Investment Decision

Financing Decisions Bulbul Sharma Roll No.- 12 PGDM

Presentation Scheme   

Introduction Leverage Types of Leverage   

Operating Financial Composite

Introduction Financing decision involves the choice of an appropriate mix of different sources of financing, namely, owners' fund and outsider/Lenders’ funds.

Leverage “the employment of an asset or sources of funds for which the firm has to pay a fixed cost or a fixed return”.

Types of Leverage   

Operating Leverage Financial Leverage Composite Leverage

Operating Leverage Operating leverage can be defined as the firm’s ability to use fixed operating expenses to magnify the effects of changes in sales on its earnings before interest and taxes. The operating expenses of a firm fall into 3 basic categories:   

Fixed Costs Variable Costs Semi-Variable Costs

Computation of OL OL= Contribution/ EBIT

A company produces & sells 1000 units p.a. SP @ Re 200 and VC @ Re 70 per unit. FC (operating) Re 50,000. What is OL?

Contd…      

Sales (1000*200) 200000 Less VC (1000*70) 70000 Contribution (sales – VC)130000 Less FC 50000 EBIT 80000 OL 130000/80000 = 1.625

Degree of Operating Leverage DOL = % change in EBIT/ % change in sales

  

E.g. increase in sales is 20% and profit @ 64%. Degree of OL = 64/20 = 3.2. If sales increase by Rs.1, profit will increase by Re 3.2. & vice versa

Financial Leverage 

The use of fixed charges sources of funds, such as debt and preference capital along with owners’ equity in the capital structure is described as financial leverage or gearing or trading on equity.



FL is favorable when earnings is more than FC and vice versa

Computation of FL FL = EBIT/EBT For e.g. Sales – Rs 50000, VC – 25000 FC – 15000, Int. - 5000 Solution: FL = 10,000/5,000 FL = 2

Degree of FL DOF= % change in EPS/ % change is EBIT Degree of Financial Leverage of Alternative Financial Plans at EBIT of 120,000 Debt level DFL 0 1

25% 50% 75%

1.185 1.456 1.882

Composite Leverage 

CL measures composite effect of all the fixed cost (operating and financial)



CL will disclose effect of changes in sales over change in taxable profit (or EPS)

Computation of CL CL = Contribution/EBT For e.g. Sales – Re 1.00 lac VC (40% of sales) 40 000 Fixed operating cost 30000 Fixed financial cost 10000 Calculate CL. Calculate CL. If 5% increase in sales 

Sales

100000

105000

VC Contribution FC – Operating EBIT FC- Financial PBT

40000 60000 30000 30000 10000 20000

42000 63000 30000 33000 10000 23000

CL

60000/20000 = 3