Question 3 (b)
Leverage: meaning and types, with an example
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 3 (b) · 7 marksDefine Leverage. What different types of leverage are there? Explain them with example. 7
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Define…What…?Explain…3 asks, each with its own marks below. Answer all 3.
- with exampleExamples are asked for: one short example with each point.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of leverage 1 mark 1 min
- 2 Operating, financial and combined leverage 4 marks 7 min
- 3 Example 2 marks 4 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning of leverage (step 1, 1 mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.
Short on time? Keep step 1 short. Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 14 minutes for 7 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Meaning. Leverage is the responsiveness of one financial variable to another: the percentage change in one variable divided by the percentage change in another. It arises from fixed costs, operating or financial, which magnify the effect of a change in sales on EBIT and of a change in EBIT on EPS.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
- Operating leverage (OL): the relationship between sales and EBIT, caused by fixed operating costs. DOL = % change in EBIT ÷ % change in sales = contribution ÷ EBIT. The higher the fixed costs relative to variable costs, the greater the DOL; with no fixed costs there is no operating leverage. It measures business risk.
- Financial leverage (FL): the relationship between EBIT and EPS, caused by fixed financial charges (interest, preference dividend). DFL = % change in EPS ÷ % change in EBIT = EBIT ÷ EBT when there is no preference dividend; with a preference dividend Dp, DFL = EBIT ÷ [(EBIT − interest) − Dp ÷ (1 − t)]. It measures financial risk: favourable when the return on assets exceeds the cost of debt (trading on equity).
- Combined leverage (CL): the product of the two, the % change in EPS for a 1% change in sales: DCL = DOL × DFL = contribution ÷ EBT (again with no preference dividend).
Example. Sales ₹10,00,000; variable cost ₹6,00,000; fixed cost ₹2,00,000; interest ₹50,000.
| Particulars | ₹ |
|---|---|
| Sales | 10,00,000 |
| Less: variable cost | 6,00,000 |
| Contribution | 4,00,000 |
| Less: fixed cost | 2,00,000 |
| EBIT | 2,00,000 |
| Less: interest | 50,000 |
| EBT | 1,50,000 |
DOL = 4,00,000 ÷ 2,00,000 = 2; DFL = 2,00,000 ÷ 1,50,000 = 1.33; DCL = 2 × 1.33 = 2.67. A 10% rise in sales raises EBIT by 20% and EPS by 26.7%; a 10% fall cuts them by the same percentages. High operating and high financial leverage together are risky; a firm usually balances one against the other.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of leverage | 1 |
| 2 | Operating, financial and combined leverage | 4 |
| 3 | Example | 2 |
| Total | 7 |
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