Question 3 (c)
Financial leverage in choosing financing plans; operating versus financial leverage
9 marks
- Time to write
- About 18 minutes
Question
Question 3 (c) · 9 marksWhy must the finance manager bear in mind the degree of financial leverage when evaluating various financing plans? At what point does financial leverage become favourable? Explain the purpose of measuring the operating leverage is different from that of measuring financial leverage.
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
- Why…?What…?Explain…3 asks, each with its own marks below. Answer all 3. Where it asks why, give reasons, not a description.
What the paper leaves open
The last sentence is printed without a word such as "how". It is read as asking how the purpose of measuring operating leverage differs from that of measuring financial leverage.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Why DFL matters in evaluating financing plans 3 marks 5 min
- 2 When financial leverage is favourable 3 marks 5 min
- 3 Difference in purpose of operating and financial leverage 3 marks 5 min
- Check: every ask answered, key terms underlined 2 min
Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 18 minutes for 9 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.
Why the degree of financial leverage matters. Financial leverage is the use of fixed-charge funds (debt, preference shares) in the capital structure. It magnifies the effect of any change in EBIT on EPS: the higher the leverage, the larger the rise in EPS when EBIT rises and the larger the fall when EBIT falls. For example, with a DFL of 2, a 5% rise or fall in EBIT moves EPS by 10% either way. The degree of financial leverage (DFL = % change in EPS ÷ % change in EBIT) measures this magnification. Financial leverage, the link between EBIT and EPS, indicates the financial risk each plan carries. When comparing financing plans the finance manager must therefore weigh the higher EPS a levered plan may give against the greater variability of EPS and the risk of being unable to meet fixed charges if EBIT falls.
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.
When financial leverage is favourable. Financial leverage helps EPS only when the return on investment is above the cost of debt and hurts it when the return is below; this is why it is called a "twin-edged" (double-edged) sword:
- Favourable when the return on investment exceeds the cost of the fixed-charge funds (ROI > cost of debt): the fixed-charge funds earn more than they cost, so EPS rises.
- Unfavourable when ROI is below the cost of debt: EPS falls.
- Neutral at the point where ROI equals the cost of debt, which is therefore the point beyond which financial leverage becomes favourable.
How the purposes of measuring operating and financial leverage differ
Operating leverage relates sales to EBIT and indicates business risk; financial leverage relates EBIT to EPS and indicates financial risk. Each degree is the % change in one figure for a 1% change in the other, and DOL depends on fixed cost while DFL depends on interest and preference dividend.
| Operating leverage (DOL) | Financial leverage (DFL) | |
|---|---|---|
| Measures | % change in EBIT from a 1% change in sales | % change in EPS from a 1% change in EBIT |
| Risk shown | Business (operating) risk | Financial risk |
| Arises from | Fixed operating costs (cost structure) | Interest and preference dividend (capital structure) |
| Decision it guides | Choice of cost structure and production methods | Choice of debt-equity mix in financing |
Together they give the combined leverage (DOL × DFL), the effect of a change in sales on EPS, i.e. the firm's total risk.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Why DFL matters in evaluating financing plans | 3 |
| 2 | When financial leverage is favourable | 3 |
| 3 | Difference in purpose of operating and financial leverage | 3 |
| Total | 9 |
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