Financial Management - Chapter 5

Subject: Financial Management

Chapter No. 5: Leverages in business

Chapter No. 5 – Operating and Financial Leverages in Business Contents ♦

Introduction to concept of leverage

♦

Operating leverage, its usefulness as a tool in decision making on scale of operations

♦

Financial leverage – advantage of debt in preference to equity, its usefulness to increase Earning Per Share (EPS) for shareholder

♦

Total leverage – combination of operating and financial leverages

♦

Attendant risks in increasing leverage, both operating and financial

♦

Numerical exercises in operating, financial and total leverages

At the end of the chapter the student will be able to ♦

Measure operating leverage at any given level of output, the output being production or sales and determine the impact on EBIT

♦

Measure financial leverage at any given level of EBIT and determine the impact on EPS

♦

Measure total leverage at any given level of output and determine the impact on EPS for any given level of output

♦

Use both the leverages as tools in financial decision relating to scale of production/output as well as how much to borrow in a given capital structure

Concept of leverage What is leverage? Leverage is a handle available to facilitate doing a work as easily as possible, as in the case of a “lever” in Physics. Let us revisit the concept of a “lever”. Suppose we want to lift a stone with a crowbar. We can lift it without any support. We can lift it with some support called “fulcrum”. The “fulcrum” is the support on which the crowbar rests while lifting the stone. Suppose the fulcrum is close to the object being lifted that is “stone”. The leverage is very good, i.e., the ease with which the stone can be lifted is high. If the “fulcrum” is in the middle of the length of the crowbar, it will be more difficult. The leverage available to the lifter is less than in the previous case. If on the contrary, the “fulcrum” is close to the hand that exerts pressure to lift the stone, it becomes increasingly difficult to lift it. The leverage is said to be the least. Thus the point of “fulcrum”, the support decides the extent of ease (leverage) in completing the work of lifting the stone. Similar is the concept of leverage in the case of a business enterprise. Leverage to a business enterprise is of two kinds: ♦

Operating leverage - leverage relating to the operations of the company, which relate either to the level of output (production) or level of sales. In this, the business tries to leverage its operations against fixed operating costs that are expected to be constant for some time. Here again, the operations could relate either to the output or level of sales. As sales represent the revenues to the organisation, let us confine our discussion on “operating leverage” to the level of sales rather than the level of output (production).

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Subject: Financial Management

Chapter No. 5: Leverages in business It is measured through “degree of operating leverage”, called DOL = Δ EBIT/ Δ Sales ♦

Financial leverage - leverage available in financing arrangement of the company to enhance the earnings per share of the equity shareholders (EPS). Financial leverage is due to “interest”1 on loans being allowed as an expense. This tells us how Earning Per Share (EPS) moves in relation to Earnings Before Interest and Tax (EBIT). Interest paid by the business enterprise on loans enjoys what is known as “tax shield” 2. In “Financial leverage”, the business enterprise tries to leverage its finances by having a proper mix of equity and debt in its capital structure. Let us see the following example to understand this concept. Equation for degree of financial leverage, DFL = Δ EPS/Δ EBIT. In the following example, the assumption is that the two enterprises under comparison are in the same line of business employing the same amount of capital in business. It is also further assumed that the loan in both the cases carries the same rate of interest and the tax rate is 38.5% (35% basic tax rate and 10% surcharge thereon). Face value of share is Rs.100/- in both the cases.

Thus “Operating Leverage” is leveraging the operations against the fixed operating costs of the business enterprise and “Financial Leverage” is leveraging the earnings against the tax shield available on interest cost on borrowings form outside and they are measured in terms of degree of operating and degree of financial leverages. Leverage means the “risk” associated with a business enterprise. Operating leverage means the risk associated with the scale of operations and financial leverage means the risk associated with the pattern of financing, i.e., debt financing or equity financing. HOW? Just as an increase in sales could impact EBIT positively, a decrease in sales also would affect EBIT negatively. Similarly an increase in EBIT could impact EPS positively, a decrease in EBIT also would affect EPS negatively. That is why leverage is often referred to as a “double edged sword”.

