Master of Business Administration- MBA Semester 2

MB0045 – Financial Management - 4 Credits

(Book ID: B1134)

Q.1 Write the short notes on 5X2= (10 Marks)

1. Financial management
2. Financial planning
3. Capital structure
4. Cost of capital
5. Trading on equity.

Q.2 a. Write the features of interim divined and also write the factors
(08 Marks)
Influencing divined policy?
b. What is reorder level ? (02Marks)

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs
300,000,
Administration and selling expenses Rs.20, 000, Interest on loans
Rs.5000, (10 Marks)
Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share
Capital
Rs.100, 000 @Rs. 10 per share. Find EPS.

Q.4 What are the techniques of evaluation of investment? (10 Marks)

Q.5 What are the problems associated with inadequate working

capital? (10 Marks)

Q.6 What is leverage? Compare and Contrast between operating (10

Marks)
Leverage and financial leverage
Answer1:

FINANACIAL MANAGEMENT AND FINANCIAL PLANNING

Financial Management can be defined as:

The management of the finances of a business / organisation in order to achieve financial objectives

Taking a commercial business as the most common organisational structure, the key objectives of
financial management would be to:

• Create wealth for the business

• Generate cash, and

• Provide an adequate return on investment bearing in mind the risks that the business is taking and
the resources invested

There are three key elements to the process of financial management:

(1) Financial Planning

Management need to ensure that enough funding is available at the right time to meet the needs of the
business. In the short term, funding may be needed to invest in equipment and stocks, pay employees
and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the productive
capacity of the business or to make acquisitions.

(2) Financial Control

Financial control is a critically important activity to help the business ensure that the business is
meeting its objectives. Financial control addresses questions such as:

• Are assets being used efficiently?

• Are the businesses assets secure?

• Do management act in the best interest of shareholders and in accordance with business rules?

(3) Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:

• Investments must be financed in some way – however there are always financing alternatives that can
be considered. For example it is possible to raise finance from selling new shares, borrowing from
banks or taking credit from suppliers

• A key financing decision is whether profits earned by the business should be retained rather than
distributed to shareholders via dividends. If dividends are too high, the business may be starved of
funding to reinvest in growing revenues and profits further.
CAPITAL STRUCTURE

In finance, capital structure refers to the way a corporation finances

its assets through some combination of equity, debt, or hybrid
securities. A firm's capital structure is then the composition or
'structure' of its liabilities. For example, a firm that sells $20 billion in
equity and $80 billion in debt is said to be 20% equity-financed and
80% debt-financed. The firm's ratio of debt to total financing, 80% in
this example, is referred to as the firm's leverage. In reality, capital
structure may be highly complex and include dozens of sources.
Gearing Ratio is the proportion of the capital employed of the firm
which come from outside of the business finance, e.g. by taking a
short term loan etc.

The Modigliani-Miller theorem, proposed by Franco Modigliani and

Merton Miller, forms the basis for modern thinking on capital
structure, though it is generally viewed as a purely theoretical result
since it assumes away many important factors in the capital structure
decision. The theorem states that, in a perfect market, how a firm is
financed is irrelevant to its value. This result provides the base with
which to examine real world reasons why capital structure is relevant,
that is, a company's value is affected by the capital structure it
employs. Some other reasons include bankruptcy costs, agency
costs, taxes, and information asymmetry. This analysis can then be
extended to look at whether there is in fact an optimal capital
structure: the one which maximizes the value of the firm.

COST OF CAPITAL

The cost of capital is the cost of a company's funds (both debt and
equity), or, from an investor's point of view "the expected return on a
portfolio of all the company's existing securities". It is used to
evaluate new projects of a company as it is the minimum return that
investors expect for providing capital to the company, thus setting a
benchmark that a new project has to meet.

For an investment to be worthwhile, the expected return on capital

must be greater than the cost of capital. The cost of capital is the rate
of return that capital could be expected to earn in an alternative
investment of equivalent risk. If a project is of similar risk to a
company's average business activities it is reasonable to use the
company's average cost of capital as a basis for the evaluation. A
company's securities typically include both debt and equity, one must
therefore calculate both the cost of debt and the cost of equity to
determine a company's cost of capital.

