Q1. Define operating, financial and combined leverage.

Leaverage: Leverage is a general term for any technique to multiply gains and
losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:

A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result. A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.

Leverage can be defined as the employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return. Because of the incurrence of fixed costs, the net income and the earnings available to the equity shareholders as well as the risk gets affected. Leverage is favorable when the earnings less the variable costs exceed the fixed costs or when the earnings before interest and taxes exceed the fixed return requirement. Leverage is unfavorable in the reverse situation.

Leverage can be of two types Operating & Financial leverages.

1. Operating leverage - The leverage associated with investment, i.e., asset acquisition activities is called as operating leverage.

2. Financial Leverage - the leverage associated with financing activities is called as financial leverage.

Combined leverage This is the product of the operating and financial leverages.

Financial Leverage Financial leverage is related to the financing activities of the firm. It is caused due to fixed financial costs in the firm. The sources of such types of funds carrying a fixed interest cost are long-term bonds and debentures. These financial fixed charges do not vary with the earnings before interest and taxes or sales. They have to be paid irrespective of the profits available. Financial leverage is concerned with the effects of changes in EBIT on the earnings available to the equity shareholders. It can be defined as "the ability of the firm to use the fixed financial charges to magnify the effects of changes in EBIT on the firm's earnings per share (EPS)". In other words, financial leverage involves the use of funds obtained at a fixed cost with a hope of increasing the returns available to the equity shareholders. A favorable financial leverage occurs when the firm earns more on the assets purchased with the funds, than the fixed cost of their use. Unfavorable leverage occurs in the reverse scenario. In a way, use of fixed cost source of funds generates increased returns for the equity shareholders without an additional requirement of finance from them. Therefore, financial leverage is alternatively also called as 'Trading on equity'. Degree of Financial leverage The degree of financial leverage can be expressed as the percentage change in Earnings per share divided by the percentage change in the firm's earnings before interest and taxes.

If

DFL

>

1,

financial

leverage

exists.

The greater the DFL, higher is the financial leverage for the firm. Example: A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed operating costs are $50,000 per year. The fixed interest expenses (nonoperating) are $25,000 and the firm has 10,000 shares outstanding. Let us evaluate the EBIT/EPS resulting from sale of 1) 2000 units & 2) 3000 units. Tax rate = 35%.

A financial leverage of 2 indicates that for every $1 change in EBIT, there would be a $2 change in EPS in the same direction.

Operating Leverage Operating leverage is the leverage associated with investment activities. Operating leverage can be determined by the relationship between a company's sales revenue and its earnings before interest and taxes. EBIT is also termed as operating profit. Operating leverage results from the existing of fixed operating expenses. The operating leverage can also be said as the firm's ability to use the fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. A firm employs or invests in fixed assets hoping that the profits generated from those assets would cover the fixed costs of operating them as well as the variable costs. Example: A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed operating costs are $50,000 per year. Let us evaluate the EBIT resulting from sale of 1) 1000 units 2) 2000 units & 3) 3000 units.

Results: From case 2 to case 3: An increase in sales by 50% (from $200,000 to $300,000) resulted in an increase in EBIT by 100% (from $50,000 to $100,000). From case 2 to case 1: A decrease in sales by 50% (from $200,000 to $100,000) resulted in a decrease in EBIT by 100% (from $50,000 to $0). This relationship between the increase/decrease in sales and change in EBIT is called as operating leverage. Degree of Operating leverage Degree of operating leverage can be expressed as the percentage change in EBIT divided by the percentage change in sales. If the proportionate change in EBIT as a result

of a given change in sales is more than the proportionate change in sales, operating leverage exists.

If DOL > 1, operating leverage exists. The greater the DOL, the higher is the operating leverage. Calculation of degree of operating leverage: Example: With the same figures given above, we can calculate the operating leverage. Percentage change in EBIT = ($100,000 - $50,000)/$50,000 x 100 100% Percentage change in Sales = ($300,000 - $200,000)/$200,000 x 100 50% DOL = 100% 50% = 2 An operating leverage of 2 indicates that for every $1 change in sales there would be $2 change in EBIT in the same direction.

Combined Leverage Combined leverage, as the name implies shows the total effect of the operating and financial leverages. In other words, combined leverage shows the total risks associated with the firm. It is the product of both the leverages. Degree of Combined Leverage (DOL) = DOL * DFL

As represented above, the degree of combined leverage measures the percentage of change in Earnings per share as a result of a percentage change in Sales. The combined leverage can work in either direction. It would be favorable if sales increase and unfavorable in the reverse scenario. It serves as an important measure in choosing financial plans as EPS measures the ultimate returns available to the owners of the company. For example, if the company invests in more risky assets than usual, the operating leverage of the company will increase. If the company does not change its capital structure, the financial leverage will not change. These two actions will increase the combined leverage of the firm, as a result of increase in the operating leverage. As said, the combined leverage measures the total risk of the firm. If the firm wants to maintain the risk or not to increase the risk, it would try to lower the financial leverage to compensate for the increase in operating leverage so that the combined leverage remains the same. Lowering the financial leverage can be done if the new investments are made in equity rather than debt. Similarly, in cases where the operating leverage has decreased due to lower fixed operating costs, the firm can think of having a more levered financial structure and still keep the combined leverage constant, thereby increasing the earnings per share of the equity holders. These are the advantages of measuring the combined leverage. Example : A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed operating costs are $50,000 per year. The fixed interest expenses (nonoperating) are $25,000 and the firm has 10,000 shares outstanding. Let us evaluate the combined leverage resulting from sale of 1) 2000 units & 2) 3000 units. Tax rate = 35%.

A combined leverage (total risk) of 4 indicates that for every $1 change in sales, there would be a $4 change in the Earnings per share in either direction.