Leverage Assignment Help

Leverage is defined as the risk-taking capacity of the organization that how much risk the company can bear in a given period of time, the risk here means the paying back the interest amount on the financial loans and paying the operating or fixed expenses of a company.

According to J. C. Van Home “Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.”

Types of Leverages: -

  1. Operating Leverage
  2. Financial Leverage
  3. Combined Leverage
Leverage Assignment Help

Operating Leverage

Operating leverage is the cost of fixed asset procured by a company and the operating fixed costs of a company that incurred in the day to day activities such as repairs and maintenance, depreciation, insurance of assets, property taxes etc.

The formula for calculating the operating leverage or the operating leverage ratio is:-

The degree of operating leverage= percentage change in EBIT/ percentage change in Sales

Percentage change in EBIT= Increase in EBIT/EBIT

Percentage change in Sales = Increase in Sales/ Sales

The degree of operating leverage can also be computed as

DOL = Contribution / EBIT

Higher is the degree of operating leverage, the better it is.

If the value of the degree of operating leverage is 1 it means there is no operating leverage or operating risk in the company.  

For Example 1:-

Calculate degree of operating leverage from the following :-

Sales - $100,000

Variable cost - $ 30,000

Fixed cost - $ 10,000

Solution

Sales = $100000

Variable cost = $30000

Contribution = Sales – Variable cost

Contribution = $70000

EBIT (Earning before interest and tax) = Contribution – Fixed cost 

EBIT = $70000- $10000

EBIT = $60000

Degree of operating leverage = Contribution / EBIT

DOL = $ 70000/ $ 60000

DOL = 1.167

Example 2:-

Calculate the degree of operating leverage from the following:-

Sales in 2018 were $150000 and Sales in 2019 is $250000, EBIT in 2018 was $10000 and EBIT in 2019 is $15000. Compute DOL.

Solution -

Degree of Operating Leverage = % change in EBIT/ % change in Sales

% change in EBIT= increase in EBIT/ EBIT

% change in EBIT = $5000/$10000

% change in EBIT = 50%

% change in Sales = Increase in Sales / Sales

% change in Sales = $100000/$150000

% change in Sales = 66.67%

DOL = % change in EBIT / % change in Sales

DOL = 50%/66.67%

DOL = 0.75

Financial Leverage

Financial leverage is the cost of interest incurred on financial capital raised from the market by the company.

The formula for calculating the financial leverage or the financial leverage ratio is:-

The degree of financial leverage= percentage change in EPS/ percentage change in EBIT

Percentage change in EPS= Increase in EPS/EPS

Percentage change in EBIT= Increase in EBIT/EBIT

Degree of financial leverage can also be computed as

DFL = EBIT / EBIT – Interest – preference dividend (if any)

DFL = EBIT/ EBT

 Lower the financial leverage ratio the better it is.

This shows the company is having a lower amount of debt.

Example 3 :-

Calculate degree of financial leverage from the following :-

Sales - $100,000

Variable cost - $ 30,000

Fixed cost - $ 10,000

Interest on 10% Debenture of $ 100,000

Solution

Sales = $100000

Variable cost = $30000

EBIT (Earnings before interest and tax)  = Sales – Variable cost – fixed cost

EBIT (Earnings before interest and tax)  = $100000- $30000 - $ 10000

EBIT = $60,000

EBT (Earnings before tax) = EBIT – interest on debenture

EBT = $60,000- $10,000

EBT = $50,000

DFL= EBIT/EBT

DFL= $60,000/$50,000

DFL = 1.2

 Example 4:-

Calculate the degree of financial leverage from the following:-

EPS in 2018 was $15 and the EPS in 2019 is $25, EBIT in 2018 was $10000 and EBIT in 2019 is $15000. Compute DFL.

Solution –

Degree of Financial Leverage = % change in EPS/ % change in EBIT

% change in EBIT= increase in EBIT/ EBIT

% change in EBIT = $5000/$10000

% change in EBIT = 50%

% change in EPS = Increase in EPS / EPS

% change in EPS = $10/$15

% change in EPS = 66.67%

DFL = % change in EPS / % change in EBIT

DFL = 66.67% / 50%

DFL = 1.33

EXAMPLE 5:-

Calculate the Degree of financial leverage ratio from the following data of ABC company (UK) :-

Sale = $200,000

Variable cost = $ 100,000

Fixed cost = $ 20,000

10% debentures of $ 100,000 and 10% preference shares of $ 200,000 are borrowed from the market.

Solution –

EBIT (Earnings before interest and tax)  = Sales – Variable cost – Fixed cost

EBIT= $200,000 - $ 100,000 - $ 20,000

EBIT = $ 80,000

EBT (Earnings before tax) = EBIT – Interest on debenture – preference dividend

EBT = $80,000 - $10,000 - $ 20,000

EBT = $ 50,000

DFL = EBIT/EBT

DFL = $80,000/ $50,000

DFL = 1.6

 

Combined Leverage

The degree of combined leverage is the combined effect of the operating leverage ratio and financial leverage ratio. It shows the effect of a change in sales on the change of earning EPS share.

The formula for calculating the combined leverage or the combined leverage ratio is:-

The degree of combined leverage= percentage change in EPS/ percentage change in Sales

Percentage change in EPS= Increase in EPS/EPS

Percentage change in Sales = Increase in Sales/ Sales

Degree of combined leverage can also be computed as

DCL = Sales – Variable cost / EBIT – Interest – preference dividend (if any)

DCL = Contribution / EBT

DCL = DOL* DFL

Lower the combined leverage ratio the better it is.

This shows the amount of fixed cost and amount of financial debt that the company is having in the given period of time.

Example 6 :-

Calculate the Degree of combined leverage ratio from the following data of XYZ company (UK) :-

Sale = $200,000

Variable cost = $ 100,000

Fixed cost = $ 20,000

10% debentures of $ 100,000 and 10% preference shares of $ 200,000 are borrowed from the market.

Solution –

Contribution = Sales – Variable cost

Contribution = $ 200,000 - $ 100,000

Contribution = $ 100,000

EBT (Earnings before tax) = Contribution – Fixed cost – Interest on debenture – Preference dividend

EBT= $ 100,000 - $20,000 - $10,000 -$ 20,000

EBT = $ 50,000

DCL = Contribution / EBT

DCL = $100,000/ $50,000

DCL = 0.5

Example 7:-

Calculate the Degree of operating leverage, Degree of Financial Leverage and Degree of combined leverage from the following given data:-

Sales = $500,000

Variable cost = $ 200,000

Fixed cost = $ 100,000

The company is having 10% debentures of $ 200,000 and 10% preference shares of $ 300,000.

Solution: -

Calculation of Degree of Operating Leverage -

DOL= Contribution / EBIT

Contribution = Sales – Variable cost

Contribution = $500,000 - $ 200,000

Contribution = $ 300,000

EBIT (Earnings before Interest and Tax) = Contribution – Fixed cost

EBIT = $ 300,000 - $ 100,000

EBIT = $ 200,000

DOL = Contribution / EBIT

DOL = $ 300,000/ $200,000

DOL = 1.5

Calculation of Degree of Financial Leverage –

DFL = EBIT / EBT

EBIT = $ 200,000

EBT (Earnings before tax) = EBIT – Interest on debenture – Preference dividend

EBT = $200,000 - $ 20,000 - $ 30,000

EBT = $ 150,000

DFL = EBIT / EBT

DFL = $200,000/ $ 150,000

DFL = 1.33

Calculation of Degree of Combined Leverage -

DCL = DOL * DFL

DCL = 1.5 * 1.33

DCL = 1.99

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