The cost of debt is relatively simple to calculate, as it is composed of

the rate of interest paid. In practice, the interest-rate paid by the
company can be modelled as the risk-free rate plus a risk component
(risk premium), which itself incorporates a probable rate of default
(and amount of recovery given default). For companies with similar
risk or credit ratings, the interest rate is largely exogenous (need to
explain use of "exogenous" in this context).

The cost of equity is more challenging to calculate as equity does not

pay a set return to its investors. Similar to the cost of debt, the cost of
equity is broadly defined as the risk-weighted projected return
required by investors, where the return is largely unknown. The cost
of equity is therefore inferred by comparing the investment to other
investments (comparable) with similar risk profiles to determine the
"market" cost of equity.

Once cost of debt and cost of equity have been determined, their
blend, the weighted-average cost of capital (WACC), can be
calculated. This WACC can then be used as a discount rate for a
project's projected cashflows.

TRADING ON EQUITY

Trading on equity occurs when a corporation uses bonds, other debt,

and preferred stock to increase its earnings on common stock. For
example, a corporation might use long term debt to purchase assets
that are expected to earn more than the interest on the debt. The
earnings in excess of the interest expense on the new debt will
increase the earnings of the corporation’s common stockholders. The
increase in earnings indicates that the corporation was successful in
trading on equity.

If the newly purchased assets earn less than the interest expense on
the new debt, the earnings of the common stockholders will decrease.
In finance, equity trading is the buying and selling of company stock
shares. Shares in large publicly-traded companies are bought and
sold through one of the major stock exchanges, such as the New York
Stock Exchange, London Stock Exchange or Tokyo Stock Exchange,
which serve as managed auctions for stock trades. Stock shares in
smaller public companies are bought and sold in over-the-counter
(OTC) markets.

Equity trading can be performed by the owner of the shares, or by an

agent authorized to buy and sell on behalf of the share's owner.
Proprietary trading is buying and selling for the trader's own profit or
loss. In this case, the principal is the owner of the shares. Agency
trading is buying and selling by an agent, usually a stock broker, on
behalf of a client. Agents are paid a commission for performing the
trade.

Major stock exchanges have market makers who help limit price
variation (volatility) by buying and selling a particular company's
shares on their own behalf and also on behalf of other clients.
Answer2:

INTERIM DIVIDEND

A dividend payment made before a company's AGM and final

financial statements. This declared dividend usually accompanies the
company's interim financial statements. Interim Dividend. If Articles
so permit, the directors may decide to pay dividend at any time
between the two Annual General Meeting before finalizing the
accounts. It is generally declared and paid when company has earned
heavy profits or abnormal profits during the year and directors which
to pay the profits to shareholders. Such payment of dividend in
between the two Annual General meetings before finalizing the
accounts is called Interim Dividend. No Interim Dividend can be
declared or paid unless depreciation for the full year (not
proportionately) has been provided for. It is, thus,, an extra dividend
paid during the year requiring no need of approval of the Annual
General Meeting. It is paid in cash.

1. Stability of Earnings. The nature of business has an important

bearing on the dividend policy. Industrial units having stability of
earnings may formulate a more consistent dividend policy than those
having an uneven flow of incomes because they can predict easily
their savings and earnings. Usually, enterprises dealing in necessities
suffer less from oscillating earnings than those dealing in luxuries or
fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding

the dividend policy. A newly established company may require much
of its earnings for expansion and plant improvement and may adopt a
rigid dividend policy while, on the other hand, an older company can
formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position

is also an important factor in dividend decisions. A dividend
represents a cash outflow, the greater the funds and the liquidity of
the firm the better the ability to pay dividend. The liquidity of a firm
depends very much on the investment and financial decisions of the
firm which in turn determines the rate of expansion and the manner of
financing. If cash position is weak, stock dividend will be distributed
and if cash position is good, company can distribute the cash
dividend.

