LEVERAGE Operating Leverage:

Transcription

1 LEVERAGE A mechanical lever magnifies a force applied at some point, in another point. A rickshaw puller applies a force at front wheel while paddling and this force is magnified at the rear wheels. In a business context LEVERAGE refers to the use of fixed costs in an attempt to increase (lever up) the profitability. Two types of fixed costs are the main concern here: i) Operating Fixed Cost like Depreciation of the factory building, Depreciation of Machineries, Fixed component of the salary of the operating staff etc. It means that costs incurred for creating the operating capacity; ii) Financial Fixed Cost like fixed interest on borrowed capital, fixed dividend on preference capital etc. It means fixed costs incurred for purchasing capital for financing the business; In the long run no costs are fixed, all are variable. Therefore our concern here is only of short-term nature. Operating Leverage: It results from the presence of fixed operating costs. Because of presence of fixed operating costs in the operating structure, for a given percentage change in sales from an existing level, there will be more than proportionate change in Operating profit i.e. EBIT (Earning Before Interest & Taxes). Say existing level of operation is Sale of 5000 units. If from this existing level sales increase by 20%, then in presence of fixed operating costs, EBIT of the company will increase by more than 20%. This extra change in EBIT indicates actions of fixed costs called LEVERAGE and under the given case it is Operating Leverage. If fixed operating costs are absent then for 20% change in sales EBIT changes also by 20%. Let us take an example:

2 Illustration: 1 (Absence of Fixed Operating Costs) Particulars Per Unit (Rs) Sale price 50 Variable cost of production 25 Existing level of Sale 5000 unit Change in Sale 30% Comparison of operating results with the above information: Particulars Results at existing level Results at changed level No of units sold x Sale Rs.50 p.u Variable costs Rs.25 p.u Contribution (Rs) Sales - VC Fixed Costs (Rs) 0 0 EBIT (Rs) Contribution - FC Change in Sales (%) - ( )/ % Change in EBIT - ( )/ % But if fixed costs say Depreciation of the factory building of Rs is present in the above case, then the results would be different, as shown below: Particulars Results at existing level Results at changed level No of units sold x Sale Rs.50 p.u Variable costs Rs.25 p.u Contribution (Rs) Sales -VC Fixed Costs (Rs) * EBIT (Rs) Contribution -FC Change in Sales (%) - ( )/ % Change in EBIT - ( )/ %

3 * Fixed costs do not change with change in volume. Therefore notice that in presence of fixed operating costs, for a 30% change in sales, there will be 36% change in EBIT. We can write- 36 % 1.2 x 30% Magnifying Factor As per finance term this magnifying factor is called DEGREE OF OPERATING LEVERAGE (DOL). Computation of DOL: DOL is defined as the %age change in EBIT for a given % change in Sales from an existing level. Therefore we can write- %age change in EBIT DOL at existing level %age change in Sales Since change in sales is always measured from the existing level of operation, so DOL is always measured at the existing level. Hence the subscript. ( EBIT/EBIT) ( Sales/Sales) [Q (P-V)-F] / (EBIT) ( Q/Q)

4 [ Q (P-V)- F] / (EBIT) ( Q/Q) [ Q (P-V)] / (EBIT) ( Q/Q) as F 0, in the short run F has no change. [ Q (P-V)] Q x (EBIT) Q Q (P-V) EBIT Q (P-V)...(1) Q (P-V) F CONTRIBUTION..(2) EBIT EBIT+FC (3) EBIT

5 Equation (1) is applicable for single product company whereas equations (2) and (3) are applicable for multi-product company. In our illustrative case in presence of fixed cost if we apply equation (1), then we arrive at the following: Q(P-V) DOL (at 5000 units) Q (P-V)-F 5000(50-25) 5000(50-25) / (approx) This means for 30% change in Sales from the existing level, there will be 1.2 times change of sales in EBIT. Therefore in the case considered, EBIT increased by 36%. This magnifying power or DOL depends on the level from where change in sales occurs. If existing level of operation is very near to BEP, then any change in sales from this existing level will be accompanied with very high DOL. More and more existing operation is away from BEP, lesser will be DOL or magnifying power. Because from equation (1) we can write Q (P-V) Q (P-V) F Or, Q Q F/ (P-V) Or, Q Q - Q BEP..(4)

