mba 2009 fm ii - leverage

8/9/2019 Mba 2009 Fm II - Leverage

1/39

FINANCIAL TOOLS

Prof S B Mishra


2/39

BREAK EVEN ANNALYSIS


3/39

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


4/39

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.


5/39

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/-


6/39

PROFIT VOLUME ANALYSIS


7/39

PROFIT-VOLUME RATIO

P/V Ratio = (Contribution / Sales ) *100

= (Sales-V.Cost) * 100

= (Fixed Cost + Profit)/Sales = Change in Profit / Change in Sales


8/39

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.


9/39

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.


10/39

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/-


11/39

EBIT-EPS ANNALYSIS


12/39

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)

==============


13/39

So.

EBIT = ( Q*P - Q*V) - F

PAT = (EBIT - I ) * (1-T)

EPS = { [ Q (P-V) F- I ] ( 1-T) Dp }/ N


14/39

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.


15/39

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


16/39

LEVERAGE


17/39

OPERATING LEVERAGE


18/39

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


19/39

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


20/39

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.


21/39

DFL =

% Change in EPS

% Change in EBIT

DFL =

Q ( s - v) - F

Q (s - v) - F- INT

Q= Quantity SoldS= Selling Price per unit


F= Fixed cost

MEASURES OF FINANCIAL LEVERAGE

OR

OR

DFL =

EBIT

PBT


22/39

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%.


23/39

DCL =

% Change in EPS

% Change in SALES

DOL =

Q ( s - v)

Q (s - v) - F- INT

Q= Quantity SoldS= Selling Price per unit


F= Fixed cost

MEASURES OF TOTAL LEVERAGE

OR

OR

DOL =

Contribution

PBT

= DOL * DFL


24/39

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.


25/39

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.


26/39

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


27/39

TYPES OF LEVERAGE

OPERATING LEVERAGEAs Represented

ThroughDegree of Operating

Leverage (DOL)

FINANCIAL LEVERAGEAs Represented

ThroughDegree of Financial

Leverage (DFL)

TOTAL LEVERAGE

Degree of TotalLeverage


28/39

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.


29/39

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


30/39

FINANCIAL LEVERAGE


31/39

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.


32/39

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 .


33/39

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.


34/39

COMBINED LEVERAGE or Total

Leverage


35/39

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) ]


36/39

To Summarize


37/39

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


38/39

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.


39/39

Thank You

mba 2009 fm ii - leverage

Documents