4. Extent of share Distribution. Nature of ownership also affects the

dividend decisions. A closely held company is likely to get the assent
of the shareholders for the suspension of dividend or for following a
conservative dividend policy. On the other hand, a company having a
good number of shareholders widely distributed and forming low or
medium income group, would face a great difficulty in securing such
assent because they will emphasise to distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their

profits for strengthening their financial position. The income may be
conserved for meeting the increased requirements of working capital
or of future expansion. Small companies usually find difficulties in
raising finance for their needs of increased working capital for
expansion programmes. They having no other alternative, use their
ploughed back profits. Thus, such Companies distribute dividend at
low rates and retain a big part of profits.

6. Trade Cycles. Business cycles also exercise influence upon

dividend Policy. Dividend policy is adjusted according to the
business oscillations. During the boom, prudent management creates
food reserves for contingencies which follow the inflationary period.
Higher rates of dividend can be used as a tool for marketing the
securities in an otherwise depressed market. The financial solvency
can be proved and maintained by the companies in dull years if the
adequate reserves have been built up.

7. Government Policies. The earnings capacity of the enterprise is

widely affected by the change in fiscal, industrial, labour, control and
other government policies. Sometimes government restricts the
distribution of dividend beyond a certain percentage in a particular
industry or in all spheres of business activity as was done in
emergency. The dividend policy has to be modified or formulated
accordingly in those enterprises.
8. Taxation Policy. High taxation reduces the earnings of he
companies and consequently the rate of dividend is lowered down.
Sometimes government levies dividend-tax of distribution of dividend
beyond a certain limit. It also affects the capital formation. N India,
dividends beyond 10 % of paid-up capital are subject to dividend tax
at 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take

the legal requirements too into consideration. In order to protect the
interests of creditors an outsiders, the companies Act 1956
prescribes certain guidelines in respect of the distribution and
payment of dividend. Moreover, a company is required to provide for
depreciation on its fixed and tangible assets before declaring
dividend on shares. It proposes that Dividend should not be
distributed out of capita, in any case. Likewise, contractual obligation
should also be fulfilled, for example, payment of dividend on
preference shares in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the
directors must keep in mind the dividend paid in past years. The
current rate should be around the average past rat. If it has been
abnormally increased the shares will be subjected to speculation. In a
new concern, the company should consider the dividend policy of the
rival organisation.

11. Ability to Borrow. Well established and large firms have better
access to the capital market than the new Companies and may borrow
funds from the external sources if there arises any need. Such
Companies may have a better dividend pay-out ratio. Whereas smaller
firms have to depend on their internal sources and therefore they will
have to built up good reserves by reducing the dividend pay out ratio
for meeting any obligation requiring heavy funds.

12. Policy of Control. Policy of control is another determining factor is

so far as dividends are concerned. If the directors want to have
control on company, they would not like to add new shareholders and
therefore, declare a dividend at low rate. Because by adding new
shareholders they fear dilution of control and diversion of policies
and programmes of the existing management. So they prefer to meet
the needs through retained earing. If the directors do not bother about
the control of affairs they will follow a liberal dividend policy. Thus
control is an influencing factor in framing the dividend policy.

13. Repayments of Loan. A company having loan indebtedness are

vowed to a high rate of retention earnings, unless one other
arrangements are made for the redemption of debt on maturity. It will
naturally lower down the rate of dividend. Sometimes, the lenders
(mostly institutional lenders) put restrictions on the dividend
distribution still such time their loan is outstanding. Formal loan
contracts generally provide a certain standard of liquidity and
solvency to be maintained. Management is bound to hour such
restrictions and to limit the rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid
is another consideration. Payment of dividend means outflow of cash.
It is, therefore, desirable to distribute dividend at a time when is least
needed by the company because there are peak times as well as lean
periods of expenditure. Wise management should plan the payment of
dividend in such a manner that there is no cash outflow at a time
when the undertaking is already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be

paid regularly because each investor is interested in the regular
payment of dividend. The management should, inspite of regular
payment of dividend, consider that the rate of dividend should be all
the most constant. For this purpose sometimes companies maintain
dividend equalization Fund.