6 So if existing level is Q Q BEP, then denominator in the equation (4), will become 0 and DOL will become. More and more one go away from BEP in the positive direction then DOL start decreasing. In our illustrative case BEP is F/(P-V) 20000/(50-25) 800. At different level of operation DOL will be as follows: Existing level (Q) DOL indication DOL value 800 DOL DOL DOL DOL DOL DOL DOL DOL DOL DOL DOL vs Level of Operation DOL Level of Operation

7 DOL and Business risk: Business risk is nothing but the uncertainty or variability or fluctuation of EBIT. The principal factors giving rise to business risk are 1) Variability or uncertainty of Sales; 2) Variability or uncertainty of Production costs; DOL magnifies the impact of these two factors on the variability of the operating Profits (EBIT). DOL, however, is not the source of the variability. It means that if Sales and Production costs are maintained at constant level, then there will not be a fluctuation in EBIT even with a very high DOL. Therefore it would be a mistake to consider DOL of a firm at an operating level as a synonym for its business risk. DOL is just a measure of Potential Risk which becomes activated only in the presence of fluctuation in sales and production costs. Financial Leverage: It results from the presence of fixed Financing costs. Because of presence of fixed financing costs being incurred to form capital structure, for a given percentage change in EBIT from an existing level, there will be more than proportionate change in Earning Per Share i.e. EPS (Earning Per Share). Say existing level of EBIT is Rs If from this existing level EBIT increases by 30%, then in presence of fixed financing costs (i.e. Interest on Debt Capital, Preference Dividend) EPS of the company will increase by more than 30%. This extra change in EPS indicates actions of fixed costs called LEVERAGE and under the given case it is Financial Leverage. If fixed financing costs are absent then for 30% change in EBIT, EPS changes also by 30%. Let us take an example:

8 Illustration: 1 (Absence of Fixed Financing Costs) Particulars (Rs) EBIT Interest on Debt Capital 0 Preference Dividend 0 No of Equity shares of 5000 Rs.10 each Tax Rate 40% From the existing level assume EBIT increased by 30% Comparison of EPS with the above information: Particulars Results at existing level Results at changed level EBIT x Less: Interest 0 0 PBT Less: Tax PAT Less: Preference Dividend 0 0 Equity Earnings No of Equity Shares EPS / / %age change in EPS - (39-30/30) * % %age change in EBIT 30% So in absence of fixed financing costs change in EBIT change in EPS, No magnification due to leverage effect But say the capital structure of the same company is composed of i) 2500 equity shares of Rs.10each and ii) 12%, Rs debt capital then the results would be different, as shown below: Particulars Results at existing level Results at changed level EBIT x Less: Interest % of Rs PBT Less: Tax PAT Less: Preference Dividend 0 0 Equity Earnings

9 No of Equity Shares EPS / / %age change in EPS - ( /59.28) * % %age change in EBIT 30% So in absence of fixed financing costs change in EBIT(30%) % change in EPS, So magnification / and this is due to leverage effect As per finance term this magnifying factor (5.25) is called DEGREE OF FINANCIAL LEVERAGE (DFL). Computation of DFL: DFL is defined as the %age change in EPS for a given % change in EBIT from an existing level. It is a quantitative measure of the sensitivity of firms EPS to a change in firms operating profit. Therefore we can write- %age change in EPS DFL at existing level %age change in EBIT Since change in EBIT is always measured from the existing level, so DFL is always measured at the existing level. Hence the subscript. ( EPS/EPS) ( EBIT/EBIT) [(EBIT-I) (1-t)-Dp] / [(EBIT-I)(1-t)-Dp] ( EBIT/EBIT) [ EBIT(1-t)- I(1-t)- Dp] / [(EBIT-I)(1-t)-Dp]

10 ( EBIT/EBIT) [ EBIT(1-t)] / [(EBIT-I)(1-t)-Dp] ( EBIT/EBIT) as I and Dp 0, I and Dp is constant for a period. [ EBIT(1-t)] EBIT x [(EBIT-I)(1-t)-Dp] EBIT EBIT (1-t) [(EBIT-I)(1-t)-Dp] EBIT...(5) EBIT-I-Dp/1-t In our illustrative case in presence of fixed cost if we apply equation (4), then we arrive at the following: DFL (at EBIT Rs ) / (approx)

