Leverage

Operating and Financial Leverage : Operating and Financial Leverage

Risks of a Business Entity : Risks of a Business Entity Operating Risk It arises due to fixed component in the operations of a business. Financial Risk Arises due to fixed financial charges resulting from financing decision of a firm

Measuring the operating risk : Measuring the operating risk

Operating Leverage : Operating Leverage Degree of Operating Leverage = % change in EBIT = 78% = 1.56 %Change in Sales 50% Q(P-V) = EBIT + fixed Cost = Contribution Q(P-V)-F EBIT EBIT

Financial Leverage : Financial Leverage Degree of Financial Leverage = %change in EPS = 89.74 = 1.15 %change in EBIT 77.78 = EBIT EBIT-I-(PD/1-t)

Slide 6 : EBIT = Q(P-V)-F Let change in EBIT be ?EBIT ?EBIT = ?Q(P-V) % Change in EBIT = ?EBIT/EBIT Let ?Q be the change in sales %change in Sales = ?Q/Q Degree of Operating Leverage = % Change in EBIT %Change in Sales = ?Q(P-V)/ Q(P-V)-F = Q(P-V) = Contribution ?Q/Q Q (P-V)-F EBIT

Slide 7 : Degree of Financial Leverage = % change in EPS % Change in EBIT % Change in EPS = ? EPS/EPS %Change in EBIT = ?EBIT/EBIT EPS = EBIT-I(1-t)- DP N ? EPS = ?EBIT(1-t) /N %Change in EPS = ?EBIT(1-t) /N [EBIT-I](1-t)- DP N DFL = ?EBIT(1-t) /N ÷ ?EBIT [ EBIT-I](1-t)- DP /N EBIT On simplification DFL = EBIT [ EBIT-I]- DP /1-t

Combined Leverage(Total Risk) : Combined Leverage(Total Risk) Combined leverage = DOL X DFL

Exercise : Exercise

Leverage-Indifference Points : Leverage-Indifference Points Hi-grade Regulator company currently has 100,000 shares of common stock outstanding with a market price of $60 per share. It also has $2 million 6 percent bonds. The company is considering a $3 million expansion program that it can finance with all common stock at $60 a share(option 1), straight bonds at 8 percent interest(option 2), preferred stock at 7 percent(option 3), and half common stock at $60 per share and half 8 percent bonds(option 4). For an expected EBIT level of $1 million after the expansion program, calculate the earnings per share for each alternative methods of financing, assume a tax rate of 50 percent. Construct an EBIT-EPS chart. Calculate the indifference point between alternatives. What is your interpretation

Slide 11 :

Thanks for Listening : Thanks for Listening