CHAPTER 14 FINANCIAL AND OPERATING LEVERAGE Q.1. A.1. Explain the concept of financial leverage. Show the impact of financial leverage on the earnings per share. The use of fixed-charges sources of funds, such as debt and preference capital, along with owners’ equity in the capital structure is known as financial leverage (or gearing or trading on equity). The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus will increase the return on the owners’ equity. The role of financial leverage in magnifying the return of the shareholders’ is based on the assumptions that the fixed-charges funds (such as the loan from financial ...view middle of the document...
Example: No Debt (Rs) 50% Debt plan (Rs) 75% Debt plan (Rs)
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11 12 Q.3. A.3.
Investment Equity capital Debt capital @ 15% EBIT Interest PBT Taxes @ 50% PAT No. of equity shares EPS (8 ÷ 9) ROI ROE
500,000 500,000 0 120,000 0 120,000 60,000 60,000 50,000 1.20 24% 12%
500,000 250,000 250,000 120,000 37,500 82,500 41,250 41,250 25,000 1.65 24% 16.5%
500,000 125,000 375,000 120,000 56,250 63,750 31,875 31,875 12,500 2.55 24% 25.5%
What is financial risk? How does it differ from business risk? How does the use of financial leverage result in increased financial risk? The variability of EBIT and EPS distinguish between two types of risk— operating risk and financial risk. Operating risk or business risk can be defined as the variability of EBIT on account of variability of sales and expenses. The fluctuation of sales happens on account of general economic conditions, events in related product lines, and boom or recession in industry. The variability of expenses may include variability in prices of factors of production, technological changes, etc. For a given degree of variability of EBIT, the variability of EPS (or ROE) increases with more financial leverage. The variability of EPS caused by the use of financial leverage is called financial risk. Firms exposed to same degree of operating risk can differ with respect to financial risk when they finance their assets differently. A totally equity financed firm will have no financial risk. But when debt is used, the firm adds financial risk. The operating risk is unavoidable, while financial risk is avoidable. Financial leverage magnifies the shareholders’ earnings. The variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure. That is, with more debt, EPS rises and falls faster than the rise and fall in EBIT. Example: Situation 1 Situation 2 Situation 3 Rs Rs Rs 1. EBIT 100,000 120,000 80,000 2. Less Interest 40,000 40,000 40,000 3. EBT (PBT) 60,000 80,000 40,000 4. Taxes @ 50% 30,000 40,000 20,000 5. PAT 30,000 40,000 20,000 6. No. of equity shares 50,000 50,000 50,000 7. EPS 0.60 0.80 0.40 Above example indicates that at the same level of debt–equity ratio in the capital structure of the firm, the EPS rises by increases in EBIT, and falls by decreases in EBIT.
If the use of financial leverage magnifies the earnings per share under favorable economic conditions, why companies do not employ very large amount of debt in their capital structures? Financial leverage works both ways. It accelerates EPS (and ROE) under favorable economic conditions, but depresses EPS (and ROE) when the going are not good for the firm. The favorable effect of the increasing financial leverage during normal and good years is on account of the fact that the rates of return on assets exceed the cost of debt. From, the table explained in A.3. above, it is clear that favorable economic condition (i.e., increase in EBIT in...