Operating leverage, its usefulness as a tool in decision making on scale of operations This is based on the assumption that in the short-run, the fixed operating costs in a business enterprise do not change. We need to define two things here – fixed operating costs and short-run

Fixed operating costs – They include all the costs in operation of the business enterprise that are fixed in nature with the exclusion of interest charges and other financial charges that are mostly fixed in nature.3 Short-run: This depends upon the industry in general and the enterprise in particular. For example in the case of a manufacturing unit, this could be two years whereas in the case of a service industry especially like IT, this could be less than six months even. The term short-run refers to the period in which, ignoring the impact of “inflation”, the operating costs of the business do not increase4. This is a very useful tool in measuring the impact of the increase in

1

Interest on loans is a pre-tax expense in the sense that it is part of the revenue expenditure of the organisation as against dividend on share capital that is profit distribution after meeting income tax obligation. 2

Tax shield is the amount of tax saved by claiming a business expense against income of the business enterprise. Hence tax shield on interest is the tax saved by taking loans and paying interest as a pre-tax expense. 3

Please note the difference between fixed operating costs in the context of operating leverage and fixed costs in the context of “marginal costing”. While in the former, interest and other financial charges are excluded, the latter would include interest and other financial charges as “fixed costs” 4

The underlying approach to fixed costs, be it in the context of “marginal costing” or “operating leverage” is that effect of “inflation” is ignored. If we consider the effect of “inflation”, all costs of a business enterprise would be variable. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter No. 5: Leverages in business the scale of operations (preferable to take “sales” as operations instead of “production”) 5. Once the operating costs are fixed, the management can decide about the scale of operations and the higher the scale of operations, the higher the EBIT as the operating costs would not increase with the increase in scale of operations. Let us examine the following example.

Example no. 1 (Rupees in lacs) Parameter

Firm A

Firm B

Sales

100

110

Fixed operating costs

70

20

Variable costs

20

70

EBIT

10

20

Fixed costs/Total costs

78%

22%

Fixed costs/Sales

70%

18%

50% increase in sales Sales

150

165

F.C.

70

20

V.C.

30

105

EBIT

50

40

400%

100%

Change in EBIT (Δ EBIT)

Conclusion It is possible to have high operating leverage, i.e., high degree of sensitivity of EBIT to change in Sales, only when the operating fixed costs form the bulk of total costs. On the contrary if variable costs form the bulk of total costs, the operating leverage vanishes almost.

Example no. 2 Sales

100

110

F.C.

---

---

V.C.

70

77

EBIT

30

33

Change in EBIT (Δ EBIT)

---

10%

Operating leverage

----

1 (Δ EBIT/Δ Sales)

This means that there is practically no leverage opportunity existing. Leverage opportunity exists only when due to change in scale of operations, the EBIT changes also to the same extent and not more than proportionately. This is called “Degree of Operating Leverage (DOL)”.

Operating leverage through Break-even sales analysis 5

Production would not recover the costs incurred whereas sales would recover the costs incurred and hence it is preferable to take sales as the base here although a number of renowned authors still consider “production” as the parameter while considering the scale of operations. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter No. 5: Leverages in business Quantity at break-even = Fixed costs/contribution per unit {Price per unit (-) variable cost per unit} And sales at break-even = Fixed costs/1 – (V.C./sales) Degree of operating leverage = % change in EBIT/% change in sales EBIT = Q (S-V) – F, change in EBIT = Change in {Q (S-V)} Where, Q = sales qty. in units S = selling price per unit V = variable cost per unit And F = total fixed costs = Q (S-V)/Q (S-V) – FC and dividing this by (S-V), Q/Q – (FC/S-V) = Q/(Q – Q at break-even) Degree of operating leverage at “R” Rupees of sales = R –VC/ R – VC – FC = (EBIT + FC)/EBIT

Note: 1.

How close a firm is to its break-even point?

2.

The farther it is from the point of break-even the less the degree of operating leverage

3.

As a general rule, firms do not like to operate under conditions of a high degree of operating leverage

4.

This means that as a general rule, firms would like to operate away from their break-even point

5.

Utility – change in pricing policy and planning for sales and profits

6.