REORDER LEVEL

A level of stock at which a replenishment order should be placed.

Traditional "optimizing" systems use a variation on the computation
of maximum usage multiplied by maximum lead, which builds in a
measure of safety stock and minimizes the likelihood of a stock out.

This is that level of materials at which a new order for supply of

materials is to be placed. In other words, at this level a purchase
requisition is made out. This level is fixed somewhere between
maximum and minimum levels. Order points are based on usage
during time necessary to requisition order, and receive materials, plus
an allowance for protection against stock out.

The order point is reached when inventory on hand and quantities

due in are equal to the lead time usage quantity plus the safety stock
quantity.

Formula of Re-order Level or Ordering Point:

The following two formulas are used for the calculation of reorder
level or point.

[ Ordering point or re-order level = Maximum daily or weekly or

monthly usage × Lead time ]

The above formula is used when usage and lead time are known with
certainty; therefore, no safety stock is provided. When safety stock is
provided then the following formula will be applicable:

[ Ordering point or re-order level = Maximum daily or weekly or

monthly usage × Lead time + Safety stock ]
Answer4:

In finance, investment is the commitment of funds by buying

securities or other monetary or paper (financial) assets in the money
markets or capital markets, or in fairly liquid real assets, such as gold
or collectibles. Valuation is the method for assessing whether a
potential investment is worth its price. Returns on investments will
follow the risk-return spectrum.

Types of financial investments include shares, other equity

investment, and bonds (including bonds denominated in foreign
currencies). These financial assets are then expected to provide
income or positive future cash flows, and may increase or decrease in
value giving the investor capital gains or losses.

Trades in contingent claims or derivative securities do not

necessarily have future positive expected cash flows, and so are not
considered assets, or strictly speaking, securities or investments.
Nevertheless, since their cash flows are closely related to (or derived
from) those of specific securities, they are often studied as or treated
as investments.

Investments are often made indirectly through intermediaries, such as

banks, mutual funds, pension funds, insurance companies, collective
investment schemes, and investment clubs. Though their legal and
procedural details differ, an intermediary generally makes an
investment using money from many individuals, each of whom
receives a claim on the intermediary.

Within personal finance, money used to purchase shares, put in a

collective investment scheme or used to buy any asset where there is
an element of capital risk is deemed an investment. Saving within
personal finance refers to money put aside, normally on a regular
basis. This distinction is important, as investment risk can cause a
capital loss when an investment is sold, unlike saving(s) where the
more limited risk is cash devaluing due to inflation.

In finance, valuation is the process of estimating the potential market

value of a financial asset or liability. Valuations can be done on assets
(for example, investments in marketable securities such as stocks,
options, business enterprises, or intangible assets such as patents
and trademarks) or on liabilities (e.g., Bonds issued by a company).
Valuations are required in many contexts including investment
analysis, capital budgeting, merger and acquisition transactions,
financial reporting, taxable events to determine the proper tax liability,
and in litigation.

Valuation of financial assets is done using one or more of these types

of models:

1. Discounted Cash Flows determine the value by estimating the

expected future earnings from owning the asset discounted to
their present value.
2. Relative value models determine the value based on the market
prices of similar assets.
3. Option pricing models are used for certain types of financial
assets (e.g., warrants, put options, call options, employee stock
options, investments with embedded options such as a callable
bond) and are a complex present value model. The most
common option pricing models are the Black-Scholes-Merton
models and lattice models.

Common terms for the value of an asset or liability are fair market
value, fair value, and intrinsic value. The meanings of these terms
differ. The most common sets market price. For instance, when an
analyst believes a stock's intrinsic value is greater than its market
price, the analyst makes a "buy" recommendation and vice versa.
Moreover, an asset's intrinsic value may be subject to personal
opinion and vary among analysts.

