CH: LEVERAGE

Concept of EBIT-EPS:
EBIT i.e., Earnings before Interest and Taxes is an indicator of a company’s profitability. on
the other hand EPS means Earnings Per Share. EBIT-EPS analysis is a technique used to
determine the optimal capital structure in which the value of earnings per share (EPS) has the
highest amount for a given amount of earnings before interest and taxes (EBIT). This analysis
gives a scientific basis for comparison among various financial plans and shows ways to
maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial planning
that evaluates various alternatives of financial a project under varying levels of EBIT and
suggests the best alternative having highest EPS and determines the most profitable level of
EBIT’.
The relationship between EBIT and EPS can be presented with the following formula.
(𝑬𝑩𝑰𝑻−𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔)𝒙 (𝟏−𝑻𝒂𝒙 𝑹𝒂𝒕𝒆)−𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒐𝒏 𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒔𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍
EPS =
𝑵𝒐 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔

Format of EBIT – EPS Calculation:

Particulars Amount (₹)
Sales
Less: Variable Cost XXX
Related to
Contribution XXX
Operating
Less: Fixed cost XXX Leverage

Earnings before Interest and Tax (EBIT) XXX

Less: Interest expenses XXX

Related to
Combined Earnings before Tax (EBT) XXX
Leverage
Less: Tax XXX
Earnings after tax (EAT) XXX Related to
Financial
Less: Preference Dividend XXX Leverage

Earnings to Equity Shareholder (a) XXX

No. of Equity Shares (b) XXX

EPS (a/b) XXX

Concept of Financial Break-even Point
Any business that generates sufficient profits to cover the fixed financial charges is called
financial break-even point. So it is the level of profit which will match fixed financial
charges.

Total
Revenue

Total
Financial cost &

Revenue
Revenue

Financial
Fixed Cost

Level of
0 𝑃2 Profit
𝑃1

Diagram of Financial break even Point

[Here, P means Profit level]
Financial cost means Interest expenses and Preference dividends.
If profit is increased, then financial risk will be higher. Risk of investment in the firm’s stock
will be higher.
Formula of determine financial break-even point:
we know Net income = (EBIT – Interest Expenses) (1 – Tax) – Preferred dividend
So, Break-even point = Net income = 0
0 = (EBIT – Interest) (1 – Tax) – Preferred dividend
𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
EBIT – Interest expenses = 1−𝑇𝑎𝑥

𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝒅𝒊𝒗𝒊𝒅𝒆𝒏𝒅
EBIT = + 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔
𝟏−𝑻𝒂𝒙

Concept of Indifference Point:

Indifference point or level is that earnings before interest and tax (EBIT) level at which the
earnings per share (EPS) is the same for two alternatives of debt-equity mix of financial
plans. it is that level of profit where EPS does not effected. Hence, the level of EBIT beyond
which the benefits of financial leverage begins to operate with respect to Earnings Per Share
(EPS) is known as indifference point.
If the EBIT exceeds the indifference point level of EBIT, the use of fixed cost source of funds
would be beneficial from the EPS viewpoint. In this case, financial leverage would be
favourable. In the reverse scenario, if the expected level of EBIT is less than the indifference
point, the advantage of EPS would be available from the use of equity capital not debt capital.

Concept of LEVERAGE:
The word ‘leverage’ comes from the French word lever, which means ‘to raise’. Leverage
refers to the use of assets and funds for which the business has to pay a fixed amount. It is a
result of the firm employing an assets or source of fund which has fixed costs or return.
Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the
return to its owners.
If higher amount of fixed financial charges is to be paid by the firm, it is obvious that the
earning per share will increase in value per share. High levered capital structure signifies the
presence of high amount of debt capital in comparison with owned capital in the capital
structure of the firm. it is to be kept in mind that if the fixed cost (interest) increases and the
income of the firm also increases accordingly. Therefore, it may be opined that if the leverage
increases the risk will increase, and if the firm is able to increase its income accordingly, the
shareholders’ claim (dividend) will also increase.

Types of LEVERAGE:
1. Operating Leverage:
Operating leverage is a measure of a firm’s level of fixed costs relative to its variable costs.
By utilizing the fixed cost if the sales increases, and thereby it influences the operating profit,
such impact is known as operating leverage. Higher the proportion of fixed operating cost as
compare to variable cost, higher is the operating leverage and its risk and vice versa.

Measurement of Operating Leverage:

% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒇𝒊𝒕
Degree of operating leverage (DOL) = >𝟏
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒔𝒂𝒍𝒆𝒔 𝒗𝒐𝒍𝒖𝒎𝒆

or,
𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
=
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒑𝒓𝒐𝒇𝒊𝒕 (𝑬𝑩𝑰𝑻)

If there is no fixed operating cost in the business then DOL is 1.

 2. Financial Leverage:
Financial leverage is a financial technique that uses borrowed funds or preferred stock (items
involving fixed financial costs) to improve the return on an equity investment. It is concerned
with the relationship between the firm’s earnings before interest and taxes (EBIT) and the
earnings available to common stockholders or other owners.

Measurement of Financial Leverage:

% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
Degree of financial leverage (DFL) = >𝟏
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻

or,
𝑬𝑩𝑰𝑻
=
𝑬𝑩𝑻

or,
In any capital structure if there is preference share capital, the amount of preference dividend
to be converted into preference dividend before tax applying the following formula in order
to determine financial leverage -
𝑬𝑩𝑰𝑻
= 𝑫𝒑 Here, 𝐷𝑝 = Preference Dividend
𝑬𝑩𝑰𝑻−𝑰−
(𝟏−𝒕)

t = Tax Expenses
I = Interest Expenses
If there is no use of fixed cost fund in the business then DFL is 1.

Note: A firm having a high degree of Operating leverage should have low Financial leverage
by preferring equity financing, and vice versa by preferring debt financing. It should be
balanced.

Difference between Operating and Financial Leverage:

Operating Leverage Financial Leverage
Relationship exist between operating profit Relationship exist between operating profit
and sales. and EPS.
Related to assets Related to liabilities.
Related to investment decision cause Related to financing decision, means related
business invested in assets. to funds.
It measures the ability of the firm to use It measures the ability of the firm to use
fixed cost asset to increase the operating fixed cost fund to increase the return on
profit. equity shares.
It is the 1st stage of Leverage. It is the 2nd stage of Leverage.
3. Combined Leverage:
Combination of Operating leverage and Financial Leverage is called Combined
Leverage.

Measurement of Combined Leverage:

% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
Degree of combined leverage =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑻
or,
𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
=
𝑬𝑩𝑻
or,
𝑭𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕−𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
=
𝑬𝑩𝑻