Home » **OPERATING FINANCIAL AND COMBINED LEVERAGE**

COMBINED LEVERAGE:TOTAL RISK
The operating leverage has its effects on operating risk and is measured by the percentage change in EBIT due to percentage change in sales. The financial leverage has its effects on financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Since both these leverages are closely concerned with ascertaining the ability to cover fixed charges (fix

Measures of Financial Leverages
Financial leverage measures the degree of the use of debt and other fixed-cost sources of fund to finance the assets the firm has acquired. As shown above, the use of debt has a magnifying effect on the earnings per share. It can be said that the higher the proportion of debt in the capital structure, the higher is the financial leverage and vice-versa. Broadly speaking, financial

For a New Company
The indifference point can be determined by using the following equations:
For on Existing Company
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Algebraic Approach
Mathematically, the indifference point can be obtained by using the following
symbols:
X = earnings before interest and taxes (EBIT) at the indifference point.
N1 = number of equity shares outstanding if only equity shares are issued.
N2 = number of equity shares outstanding if both debentures and equity shares are issued.
N3 = number of equity shares outstanding if both preference and equity s

Indifference Point
The EBI’T level at which the EPS is the same for two alternative financial plans is referred to as the indifference point/level. The indifference point may be defined as the level of EBIT beyond which the benefits of financial begin to operate respect to earning share. In operational terms, if the expected level is to exceed the indifference level of EBIT, the use of fixed-charge sou

EBIT-EPS Analysis
The EBIT-EPS analysis, as a method to study the effect of leverage, essentially involves the comparison of alternative methods of financing under various assumptions of EBIT. A firm has the choice to raise funds for financing its investment proposals from different sources in different proportions. For instance, it can (i) exclusively use equity capital (ii) exclusively use debt, (iii) exclusi

EPS at Various EBIT Levels
TABLE
Alternative Definition of Financial Leverage
Thus, the quotient is 1. Its implication is that 1 per cent change in EBIT will result in 1 per cent change in EPS, that is, proportionate. There is, therefore, no magnification in the EPS.
Like operating leverage, higher levels of risks are attached to higher degrees of financial leverage also. High fixed financial costs increase the

Alternative Definition of Financial Leverage
The procedure outlined above is merely indicative of the presence or absence of financial leverage. Financial leverage can be more precisely expressed in terms of the degree of financial leverage (DFL). The DFL can be calculated by Eq. (14.3)
As a rule, when a percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage ch

EPS for Various EBIT Levels
TABLE
FINANCIAL LEVERAGE
Case 1: A 40 per cent increase in EBIT (from Rs 10,000 to Rs 14,000) results in 81.25 per cent increase in EPS (from Rs 3.2 to Rs 5.8).
Case 2: A 40 per cent decrease in EBIT(from Rs 10,000 to Rs 6.000) leads to 81.25 per cent decrease in EPS (from Rs 3.2 to Re 0.6).
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FINANCIAL LEVERAGE
As already indicated, financial leverage relates to the financing activities of a firm. The sources from which funds can be raised by a firm, from the point of view of the cost/charges, can categorized into (i) those which carry a fixed financial charge, and (ii) those which do not involve any fixed charge. The sources of funds in the first category consist of various types of long term debt,