Business valuation

Businesses or fractional interests in businesses may be valued for

various purposes such as mergers and acquisitions, sale of
securities, and taxable events. An accurate valuation of privately
owned companies largely depends on the reliability of the firm's
historic financial information. Public company financial statements
are audited by Certified Public Accountants (US), Chartered Certified
Accountants (ACCA) or Chartered Accountants (UK and Canada) and
overseen by a government regulator. Alternatively, private firms do
not have government oversight—unless operating in a regulated
industry—and are usually not required to have their financial
statements audited. Moreover, managers of private firms often
prepare their financial statements to minimize profits and, therefore,
taxes. Alternatively, managers of public firms tend to want higher
profits to increase their stock price. Therefore, a firm's historic
financial information may not be accurate and can lead to over- and
undervaluation. In an acquisition, a buyer often performs due
diligence to verify the seller's information.

Financial statements prepared in accordance with generally accepted

accounting principles (GAAP) often show the values of assets at their
historic costs rather than at their current market values. For instance,
a firm's balance sheet will usually show the value of land it owns at
what the firm paid for it rather than at its current market value. But
under GAAP requirements, a firm must show the values of some
types of assets—securities held for sale, for instance—at their market
values rather than at cost. When a firm is required to show some of its
assets at market value, some call this process "mark-to-market." But
reporting asset values on financial statements at market values gives
managers ample opportunity to slant asset values upward—to
artificially increase profits and stock prices. Managers may be
motivated to alter earnings upward so they can earn bonuses. Despite
the risk of manager bias, investors and creditors prefer to know the
market values of a firm's assets—rather than their costs—because the
current values give them better information to make decisions.

Discounted cash flows method

This method estimates the value of an asset based on its expected

future cash flows, which are discounted to the present (i.e., the
present value). This concept of discounting future monies is
commonly known as the time value of money. For instance, an asset
that matures and pays $1 in one year is worth less than $1 today. The
size of the discount is based on an opportunity cost of capital and it
is expressed as a percentage. Some people call this percentage a
discount rate.
The idea of opportunity cost can be illustrated in an example. A
person with only $100 to invest can make just one $100 investment
even when presented with two or more investment choices. If this
person is later offered an alternative investment choice, the investor
has lost the opportunity to make that second investment since the
$100 is spent to buy the first opportunity. This example illustrates that
money is limited and people make choices in how to spend it. By
making a choice, they give up other opportunities.

In finance theory, the amount of the opportunity cost is based on a

relation between the risk and return of some sort of investment.
Classic economic theory maintains that people are rational and
averse to risk. They, therefore, need an incentive to accept risk. The
incentive in finance comes in the form of higher expected returns
after buying a risky asset. In other words, the more risky the
investment, the more return investors want from that investment.
Using the same example as above, assume the first investment
opportunity is a government bond that will pay interest of 5% per year
and the principal and interest payments are guaranteed by the
government. Alternatively, the second investment opportunity is a
bond issued by small company and that bond also pays annual
interest of 5%. If given a choice between the two bonds, virtually all
investors would buy the government bond rather than the small-firm
bond because the first is less risky while paying the same interest
rate as the riskier second bond. In this case, an investor has no
incentive to buy the riskier second bond. Furthermore, in order to
attract capital from investors, the small firm issuing the second bond
must pay an interest rate higher than 5% that the government bond
pays. Otherwise, no investor is likely to buy that bond and, therefore,
the firm will be unable to raise capital. But by offering to pay an
interest rate more than 5% the firm gives investors an incentive to buy
a riskier bond.

For a valuation using the discounted cash flow method, one first
estimates the future cash flows from the investment and then
estimates a reasonable discount rate after considering the riskiness
of those cash flows and interest rates in the capital markets. Next,
one makes a calculation to compute the present value of the future
cash flows.
Guideline companies method

This method determines the value of a firm by observing the prices of

similar companies (guideline companies) that sold in the market.
Those sales could be shares of stock or sales of entire firms. The
observed prices serve as valuation benchmarks. From the prices, one
calculates price multiples such as the price-to-earnings or price-to-
book value ratios. Next, one or more price multiples are used to value
the firm. For example, the average price-to-earnings multiple of the
guideline companies is applied to the subject firm's earnings to
estimate its value.

