Page 172 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 7: Concept of Leverages

Significance of Combined Leverage Notes

A high operating leverage and a high financial leverage combination is very risky. If the company
is producing and selling at a high level it will make extremely high profit for its shareholders.
But, even a small fall in the level of operations would result in tremendous fall in earnings per
share. A company must, therefore, maintain a proper balance between these two leverages.
A combination of high operating level and a low financial leverage indicates that the management
is careful since the higher amount of risk involved in high operating leverage has been sought
to be balanced by low financial leverage. However, a more preferable option would be to have
a low operating leverage and a high financial leverage. A low operating leverage implies that
the company reaches its break-even point at a low level of sales. Therefore, risk is diminished.
A highly cautious and conservative manager will keep both its operating and financial leverage
at a very low level, but the approach may, however, mean that the company is losing profitable
opportunities.

Example: Cable Company, a computer cable manufacturer expects sales of 20,000 units
@ 50 per unit in the coming year and must meet the following obligations: Variable operating
costs of 20 per unit, fixed operating costs of 100,000, interest of 200,000 as preferred stock
dividends of 120,000. The firm is in the 40% tax bracket and has 50,000 of equity shares
outstanding. If we present the levels of earnings per share associated with the expected sales of
20,000 units as with sales of 30,000 units, it will look as below:

= 50% [% increase in sales (units)]
Sales in units 20,000 30,000 Operating leverage
Sales revenue 10,00,000 15,00,000 + 60%

+ 50%
Less variable operating costs 400,000 600,000
= 1.2
Less fixed operating costs 100,000 100,000
Earnings before interest & taxes EBIT 500,000 800,000
+ 60% [% increase in EBIT]
Less interest 200,000 200,000
Net profit before taxes 300,000 600,000
Less taxes 40% 120,000 240,000
Net profit after tax 180,000 360,000
Less pref. stock dividends 120,000 120,000 Financial leverage
Earnings available for equity shares 60,000 240,000 + 300%
 = 5.0
+ 60%
No. of shares 50,000 50,000
Earnings per share 1.20 4.80
+ 300% [% increase in EPS] Combined leverage
+ 300%
 = 6.0
50%

The table illustrates that as a result of 50% increase in sales (from 20,000 to 30,000 units), the firm
would have a 300% increase in earnings per share (from 1.20 to 4.80). Similarly, a 50%
decrease in sales would conversely, result in a 300% decrease in earnings per share (not shown
in the table). The linear nature of the leverage relationship accounts for the fact that sales charges
of equal magnitude in opposite directions results in EPS charges of equal magnitude in the

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