11 This means for 30% change in EBIT from the existing level, there will be times change of in EPS. Therefore in the case considered, EPS increased by %. This magnifying power or DFL depends on the level from where change in EBIT occurs. If existing level of operation is very near to Financial BEP, then any change in EBIT from this existing level will be accompanied with very high DFL. More and more existing operation is away from BEP, lesser will be DFL or magnifying power. At Financial BEP DFL will be infinite. From equation (5) DFL will be infinite if we put EBIT-I-Dp/1-t 0 Or, EBIT I +Dp/1-t So Financial Break-Even point is that EBIT at which Fixed interest payments to debt capital and fixed preference dividend on pre-tax term could be satisfied without generating something for equity earnings. In our illustrative case Financial BEP is I+Dp/1-t Rs At different level of EBIT, DFL will be as follows: Existing level (Rs.) DFL indication DFL value 3000 DFL DOL DOL DOL DOL DOL DOL DOL DOL DOL

12 DFL VS EBIT DFL EBIT DFL and Risk Financial Leverage is a choice item but Operating Leverage sometimes is not. Physical requirements of a firm s operation fix up the nature of Assets meant for operation and in turn fix up the amount of depreciation as fixed operating costs. But how these assets will be financed is dependent on the choice of the finance manager. The finance manager can either finance the assets with all equity, or with debt or with preference capital or with combination of all. Depending upon these alternative choices fixed financial costs vary and in turn effect of presence of fixed financial costs. Financial Leverage is employed in the hope of increasing return to the equity shareholders. Employing debt and preference capital at a return more than the fixed cost of purchasing these fund (i.e. interest and dividend respectively) results in increasing returns to equity holders. This is positive financial leverage and also called Trading on Equity.

13 Business risk, as mentioned earlier, is nothing but the uncertainty or variability or fluctuation of EBIT. Similarly we can define Total Firm Risk as nothing but the uncertainty or variability or fluctuation of EPS. The difference between Relative fluctuation in EPS and Relative fluctuation in EBIT is called the Relative Financial Risk of the firm. Financial Risk of a firm encompasses both 1) Risk of possible insolvency; 2) Added/magnified variability in earnings per share that is induced by the use of financial leverage ; More and more Debt capital in capital structure means more and more Interest burden. This result in more and more possibility of default in payment of interest. This is risk of insolvency Whereas between two firms we can use the difference between the Coefficient of Variation of EPS for the two firms as added variability in earnings per share induced by the use of financial leverage. Relative fluctuation in EPS or Coefficient of Variation of EPS σ EPS / E (EPS), where σ EPS Standard deviation of EPS and E (EPS) is the expected value of EPS and Relative fluctuation in EBIT or Coefficient of Variation of EBIT σ EBIT / E (EBIT), where σ EBIT Standard deviation of EBIT and E (EBIT) is the expected value of EBIT Say there are two firms A and B and the respective data are as follows: Particulars Firm A Firm B Expected EBIT E (EBIT) A E (EBIT) B S.D of EBIT σ EBITA σ EBITB Expected EPS E (EPS) A E (EPS) B S.D. of EPS σ EPSA σ EPSB Coefficient of Variation of EBIT (c.v.) A (c.v.) B Coefficient of Variation EPS (C.V.) A (C.V.) B DFL DFL(A) DFL(B)

14 The following numerical measures we can make from above: 1) Total Business Risk are σ EBITA & σ EBITB respectively for firm A & B; 2) Total Firm Risk are σ EPSA & σ EPSB respectively for firm A & B; 3) Relative Business Risk are (c.v.) A & (c.v.) B respectively for firm A & B; 4) Relative Firm Risk are (C.V.) A & (C.V.) B respectively for firm A & B; 5) Relative Financial Risk are [(C.V.) A - (c.v.) A ] & [(C.V.) B - (c.v.) B ] respectively for firm A & B; 6) Relative Financial Risk of Firm A in comparison to firm B i.e. Added/magnified variability in earnings per share of firm A in comparison to firm B that is induced by the use of financial leverage (C.V.) A - (C.V.) B Or 7) Relative Financial Risk of Firm A in comparison to firm B i.e. Added/magnified variability in earnings per share of firm A in comparison to firm B that is induced by the use of financial leverage [(C.V.) A - (c.v.) A ] - [(C.V.) B - (c.v.) B ] 8) Coefficient of Variation EPS DFL* Coefficient of Variation EBIT Thus DFL is not synonymous with financial Risk. It is the measure pf potential effect of presence of fixed financial cost on the variability of EBIT in resulting ultimate variability of EPS

