mba 2009 fm ii - leverage
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FINANCIAL TOOLS
Prof S B Mishra
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BREAK EVEN ANNALYSIS
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BEP
What happens if variable costs change?
How much should be produced to earn a certainquantity of profit.
Sales
$ Rev.
TC
FC
QBE Sales
$ Rev.
TCFC
QBE
} Profit
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BREAK EVEN ANNALYSIS
BEP ( Units) = Fixed Cost / ( S.P V.C)p.u
BEP(VOLUME)= Fixed Cost /Sales-V.Cost
BEP represents the Q at which the firm is at no
profit and no loss.
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Example.
Qs. From the following information , calculate
the break-even point in units and in sales
value :
Output = 3000 units
Selling Price per unit = Rs.30
Variable Cost per Unit= Rs.20Total fixed Cost = Rs.20000/-
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PROFIT VOLUME ANALYSIS
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PROFIT-VOLUME RATIO
P/V Ratio = (Contribution / Sales ) *100
= (Sales-V.Cost) * 100
= (Fixed Cost + Profit)/Sales = Change in Profit / Change in Sales
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Whats the use of P/V Ratio
It reveals the effect on profit of changes in the
volume.
For example a P/V ratio of 25% means that for every
Rs. 100 sales , Contribution of Rs.25 is made towardsmeeting the fixed expenses.
Higher the P/V Ratio, more will be the profit and
lower the P/V ratio , lesser will be the profit.
P/V ratios comparison can be made to find out which
product, department or process is more profitable.
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So..Continued
Every Management aims at increasing the P/V
ratio. The ratio can be increased by
Increasing the selling price per unit.
Reducing the variable cost per unit.
Changing the sales mixture and selling more
profitable products for which the P/V ratio is
higher.
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Example
Qs. If Sales is Rs.100000/-,Profit is Rs.10000 and
variable cost is 70% , find out
(i) P/V ratio(ii) Fixed Cost
( iii) Sales volume to earn a profit of
Rs.40000/-
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EBIT-EPS ANNALYSIS
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Income statement relationships
Total Revenue (TR)
Less Variable Cost (V)
= Contribution
Less Fixed Cost (F)
= Earning Before Interest and Tax ( EBIT)
Less Interest on Debt (INT)
= Profit Before Tax (PBT)
Less Tax (T)
= Profit After Tax (PAT )
Less Preference Dividend ( Dp)------------------------------
= EQUITY EARNING (E)
==============
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So.
EBIT = ( Q*P - Q*V) - F
PAT = (EBIT - I ) * (1-T)
EPS = { [ Q (P-V) F- I ] ( 1-T) Dp }/ N
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Example
Firm = M/s Brown Bovary Ltd
Q = 150000 units ,
Selling Price = Rs.10 per unit
Variable cost per unit = Rs.5Fixed Operating Cost is Rs.150000,Interest on Debt is Rs.80000
Preference dividend is Rs.25000Tax rate is 40%.
Show the EBIT-EPS Relationship.
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INCOME STATE MENT OF BROWN BOVERY LIMITED FOR 2003
Particulars Details AMOUNT
Total Revenue (R)
Less Variable Cost (V)
Contribution ( C)
Less Fixed Cost (F)
Earning Before Interest and
Tax ( EBIT)
Less interest on Debt (I)Profit Before Tax (PBT)
Less Tax (T)
Profit After Tax (PAT )
Less Preference
Dividend ( Dp)
EQUITY EARNING (E)
NO. OF EQUITY SHARES
EARNING PER SHARE
150000*10
150000*5
(R-V)
(C-F)
(EBIT-I)
(PBT-T)
(E / # of Shares )
1500000
750000
750000
150000
500000
80000420000
168000
252000
25000
225000
20000
Rs.11.25
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LEVERAGE
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OPERATING LEVERAGE
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DOL =
% Change in EBIT
% Change in Sales
DOL =
Q ( s v )
Q (s v ) - F
Q= Quantity Sold
S= Selling Price per unit
V= Variable cost per unit
F= Fixed cost
MEASURES OF OPERATING LEVERAGE
OR
OR
DOL =
Contribution
EBIT
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Example
From the following figures relating to Firm A andFirm B whose cost structure is almost same
except for the fixed cost , show how does a 20%
increase or decrease in Quantity produced and
sold affects its profits. Calculate DOL at different
levels
Quantity produced and sold : 10000 units
Selling Price Rs.10 each Variable Cost per unit is Rs.6
Fixed Cost Firm A Rs.10000 and for B Rs.30000
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FINANCIAL LEVERAGE ( FL)
Presence of fixed cost bearing sources of finance (Debt, Preference Shares, Bank loan etc)in thecapital structure of a Firm results in giving more %change in EPS for a given
% change in EBIT.
Degree of Financial Leverage ( DFL) is themeasure for financial leverage.
