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Indifferent point
Point of Indifference: The level of EBIT at which EPs is same for two alternative capital structures
(X I1) (1 t) PD (1 + Dt) ES1 = (X I2) (1 t) PD (1 + Dt) ES2
Where: X = EBIT I1,I2 = Interest under alternatives 1 and 2 t = Tax rate PD = Preference dividend Dt = Preference dividend tax ES1, ES2 = No. of equity share outstanding under alternative 1 and 2
Traditional Approach
Also known as intermediate approach, is a compromise between the two extremes of NI & NOI approach. According to this theory the value of the firm can be increased initially or the cost of capital can be decreased by using more debt as the debt is the cheaper source of funds than equity. Beyond a particular point, the cost of equity increases because increased debt increases the financial risk of the equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by increased cost of equity. After this there comes a stage, when the increased cost of equity cannot be offset by the advantage of low-cost debt. Thus overall cost of capital, according to this theory, decreases up to a certain point, remains more or less unchanged for moderate increase in debt thereafter; & increases or rises beyond a certain point. Even the cost of debt may rise at this stage due to increased financial risk.
Leverage
Leverage: The action of a lever and mathematical advantage gained by it Types of Leverages: Operating leverage Financial leverage
Operating Leverage
Operating Leverage: The firms ability to use operating cost to magnify the effects of changes in sales on its EBIT
Degree of Operating Leverage (DOL) = Percentage change in EBIT Percentage change in Sales Or
When the data is given only for one year, then we have to compute operating leverage, by the following formula. Operating =
Leverage Contribution Operating Profit (EBIT)
Financial Leverage
Financial Leverage: Ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on firms EPS
Financial Leverage = EBIT (Operating profit) EBT (Taxable income) Degree of Financial Leverage (DFL) Percentage change in EPS Or
Combined Leverage
Combined leverage: The percentage change in EPS due to the percentage change in sales
% Change in EBIT X % Change in Sales % Change in EPS % Change in EBIT Or Contribution EBIT X EBIT EBT = Contribution EBT = % Change in EPS % Change in Sales
Low
High