15 7 EPS1(Rs) G Co EPS2(Rs) D Co EPS 3---> 0.25 Prob--- > EBIT -----> 0 EBIT-EPS Break-Even or Indifference Analysis: We learnt that presence of fixed cost bearing capital like Debt Capital in the capital structure brings the impact of Financial Leverage by which any change in EBIT gets reflected in EPS in a magnified way. It means that impact of financing alternatives i.e. capital structure with or without debt/preference capital is different. But selection between financing alternatives depends on, besides other factors, Indifference point. To illustrate this indifference point let us take one example: Let a company s capital structure of Rs.1000 lakhs can be financed in either of the two alternatives: Alternative 1: By equity capital of Rs.10 each; Alternative 2: 50% by equity capital of Rs.10 each, 50 % by Debt 12% interest; We will now compute the indifference point Indifference point between any two alternatives is an EBIT at which both the alternatives give the same EPS i.e. Earnings Per Share. Numerically it could be solved by solving the following equalities:

16 (EBIT-I 1 )(1-t)-pd 1 (EBIT-I 2 )(1-t)-pd 2 N 1 N 2..(6) Where, I 1 and I 2 are Rupee interests in alternatives1 and alternatives 2 respectively; t is the tax rate; pd 1 & pd 2 are preference dividends in alternatives1 and alternatives 2 respectively; N 1 & N 2 are number of equity shares in alternatives1 and alternatives 2 respectively; EBIT is the earning before interest and tax, and here is the indifference point; From our illustrative example respective data are- I 1 Nil, I 2 (12/100) * 500, 00,000 6,000,000. pd 1 & pd 2 both are nil. N 1 Rs.1000, 00,000 of Rs.10 each 10,000,000. N 2 Rs.500,00,000 of Rs.10 each 5,000,000. Putting all these values in equation (6) we get EBIT Rs. 120,00,000 Indifference point. Now under consideration of different EBITs including the indifference point EPS with alternative1 and alternative 2 are computed and the result is furnished below: EBIT (Rs) EPS1(Rs) EPS2(Rs) ,00, ,00, ,00, ,00, ,00, ,00, ,00, ,00, With the above data EBIT-EPS straight line chars are prepared and shown in diagram above.

17 Let us now assume that future EBIT of two firms G.Co and D.Co varies in the following two fashions: fig in '00000 G Co fig in '00000 D Co. EBIT prob return sd EBIT prob return sd From the above table it is clear that Expected EBIT of both the company is same at Rs lakhs whereas s.d of the same is different that of G.Co is Rs Analysis: If EBIT is less than the indifference point then alternative 1 (all equity financing) is more preferable as financing options to alternative 2 (mix of debt and equity). Because in that case EPS will be more as can be seen from the two straight lines namely EPS1 and EPS2. Above the indifference point alternative 2 is preferable. So from above we could conclude that if EBIT is above Rs.120,00,000 then Debt financing (in our case alternative 2) is the preferred alternative so far as EPS is concerned. But this is a much generalized decision. Actually financial manager should compare the indifference point between two alternatives with i) Expected or most likely value of future EBIT; ii) The probability of the future EBIT actually falling below the indifference point; So in our illustrative diagram we have considered two companies (G & D) with their probabilistic distribution of EBIT. The expected or most likely EBIT of both the company is Rs lakhs i.e. more than the indifference point. So both of G & D could finance their operation with Debt financing in order to have favourable effect of Financial Leverage. But in case of D

18 company likelihood of EBIT falling below indifference point is more than that of G company as shown by probability distribution superimposed on EBIT-EPS. So degree of preference for debt financing in case of D will be less than that of G. In summary, the higher the level of expected EBIT above the indifference point and lower the probability of EBIT falling below indifference point (i.e. downside fluctuation), the stronger the case that can be made for the use of Debt financing. Moreover before taking any financial decision on Debt financing, firm should also consider its cash flow ability to honour fixed financial charges accompanied by the debt finance in the form of interest and capital repayment.