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DFL =
% Change in EPS
% Change in EBIT
DFL =
Q ( s - v) - F
Q (s - v) - F- INT
Q= Quantity SoldS= Selling Price per unit
V= Variable cost per unit
F= Fixed cost
MEASURES OF FINANCIAL LEVERAGE
OR
OR
DFL =
EBIT
PBT
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Example -DFL
2 Firms A & B having the same capital base of Rs.5lacs divided as follows
Firm A = All equity.
Firm B= Rs.4 lacs Equity plus Rs.1 lacs Debt (8% p.a)
Equity Shares are of Rs.100 each.
The firms need Rs.3 lakh for expansion which they
want to finance in the existing ratio of Debt and
Equity. With same interest rate. If the expected EBIT
is Rs.1 lacs and tax rate is 50% for calculate the DFL
for each. Show the changes in EPS if expected EBIT
goes up by 50%.
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DCL =
% Change in EPS
% Change in SALES
DOL =
Q ( s - v)
Q (s - v) - F- INT
Q= Quantity SoldS= Selling Price per unit
V= Variable cost per unit
F= Fixed cost
MEASURES OF TOTAL LEVERAGE
OR
OR
DOL =
Contribution
PBT
= DOL * DFL
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LEVERAGE MEANING :
Leverage = Influence of Power
It describes the firms ability to use fixed
cost assets and fixed cost funds to increasethe return to its owners
Fixed Operating Cost in Cost Structure andfixed return bearing sources of finance in
Capital Structure.
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Financial Structure ?
The various means of financing represent the
financial structure of an enterprise. The left-
hand side of the balance sheet (liabilities plus
equity) represents the financial structure of a
company. It includes
Short term sources of financing.
Long term sources of financing.
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Capital Structure
The Capital Structure represents the long term
sources of finance. It includes Owners claim
and Creditors claim.
The term capital structure is used to represent
the proportionate relationship between debt
and equity
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TYPES OF LEVERAGE
OPERATING LEVERAGEAs Represented
ThroughDegree of Operating
Leverage (DOL)
FINANCIAL LEVERAGEAs Represented
ThroughDegree of Financial
Leverage (DFL)
TOTAL LEVERAGE
Degree of TotalLeverage
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OPERATING LEVERAGE ( OL)
The presence of fixed cost in coststructure of products of a firm, results ingiving extra % change in EBIT inresponse to a given % of change in
Quantity (Q). This effect is otherwisecalled as Operating Leverage.
Degree Of Operating Leverage (DOL)=measures % change in EBIT for %change in (Q) output/ unit sold.
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Characteristics of DOL
Each Level of Output has a distinct DOL
DOL is undefined at operating breakeven point (Q= F / S-V)
If Q is less than BEP , DOL is negative.
If Q is higher than BEP , DOL is positive.
DOL is measure of firms Business Risk. Everything else being equal, a
higher DOL means higher business risk & vice versa .
Helps in production planning
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FINANCIAL LEVERAGE
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What is financial leverage?
Financial risk?
Financial leverage is the use of debt andpreferred stock in the capital structure of afirm. It helps in increasing the EPS( return
available to the equity share holders orowners)
Financial leverage represents the financialleverage of a firm.Financial risk is the
additional risk concentrated on commonstockholders as a result of financialleverage.
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Characteristics of DFL
Each Level of EBIT has a distinct DOL
DOL is undefined at Financial breakeven point(EBITBEP= I- Dp /(1-T)
If EBIT is less than Financial BEP , DFL is negative.
If EBIT is higher than Financial BEP , DFL is positive.
DFL is measure of firms Financial Risk. Everything else beingequal, a higher DFL means higher business risk v& vice versa .
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Business risk vs. Financial risk
Business risk depends on business factorssuch as competition, product liability, andoperating leverage.
Financial risk depends only on the types ofsecurities issued.
More debt, more financial risk.
Concentrates business risk on stockholders.
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COMBINED LEVERAGE or Total
Leverage
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TOTAL LEVERAGE (TL)
Degree of Total Leverage (DTL) is the measure of
Total or Composite Leverage.
DTL = DOL * DFL
= [Q(S-V)] / [Q(S-V) F-I (Dp /(I-T) ]
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To Summarize
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MEASURES OF LEVERAGE
OPERATING LEVERAGE :
Studies impact of Q ( EBIT& EPS)
%change in EBIT/ % change in output
FINANCIAL LEVERAGE :Studies change in EPS as a result of change
in Debt in Capital structure.
% change in EPS/% change in EBIT
TOTAL LEVERAGE :This measures combined effect of DOL and DFL. = DFL*DOL
% change in EPS / % change in output
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REVIEW POINTS.
DTL = % change in EPS as result of % change in output. DFL is zero when operating profit is zero.
When the firm is operating at BEP , DTL is zero.
When EPS is zero, EBIT is infinity which is called the financial
break even point. If DOL is 2 and DFL is 1.5 ,then DTL =3.0 , meaning thereby
that each % change in output will increase EPS by three times.
When the DFL is zero , the firm does not earn profit.
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Thank You
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