Operating, Financial and Combined Leverage

The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return may be termed as LEVERAGE. This affects the earnings to shareholders and also some element of risk is involved Types of Leverage s: 1. Operating Leverage Due to the existence of fixed operating expenses in the firms cost structure. 2. Financial Leverage Associated with financing activities. Operating Leverage The operating leverage may be defined as the firms ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. In other words, by employing fixed costs, the percentage change in profits accompanying a change in volume is greater than the percentage change in sales/volume. Let us see an example in this regard.

Illustration 1: A firm sells products for Rs. 100 per unit, has variable operating costs of Rs. 50 per unit and fixed operating costs of Rs. 50,000 per year. Show the various levels of EBIT that would result from sale of (i) 1,000 units (ii) 2,000 units (iii) 3,000 units.
EBIT = S VC = Contribution FC = EBIT EBIT = S VC - FC = 100,000 50,000 50000 = 0 = 200,000 100,000 50,000 = 50,000 = 300,000 150,000 50,000 = 100,000 Formula for Degree of Operating Leverage, Q (S-V) DOL = ----------Q (S-V)-F

or DOL = Contribution / EBIT

Where, Q = quantity produced and sold operating fixed costs

S = selling price per unit V = variable cost per unit F =

 Financial Leverage Financial leverage results from the presence of fixed financial charges in the firms income stream. It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share.

 Illustration 3 The financial manager of the Hypothetical Ltd. expects that its EBIT in the current year would amount to Rs. 10,000. The firm has 5% bonds aggregating Rs. 40,000, while the 10% preference shares amount to Rs. 20,000. Tax rate 30% What would be the earnings per share? Assuming the EBIT being (i) Rs.6,000 (ii) Rs. 14,000, how would the EPS be affected? The tax rate can be assumed to be 30%. The no. of outstanding ordinary shares is 1,000. Degree of financial leverage is calculate as follows DFL = EBIT / EBT

 Combined Leverage The operating leverage has its effect on operating risk and the financial leverage has its effect on financial risk. If both the leverages are combined, the result is total leverage. The risk associated with combined leverage is known as total risk. Symbolically, Degree of combined leverage is DCL = DOL x DFL

Capital Structure, Appraisal of Term Loans

Introduction Every time the firm takes an investment decision, it also takes a financing decision. The assets of a company can be financed by either increasing the owners claims (Owned Capital) or the creditors capital (Owed Capital).

The term Capital Structure is used to represent the proportionate relationship between debt & equity.

Steps involved in Capital Structure Decisions

1. Capital Budgeting Decision Replacement, Modernization, Expansion, Diversification. 2. Need to raise funds Internal resources, Debt, External Equity. 3. Capital Structure Decisions: Existing capital structure, Desired debt-equity mix 4. Effect On return and On risk 5. Effect on cost of capital

6. Optimum capital structure

7. Value of firm Maximization

Capital Structure Theories

1) Net Income Approach This theory was given by David Durand. According to him, the capital structure decision is relevant to the valuation of the firm. In other words, a change in the financial leverage will lead to a corresponding change in the overall cost of capital as well as the total value of the firm. 2) Net Operating Income Approach: This theory is also suggested by David Durand. This theory is diametrically opposite to the NI approach. According to this approach, the capital structure decision of a firm is irrelevant. Any change in leverage will not lead to any change in the total value and the market price of shares as well as the overall cost of capital is independent of the degree of leverage. 3) Modigliani Miller Approach: This approach is akin to the NOI theory. The MM proposition supports the NOI approach relating to independence of the cost of capital of the degree of leverage at any level of debt-equity ratio. 4) Traditional Approach The traditional approach is a mid-way between the NI &NOI Approaches. The crux of the traditional view relating to leverage and valuation is that through judicious use of debt-equity proportions, a firm can increase its total value & thereby reduce its overall cost of capital.

Term Loan Appraisal

Borrower submits: (i) Promoters background (ii) particulars of industrial concern (iii) particulars of project (capacity, process, etc.) (iv) cost of project (v) means of financing (vi) marketing and selling arrangement (vii) profitability and cash flows (viii) economic considerations and (ix) government consensus

Term Loan Appraisal

As a part of the term loan approval, the lender will normally check: (i) technical feasibility (ii) economic viability (iii) financial viability (iv) managerial competence (v) Loan aspects: (a) amount of loan (b) maturity duration (c) security (d) covenants/conditions (e) repayment schedule/loan

Basic Valuation concepts

Concepts: Book Value Market value Intrinsic value Liquidation value Replacement value Salvage value Fair value (average of book, market and intrinsic values)

Methods of Valuation
Asset based approach Earnings based approach Capitalization method P/E ratio method DCF method EVA MVA

Merchant Banking
Definition of 'Merchant Bank' A bank that deals mostly in (but is not limited to) international finance, long-term loans for companies and underwriting. Merchant banks do not provide regular banking services to the general public. Investopedia explains 'Merchant Bank' Their knowledge in international finances make merchant banks specialists in dealing with multinational corporations.

Areas of Merchant Banks

The activities of the merchant banking in India is very vast in nature of which includes the following a) The management of the customers securities b) The management of the portfolio, c) The management of projects and counseling as well as appraisal d) The management of underwriting of shares and debentures e) The circumvention of the syndication of loans f) Management of the interest and dividend etc

Corporate Taxation and Inflation Impact on corporate finance

Impact of Taxes on Corporate finance

Interest deduction to arrive at tax outflows impact on decision to raise debt

Dividends not tax-deductible impact on decision to raise equity Impact of Inflation on Corporate Finance

Inflation and asset revaluation (impact on depreciation)

Inflation and firm value (EVA,MVA calculation) Inflation and financial returns (ROCE/ROE) Inflation and innovation in the financial markets Inflation and financial analysis Inflation and capital budgeting