Paf-Finance

Financial Leverage & Project Appraisal

LEVERAGE

The various means of financing represent the financial structure of an organization. This is a significant decision as it influences the shareholder’s risk & return & therefore the cost of capital also.

Leverage is a general term for any technique to multiply gains and losses. 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.

* 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.

Measures of Leverage

1. Operating Leverage:

Operating leverage measures a firm's fixed versus variable costs. The greater proportion of fixed costs, the greater the operating leverage.

Degree of OL = (%Change in EBIT)/(%Change in Qty Sold)

2. Financial Leverage:

Financial Leverage is also known as Financial Gearing. It measures to the mix of debt & equity in the capital structure of a company.

DFL = (% Change in EPS)/ (% Change in EBIT)

*Vertical Axis Showing EPS & Horizontal EBIT

Example

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EBIT                                                        $ 6,000       $ 10,000  $ 14,000

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Less interest on bonds                               $2,000        $ 2,000        $ 2,000

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Earnings before taxes (EBT)                      $ 4,000       $ 8,000        $ 12,000

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Less taxes (35%)                                        $ 1,400       $ 2,800        $ 4,200

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Earning after taxes...