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Category: Business and Industry
Date Submitted: 08/20/2011 10:54 PM
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...