The Use of Leverage & Financial structure

The Use of Leverage & Financial structure

Financial Management-IIDepartment of CommerceUniversity of North Bengal

Topics in the Syllabus

Operating and Financial Leverage:

1. Effects of operating and financial leverage on profit

2. Measurement of leverages

3. Analyzing alternate financial plans

4. Combined financial and operating leverage.

LEVERAGE

Leverage factor is defined as the ratio of total debt to total assets.

Let us suppose that a firm’s total asset is Rs. 100.0 which consists of debt Rs. 50.0 and common equity Rs 50.0

Thus

Debt Equity Ratio = 1 or 100 percent,

and

Leverage factor = 0.5 or 50 percent

RISK

Business Risk:

It means the inherent uncertainty or variability of expected returns on the firm’s assets (EBIT).

Financial Risk:

By financial risk we mean the additional risk that is induced by the use of financial leverage.

CAPITAL STRUCTURE OF FOUR DIFFERENT FIRMS

DebtEquity 25% Leverage factor=20%

DebtEquity 0 Leverage factor=0

FIRM-A

LIABILITY Rs.

Debt 0 Stock 10,000

Total Liability 10,000

ASSETSRs.

Assets- 10,000

Total Assets 10,000

FIRM-B

LIABILITY Rs.

Debt 2,000 Stock 8,000

Total Liability 10,000

ASSETSRs.

Assets- 10,000

Total Assets 10,000

CAPITAL STRUCTURE OF FOUR DIFFERENT FIRMS

DebtEquity

44 or 400% Leverage factor= or 80%

5

Debt 1Equity 21 or 100% Leverage factor= or 50%

FIRM-C

LIABILITY Rs.

Debt 5,000 Stock 5,000

Total Liability 10,000

ASSETSRs.

Assets- 10,000

Total Assets 10,000

FIRM-D

LIABILITY Rs.

Debt 8,000 Stock 2,000

Total Liability 10,000

ASSETSRs.

Assets- 10,000

Total Assets 10,000

Additional Information

• The Rate of Interest on debt = 10 percent• The Tax Rate is = 50 percent• Variable Costs = 40 percent of Sales• Fixed Costs = Rs. 2000• There are four probable market conditions:

Very poor when sales = 0Poor when sales = Rs. 6,000Normal when sales = Rs. 10,000Good when sales = Rs. 20,000

(probability 0.1)(probability 0.3)(probability 0.4)(probability 0.2)

Probability of Expected Sales   0.1 0.3 0.4 0.2

           

Sales   0 6000 10000 20000

           

  Fixed Costs 2000 2000 2000 2000

 Variable Costs (40 % of Sales) 0 2400 4000 8000

  Total Costs 2000 4400 6000 10000

           

EBIT   -2000 1600 4000 10000

EBIT of Each Firm under Four Different Market Conditions

FIRM-A          

EBIT   -2000 1600 4000 10000

  Less Interest 0 0 0 0

  Less Tax -1000 800 2000 5000

Net Profit after Taxes   -1000 800 2000 5000

Earnings per Share (1000)   -1.00 0.80 2.00 5.00

Return on Stockholders Equity (Rs. 10)

 (percent)-10 8 20 50

EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY

FIRM- B          

EBIT   -2000 1600 4000 10000

 Less Interest (10% of 2000) 200 200 200 200

 Earnings before Taxes -2200 1400 3800 9800

 Less Tax (50 percent) -1100 700 1900 4900

Net Profit after Taxes   -1100 700 1900 4900

Earnings per Share (800)   -1.38 0.88 2.38 6.13

Return on Stockholders Equity (Rs. 10) (percent) -13.80 8.80 23.80 61.30

EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY

FIRM-C          

EBIT   -2000 1600 4000 10000

 Less Interest (10% of 5000) 500 500 500 500

 Earnings before Taxes -2500 1100 3500 9500

 Less Tax (50 percent) -1250 550 1750 4750

Net Profit after Taxes   -1250 550 1750 4750

Earnings per Share (500)   -2.50 1.10 3.50 9.50

Return on Stockholders Equity (Rs. 10) (percent) -25.00 11.00 35.00 95.00

EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY

FIRM-D          

EBIT   -2000 1600 4000 10000

 Less Interest (10% of 8000) 800 800 800 800

 Earnings before Taxes -2800 800 3200 9200

 Less Tax (50 percent) -1400 400 1600 4600

Net Profit after Taxes   -1400 400 1600 4600

Earnings per Share (200)   -7.00 2.00 8.00 23.00

Return on Stockholders Equity (percent) -70.00 20.00 80.00 230.00

EARNING PER SHARE (EPS) & RETURN ON STOCKHOLDERS EQUITY

Expected EPS of four firms

Sales Prob A B C D

0 0.1 -1 -1.38 -2.5 -7

6000 0.3 0.8 0.88 1.1 2

10000 0.4 2 2.38 3.5 8

20000 0.2 5 6.13 9.5 23

Expected EPS 1.94 2.304 3.38 7.7

Leverage 0 25 100 400

Var 3.12 4.89 12.51 78.21

sd 1.76 2.21 3.53 8.84

Return on Stockholders Equity

EBIT -2000 1600 4000 10000

Return on Stockholders Equity A -10 8 20 50

Return on Stockholders Equity B -13.8 8.8 23.8 61.3

Return on Stockholders Equity C -25 11 35 95

Return on Stockholders Equity D -70 20 80 230

-100

-50

0

50

100

150

200

250

-2000 1600 4000 10000

Re

turn

on

Sto

ckh

old

ers

Equ

ity

EBIT

B

C

D

A

END