While attempting problems in operating leverage formula is as under especially when two positions are not available6 DOL (degree of operating leverage) in sales volume = (EBIT + Fixed costs)/EBIT DOL in sales output in units = Q (SP – VC)/Q (SP-VC) – FC

Example no. 3 Example of operating leverages at different levels of output – ABC Limited Parameter

Amount (Rs. In lacs)

Sales

250

Variable expenses

100

Fixed costs

90

EBIT

60

Interest on debt

7.50

Profit before tax

52.50

Income Tax @ 35%

18.38

Profit After Tax

34.12

Dividend on preference share capital Equity earnings

5.00 29.12

Quantity produced – 5000 units 6

When two comparative positions are available as in Example nos. 1 and 2, the degree of operating leverage would be Δ EBIT/Δ Sales. However most of the times two comparative positions may not be available. Based on a single level of operation, the formulae given here would help in determining the DOL. The same thing holds good for Degree of Financial leverage. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter No. 5: Leverages in business Variable cost per unit – Rs. 2000/Selling price per unit – Rs. 5000/Degree of operating leverage – 5000 (5000-2000)/5000 (5000-2000) – 90,00,000 = 150/60 = 2.5 Break-even point = 3000 units when contribution = fixed costs

Let us tabulate the degree of operating leverage at different levels of outputs: Quantity produced

Degree of operating leverage

1000

- 0.50

2000

- 2.00

3000

Undefined (at break-even point)

4000

4.00

5000

2.50

The following conclusions can be drawn from the above table: 1.

For each level of output, the DOL changes;

2.

At the break-even point, DOL cannot be defined;

3.

Below break-even point, DOL is negative;

4.

Above break-even point, DOL is positive

5.

Operating leverage represents the risk associated with the scale of operations.

6.

Operating leverage can also be referred to as a measure of “business risk”.

Financial leverage – advantage of debt in preference to equity, its usefulness to increase Earning Per Share (EPS) for shareholder 1.

It measures the sensitivity of the undertaking’s Earnings Per Share (EPS) to the changes in the Earnings Before Interest and Tax (EBIT)

2.

The basic assumption for this is that source of funds (whether equity or debt) does not affect the EBIT whereas it does affect the EPS

3.

This is based on the advantage of interest on debt being a pre-tax expense.

Example no. 4 Unit 1 Equity share capital

Rs. 100 lacs = 1 lac shares

Rs. 200 lacs = 2 lac shares

Debt capital @ 14% interestRs. 300 lacs

Rs. 200 lacs

EBIT

Rs. 150 lacs

Rs. 150 lacs

Less: Interest EBT or PBT Tax say at 35% EAT or PAT 7

Unit 2

7

Rs. 42 lacs

Rs. 28 lacs

Rs. 108 lacs

Rs. 122 lacs

Rs.37.8 lacs

Rs.42.7 lacs

Rs.70.2 lacs

Rs.79.3 lacs

Actual tax rate is at present = 35% + 10% Surcharge thereon making a total of 38.5%

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Subject: Financial Management

Chapter No. 5: Leverages in business Earnings Per share (EPS)

Rs. 70.20

Rs. 39.65

It can be seen from the above that increasing the debt component in a given capital structure increases the Earnings Per Share (EPS) as the number of shares issued is less than when more equity share capital is present in the capital structure. This is the concept of “Financial leverage”.

Observations: 1.

As debt component increases in a capital structure, EPS also increases;

2.

Presence of corporate tax makes the difference

3.

In the absence of taxes, the difference in EPS will be negligible

Example no. 5 (Rupees in lacs) Alternative 1

Alternative 2

200

200

45

60

PBT

155

140

Tax

0

0

EBIT Interest

PAT

5.17

7

Difference = 36.6% Earlier difference = 36.4%

So what makes the difference? Interest being allowed as operating expense Does it mean that we can increase the debt component without any ceiling? Answer is “No”. Even if the project/enterprise owner wants it that way (as he will be required to put in less of his money) lenders will not permit it. The ceiling prescribed by the market or lenders at present is 2: 1. This is considering only the medium and long-term debts and excluding the short-term debts.

What are the risks of increased financial leverage? 1.

Risk of default in repayment of debt – stage 1

2.

Default in payment of interest on debt – stage 2

3.

Increasing perception of risk in the eyes of the lender/market

4.

Strong possibility of increase in rates of interest on various components of debt

5.

Investors shying away from the company

6.