Many price multiples can be calculated. Most are based on a financial

statement element such as a firm's earnings (price-to-earnings) or
book value (price-to-book value) but multiples can be based on other
factors such as price-per-subscriber.
Answer5:

WORKING CAPITAL

Working capital is the life blood and nerve centre of a business. Just
as circulation of blood is essential in the human body for maintaining
life, working capital is very essential to maintain the smooth running
of a business. No business can run successfully with out an adequate
amount of working capital.

Working capital refers to that part of firm’s capital which is required

for financing short term or current assets such as cash, marketable
securities, debtors, and inventories. In other words working capital is
the amount of funds necessary to cover the cost of operating the
enterprise.

Meaning:

Working capital means the funds (i.e.; capital) available and used for
day to day operations (i.e.; working) of an enterprise. It consists
broadly of that portion of assets of a business which are used in or
related to its current operations. It refers to funds which are used
during an accounting period to generate a current income of a type
which is consistent with major purpose of a firm existence.

Decisions relating to working capital and short term financing are

referred to as working capital management. These involve managing
the relationship between a firm's short-term assets and its short-term
liabilities. The goal of working capital management is to ensure that
the firm is able to continue its operations and that it has sufficient
cash flow to satisfy both maturing short-term debt and upcoming
operational expenses.

Decision criteria

By definition, working capital management entails short term

decisions - generally, relating to the next one year period - which are
"reversible". These decisions are therefore not taken on the same
basis as Capital Investment Decisions (NPV or related, as above)
rather they will be based on cash flows and / or profitability.

• One measure of cash flow is provided by the cash conversion

cycle - the net number of days from the outlay of cash for raw
material to receiving payment from the customer. As a
management tool, this metric makes explicit the inter-
relatedness of decisions relating to inventories, accounts
receivable and payable, and cash. Because this number
effectively corresponds to the time that the firm's cash is tied up
in operations and unavailable for other activities, management
generally aims at a low net count.

• In this context, the most useful measure of profitability is Return

on capital (ROC). The result is shown as a percentage,
determined by dividing relevant income for the 12 months by
capital employed; Return on equity (ROE) shows this result for
the firm's shareholders. Firm value is enhanced when, and if, the
return on capital, which results from working capital
management, exceeds the cost of capital, which results from
capital investment decisions as above. ROC measures are
therefore useful as a management tool, in that they link short-
term policy with long-term decision making. See Economic value
added (EVA).

Management of working capital

Guided by the above criteria, management will use a combination of

policies and techniques for the management of working capital. These
policies aim at managing the current assets (generally cash and cash
equivalents, inventories and debtors) and the short term financing,
such that cash flows and returns are acceptable.

• Cash management. Identify the cash balance which allows for

the business to meet day to day expenses, but reduces cash
holding costs.

• Inventory management. Identify the level of inventory which

allows for uninterrupted production but reduces the investment
 in raw materials - and minimizes reordering costs - and hence
increases cash flow. Besides this, the lead times in production
should be lowered to reduce Work in Progress (WIP) and
similarly, the Finished Goods should be kept on as low level as
possible to avoid over production - see Supply chain
management; Just In Time (JIT); Economic order quantity
(EOQ); Economic production quantity

• Debtors management. Identify the appropriate credit policy, i.e.

credit terms which will attract customers, such that any impact
on cash flows and the cash conversion cycle will be offset by
increased revenue and hence Return on Capital (or vice versa);
see Discounts and allowances.

• Short term financing. Identify the appropriate source of

financing, given the cash conversion cycle: the inventory is
ideally financed by credit granted by the supplier; however, it
may be necessary to utilize a bank loan (or overdraft), or to
"convert debtors to cash" through "factoring".

