fluctuations in sales.
  • Impact: With higher operating leverage, even a small increase in sales can lead to a large increase in profits, as fixed costs do not change with the level of output. However, this also means that a decline in sales can result in a larger decrease in operating income, making the company more vulnerable during economic downturns.
  • Formula:

Degree of Operating Leverage (DOL)=Percentage change in EBITPercentage change in Sales\text{Degree of Operating Leverage (DOL)} = \frac{\text{Percentage change in EBIT}}{\text{Percentage change in Sales}}

A higher DOL indicates higher operating leverage.

2. Financial Leverage

  • Definition: Financial leverage involves the use of borrowed funds (debt) to finance the firm's operations or investments. It refers to the extent to which a firm uses debt to finance its assets. The greater the proportion of debt in the capital structure, the higher the financial leverage.
  • Impact: The primary benefit of financial leverage is that it can increase the return on equity (ROE) if the firm’s return on assets (ROA) exceeds the cost of debt. However, it also increases the financial risk, as the company must meet its debt obligations regardless of its financial performance. If the firm’s earnings are insufficient to cover interest payments, it can lead to financial distress.
  • Formula:

Degree of Financial Leverage (DFL)=Percentage change in EPSPercentage change in EBIT\text{Degree of Financial Leverage (DFL)} = \frac{\text{Percentage change in EPS}}{\text{Percentage change in EBIT}}

A higher DFL indicates greater financial leverage, which increases the potential return to equity holders but also magnifies the risk.

3. Combined Leverage (Operating + Financial)

  • Definition: Combined leverage refers to the combined effect of both operating and financial leverage. It reflects the overall risk of the firm, considering both fixed operating costs and the impact of debt in the capital structure.
  • Impact: A company with both high operating and high financial leverage is more sensitive to changes in sales and earnings, leading to more significant fluctuations in both profits and risk.
  • Formula:

Degree of Combined Leverage (DCL)=Percentage change in EPSPercentage change in Sales\text{Degree of Combined Leverage (DCL)} = \frac{\text{Percentage change in EPS}}{\text{Percentage change in Sales}}

DCL takes into account both the operating and financial leverage, reflecting the total risk of the firm.

 


Calculations:


Question: Calculate the degree of financial leverage (DFL) and degree of operating leverage (DOL) based on the following information:

  • Sales: ₹1,00,000
  • Variable Costs: ₹60,000
  • Fixed Costs: ₹15,000
  • EBIT (Earnings Before Interest and Tax): ₹25,000
  • Interest on Debt: ₹5,000

Also, calculate the Degree of Combined Leverage (DCL).

Answer:

To answer this question, we will calculate Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL), and Degree of Combined Leverage (DCL) step by step.

1. Degree of Operating Leverage (DOL)

Formula:

DOL=ContributionEBIT\text{DOL} = \frac{\text{Contribution}}{\text{EBIT}}

Where:

  • Contribution = Sales - Variable Costs
  • EBIT = ₹25,000 (Given)

Step-by-Step Calculation:

  • Contribution = ₹1,00,000 - ₹60,000 = ₹40,000

Now, calculate DOL:

DOL=40,00025,000=1.6\text{DOL} = \frac{40,000}{25,000} = 1.6

So, the Degree of Operating Leverage (DOL) is 1.6.

2. Degree of Financial Leverage (DFL)

Formula:

DFL=EBITEBIT−Interest on Debt\text{DFL} = \frac{\text{EBIT}}{\text{EBIT} - \text{Interest on Debt}}

Where:

  • EBIT = ₹25,000 (Given)
  • Interest on Debt = ₹5,000 (Given)

Step-by-Step Calculation:

DFL=25,00025,000−5,000=25,00020,000=1.25\text{DFL} = \frac{25,000}{25,000 - 5,000} = \frac{25,000}{20,000} = 1.25

So, the Degree of Financial Leverage (DFL) is 1.25.

3. Degree of Combined Leverage (DCL)

Formula:

DCL=DOL×DFL\text{DCL} = \text{DOL} \times \text{DFL}

Now, calculate DCL using the values we have:

DCL=1.6×1.25=2.0\text{DCL} = 1.6 \times 1.25 = 2.0

So, the Degree of Combined Leverage (DCL) is 2.0.

Conclusion:

  • Degree of Operating Leverage (DOL): 1.6
  • Degree of Financial Leverage (DFL): 1.25
  • Degree of Combined Leverage (DCL): 2.0

These leverage ratios help in understanding the impact of changes in sales, EBIT, and interest on the company’s overall profitability. The Degree of Operating Leverage measures the sensitivity of EBIT to sales, while Degree of Financial Leverage measures the sensitivity of Earnings Per Share (EPS) to changes in EBIT due to fixed financial costs (interest). The Degree of Combined Leverage combines both operating and financial leverage to measure the overall sensitivity of EPS to changes in sales.

 


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