Reduction in the share price in the secondary market and hence reduction in share holders’ wealth

Just like we measured the DOL for a given point, can we measure degree of financial leverage also? Yes HOW? DFL = EBIT/ EBIT – I – {Dp/(1-t)} --------------------- Equation no. 2 The above formula is derived as under: DFL = (Δ EPS/EPS)/ (Δ EBIT/EBIT) –------------------ Equation no. 1

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Subject: Financial Management

Chapter No. 5: Leverages in business We know that EPS = {(EBIT – I) (1-t)8 – Dp}/ no. Of equity shares in which Dp is the dividend on preference share capital. Substituting this in equation no. 1, we get equation no. 2 as above.

How does one determine the level of finance for the firm? When trying to determine the appropriate financial leverage for a firm, we would also analyze the cash-flow ability of the firm to service the fixed financial charges. The greater the rupee amount of debts taken by the company, the greater the fixed financial charges. This further increases in case the maturity of these debts is of shorter duration, i.e., less than 5 years. Before taking on additional fixed financial charges, the firm should analyze its expected future cash flows, as fixed financial charges must be met with cash. The inability to meet these charges may result in financial insolvency. The greater and more stable the expected future cash flows, the greater the debt capacity of the firm.

Usefulness of financial leverage 1.

It enables a business enterprise to designate its capital structure with proper mix of debt and equity

2.

It also tells the management to evolve what is known as “debt policy” suitable for the industry in which they are operating.

3.

It tells the management how to increase the Earnings Per Share (EPS) of course up to a point, beyond which any further increase in debt becomes counterproductive.

4.

Financial leverage is a measure of financial risk associated with a business enterprise

Total leverage – combination of operating and financial leverages 1.

Total leverage is a measure of total firm risk = business risk (operating leverage) + financial risk (financial leverage)

2.

It measures the sensitivity of the firm’s Earnings per share (EPS) to the changes in output, i.e., sales

3.

It combines the operating leverage and financial leverages of the firm.

4.

Formula is = (Δ EPS/EPS)/(Δ Sales/Sales)

5.

Direct measurement formula – this uses the formulae for DOL and DFL. We get, Q (S-V)/Q (S-V) – FC – I – Dp/(1-t)

Conclusion on leverages 1.

Leverage is a double-edged sword; if used properly it will enhance the operating efficiency of the firm by increasing the EBIT in response to sales (operating leverage) and maximize the return to shareholders by increasing the EPS in response to EBIT.

2.

Simultaneously if not used properly, the results could be disastrous in the sense that the firm’s operating risk and financial risk both increase

3.

Business enterprises use the leverage opportunities depending upon their risk taking ability or risk aversion that in turn depend upon the corporate philosophy of the management – whether they are conservative or aggressive. If they are conservative, they would like to operate at a very low leverage level – the DOL and DFL could be less than 1 and on the contrary if they are aggressive, the level of leverages would also increase – the DOL and DFL would be well above 1

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Please note that as dividend is post-tax and interest is pre-tax, this needs to be converted into post-tax and for this the formula is post-tax rate or value = pre-tax rate or value (1-t) wherein “t” represents the tax rate expressed in decimals. Suppose the tax rate is 35%, then “t’ is 0.35. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter No. 5: Leverages in business

Numerical exercises in operating, financial and total leverages 1.

Is there any difference between operating leverage and degree of operating leverage? Explain with an example.

2.

Is there any difference between financial leverage and degree of financial leverage? Explain with an example.

3.

Classify the following short-run manufacturing costs as either typically fixed or typically variable. Are any of these costs fixed in the long run? ♦

Insurance

♦

Direct labour

♦

Research and development

♦

Advertising

♦

Raw materials

♦

Depreciation

♦

Repairs and maintenance

4.

What is the difference between fixed costs in break-even sales analysis and fixed operating costs in the context of operating leverage?

5.

How does continuous increase in debt affect the firm in the long run? Discuss with an example.

6.

A firm is an all-equity firm. It earns monthly after taxes Rs. 24 lacs on sales of Rs.880 lacs. The tax rate of the company is 40%. The company’s product sells for Rs. 20,000/-. (Only product). Rs. 15,000/- is the variable cost of the product. Answer the following questions: ♦

What is the monthly fixed operating cost?

♦

What is the monthly operating break-even point in units? What are the break-even sales?

♦

What is its DOL?

♦

What is its DFL?

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