BALANCING FINANCIAL AND OPERATING LEVERAGES

To understand the need for optimum mix of own money & loan money.

The capital structure of a company consists of equity and debt. The use of debt is called
financial leverage or gearing. Debt is raised on the basis of equity funds supplied by owners.
Therefore, financial leverage is also called trading on equity. The basic purpose in using debt is to increase the return of owners (shareholders) of a co. by employing the debt to earn more than its cost. For example, you have an opportunity of earning 15 % return on an investment of Rs. 1000 for one year. If you put your own money, you would earn 15 % . Suppose you are able to borrow Rs. 500 at 10% interest from your friend, and then you invest Rs. 500 of borrowed funds and Rs. 500 of your own. Your return would be Rs.
15, out of which you will have to pay Rs 5 to your friend as interest. On your investment of Rs. 500, you could earn Rs. 10, which is 20%. It is 5% more than what you would have earned if you had put entirely your own money. (Remember you still have Rs.500 to invest elsewhere) .How did your rate of return increase? You earned 15% on your friend’s money, but paid him only 10%. The difference of 5% accrued to you without your having put your money. This analysis may be applied to a co. also. The co.’s borrowings can be evaluated in terms of its impact on shareholders’ return. Shareholders’ return can be expressed in various ways. One most popular measure is earnings per share (EPS). You obtain EPS when a co.’s profit after tax is divided by the number of common shares outstanding:

EPS= PROFIT AFTER TAX/ No. of shares

=PAT/N Alternatively, EPS can be calculated by using the following formula:
EPS= (PBIT-INT) (1-T)/ N where PBIT is profit before interest and tax, INT interest on debt, T tax
rate and N the no. of outstanding shares. We can also deduce that (PBIT-INT) (1-T) =PAT (profit
after tax)

White Cement Company ( WCC ) Basic Data
A new company, WCC, is being incorporated by a business house from North India. An
investment of Rs. 10 crores is contemplated. Two alternate ways of financing the investment
are under consideration:

1. To raise Rs. 10 crores equity capital by issuing one cr. shares at par value of Rs. 10 per share or
2. To raise Rs. 5 crore equity capital by issuing 50 lakh shares at a par value of Rs. 10 per share & borrowing Rs. 5 crs at an annual rate of interest of 14% from a financial institution. It is expected that the investment will yield a before tax return of 25% per year. The corporate tax rate is 50%. The projected P&L A/c for the 1st year is as under:

White Cement Company: Projected Profit & loss Statement
Rs. Crs.
Sales 25.00
Less: Variable costs 8.70
contribution 16.30
Less: fixed costs 13.80
Profit before interest & tax ( PBIT ) 2.50
Less: tax @ 50% 1.25
Profit after tax ( PAT ) 1.25

Questions
1. Should WCC employ debt or not? You have to examine the effect of debt on EPS.
2. If debt causes EPS to increase, why should WCC not employ more debt?
3. If PBIT increases and decreases by 20%, what will be the effect on EPS under Alternative
Financial Plans?
4. For WCC what is the Degree of Financial Leverage?
5. For WCC what is the Degree of Operating Leverage if we assume that sales are 10%
higher or 10% lower than the projected sales of 25 crs.