Working capital management is a significant fact of financial

management due to the fact that it plays a pivotal role in keeping
wheels of business enterprise running. Shortage of funds for working
capital has caused many businesses to fail and in many cases, has
recorded poor growth. Lack of efficient and effective utilization of
working capital leads to earn low rate of return on capital employed or
even compels to sustain losses. Working capital is the flow of ready
funds necessary working of the enterprise. It consists of funds
invested in current assets or those assets which in the ordinary
course of business can be turned into cash within a brief period
without undergoing diminution in value and without disruption of the
organization.
Answer6:

LEVERAGE

In finance, leverage is a general term for any technique to multiply

gains and losses. Common ways to attain leverage are borrowing
money, buying fixed assets and using derivatives. Important
examples are:

• A public corporation may leverage its equity by borrowing

money. The more it borrows, the less equity capital it needs, so
any profits or losses are shared among a smaller base and are
proportionately larger as a result.
• A business entity can leverage its revenue by buying fixed
assets. This will increase the proportion of fixed, as opposed to
variable, costs, meaning that a change in revenue will result in a
larger change in operating income.
• Hedge funds often leverage their assets by using derivatives. A
fund might get any gains or losses on $20 million worth of crude
oil by posting $1 million of cash as margin

A good deal of confusion arises in discussions among people who

use different definitions of leverage. The term is used differently in
investments and corporate finance, and has multiple definitions in
each field.

Investments

Accounting leverage is total assets divided by total assets minus total

liabilities. Notional leverage is total notional amount of assets plus
total notional amount of liabilities divided by equity. Economic
leverage is volatility of equity divided by volatility of an unlevered
investment in the same assets. To understand the differences,
consider the following positions, all funded with $100 of cash equity.

• Buy $100 of crude oil. Assets are $100 ($100 of oil), there are no
liabilities. Accounting leverage is 1 to 1. Notional amount is $100
($100 of oil), there are no liabilities and there is $100 of equity.
Notional leverage is 1/2 to 2/1. The volatility of the equity is
 equal to the volatility of oil, since oil is the only asset and you
own the same amount as your equity, so economic leverage is 1
to 1.
• Borrow $100 and buy $200 of crude oil. Assets are $200,
liabilities are $100 so accounting leverage is 2 to 1. Notional
amount is $200, equity is $100 so notional leverage is 2 to 1. The
volatility of the position is twice the volatility of an unlevered
position in the same assets, so economic leverage is 2 to 1.
• Buy $100 of crude oil, borrow $1000 worth of gasoline and sell
the gasoline for $100. You now have $100 cash, $100 of crude oil
and owe $100 worth of gasoline. Your assets are $200, liabilities
are $100 so accounting leverage is 2 to 1. You have $200
notional amount of assets plus $100 notional amount of
liabilities, with $100 of equity, so your notional leverage is 3 to 1.
The volatility of your position might be half the volatility of an
unlevered investment in the same assets, since the price of oil
and the price of gasoline are positively correlated, so your
economic leverage might be 1.5 to 1.
• Buy $100 of a 10-year fixed-rate treasury bond, and enter into a
fixed-for-floating 10-year interest rate swap to convert the
payments to floating rate. The derivative is off-balance sheet, so
it is ignored for accounting leverage. Accounting leverage is
therefore 1 to 1. The notional amount of the swap does count for
notional leverage, so notional leverage is 2 to 1. The swap
removes most of the economic risk of the treasury bond, so
economic leverage is near zero.

Corporate finance

Accounting leverage has the same definition as in investments. There

are several ways to define operating leverage, the most common.is:

Financial leverage is usually defined as:

Operating leverage is an attempt to estimate the percentage change in
operating income (earnings before interest and taxes or EBIT) for a
one percent change in revenue.

Financial leverage tries to estimate the percentage change in net

income for a one percent change in operating income.

The product of the two is called Total leverage,and estimates the

percentage change in net income for a one percent change in
revenue.

There are several variants of each of these definitions,and the

financial statements are usually adjusted before the values are
computed. Moreover, there are industry-specific conventions that
differ somewhat from the treatment above.

Leverage in business is derived from the word ‘lever’. A lever is a

simple tool by which a large weight can be moved with a small force.

The study of Leverage starts with our understanding of break-even or

the point at which a firm covers both fixed and variable costs.

OPERATING LEVERAGE

Operating leverage is a measure of the extent to which, fixed operating

costs are being used in an organization.

It is greatest (largest) in companies that have a high proportion of fixed

operating costs in relation (proportion) to variable operating costs. This
type of company is using more fixed assets in the operation of the
company.

Conversely, operating leverage is lowest in companies that have a low

proportion of fixed operating costs in relation to variable operating
costs.

Firms with large amounts of fixed operating costs have high break-even
points and high operating leverage. Variable cost in these firms tends
to be low and both the contribution (CM) and unit contribution (UC)
margin is high.

Formula(s) for calculating Operating leverage :

Percent Change in Operating Income

Degree of Operating Leverage = Percent Change in Sales

or

Contributi on Margin
Degree of Operating Leverage = Earnings Before Interest and Taxes

or

Degree of Operating Leverage =

Total Sales −Total Variable Cost

Total Sales − Total Variable Cost − Total Operating Fixed Cost
or

Degree of Operating Leverage =

Q ua w at Ohn ipt ci eth yr a t i n g

L e i cvs oe mr ax p g ( uPe t r e ui d−cVn e i a ct roP iu sae) nt br i lt p e e r
 Q ua w at Ohn ipt ci eth yr a t i n g 
 L e i Cvs e o r max (Pgp peru u ei t− cVnre eida t c rp oui e a)sn− r Obt i tl peF e Ci r x ao e st d i t ns g
 
Implications:

1. A firm with a high break-even point is more risky than one with a
low
Break-even point. In periods of increasing sales, operating income
(OI or

EBIT) of the leveraged firm tends to increase rapidly. This

increase in

OI (EBIT) is the ‘pay-off’ for being more risky. But in periods of

decreasing sales, operating income of the firm tends to decrease

rapidly, that is the risk.

2. Firms with small amounts of fixed operating costs have low break-
even
points and are therefore less risky and have low operating
leverage. Variable costs in these firms tend to be high and both
the CM and UC is

low. In periods of increasing sales, Operating income (EBIT) for

these

firms tends to increase slowly. But in periods of decreasing sales,

Operating income will tend to decrease slowly making the firm

less risky.

3. In conclusion, if a company has high operating leverage, then the

operating income (OI or EBIT) will become very sensitive to
changes in

sales volume. Just a small percentage (%) chance in sales can

yield

(produce) a large percentage change in Operating Income. A

Company

with low operating leverage the reverse is true.

FINANCIAL LEVERAGE

Financial leverage is the extent to which debt (liability) is used in the

Capital Structure (financing) of the firm. Capital Structure refers to the
relationship between assets, debt (liability) and equity. The more debt a
firm has relative to equity the greater the financial leverage (these firms
have a higher Debt to Asset ratios).
Substantial use of debt will place a great burden on the firm at low
levels of profitability (low EBIT, since interest must be paid). However,
it will also help to magnify (enlarge) increases in earning per share
(EPS) as the EBIT or operating income increases.

Percent Change in Earnings Per Share

Degree of Financial Leverage = Percent Change in Operating Income

or

Earnings Before Interest and Taxes

Degree of Financial Leverage = Earnings Before Interest and Taxes − Interest

Implications

1. Financial leverage can be very useful to a firm if properly used

under the
right conditions. For firms in industries that have a degree of
stability

and/or show growth, the use of debt is recommended because of

the

positive aspects of financial leverage.

BUT...

2. As a firm increases the use of debt in its capital structure,

creditors
(lenders) will perceive a greater financial risk in lending money to
the
 firm and therefore may charge a higher interest rate which may
lower

earning before tax (EBT). These lenders will perhaps place other

restrictions on the firm. Stockholders may become concerned

with the

risk to EPS and sell the stock (which will force the market price
down).

3. In conclusion, Financial leverage is a very useful tool if used

correctly
and under the right conditions. At times, the value of the firm is

enhanced by financial leverage.