Finance & Investment

Decisions
FINANCIAL MANAGEMENT
MODULE 3
 LEVERAGE
The term leverage is derived from the French word ‘lever’ which means ‘to raise’ or ‘to enhance’.

• The object of application of which is made to gain higher financial benefits compared to the fixed charges
payable, as it happens in physics i.e., gaining larger benefits by using lesser amount of force.

• Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset
base and generate returns on risk capital.

• Leverage is an investment strategy of using borrowed money—specifically, the use of various financial
instruments or borrowed capital—to increase the potential return of an investment.

• Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company,
property or investment as "highly leveraged," it means that item has more debt than equity
Definitions of Leverage:

• According to Ezra Solomon: “Leverage is the ratio of net returns on shareholders equity and the
net rate of return on capitalisation”.

• According to J. C. Van Home: “Leverage is the employment of an asset or funds for which the
firm pays a fixed cost of fixed return.”
Types of Leverage:
Leverage are the three types:

(i) Operating leverage

(ii) Financial leverage

(iii) Combined leverage

 1. Operating Leverage
Operating leverage refers to the use of fixed operating costs such as depreciation, insurance of assets, repairs and
maintenance, property taxes etc. in the operations of a firm. But it does not include interest on debt capital.

Higher the proportion of fixed operating cost as compared to variable cost, higher is the operating leverage, and
vice versa.

Degree of Operating Leverage: The earnings before interest and taxes (i.e., EBIT) changes with increase or
decrease in the sales volume.

Operating leverage is used to measure the effect of variation in sales volume on the level of EBIT.
The formula used to compute operating leverage is
 Importance of Operating Leverage
1. It gives an idea about the impact of changes in sales on the operating income of the firm.
2. High degree of operating leverage magnifies the effect on EBIT for a small change in the sales volume.
3. High degree of operating leverage indicates increase in operating profit or EBIT.
4. High operating leverage results from the existence of a higher amount of fixed costs in the total cost structure
of a firm which makes the margin of safety low.
5. High operating leverage indicates higher amount of sales required to reach break-even point.
6. Higher fixed operating cost in the total cost structure of a firm promotes higher operating leverage and its
operating risk.
7. A lower operating leverage gives enough cushion to the firm by providing a high margin of safety against
variation in sales.
 2.Financial Leverage
Financial leverage is primarily concerned with the financial activities which involve raising of funds from the sources for
which a firm has to bear fixed charges such as interest expenses, loan fees etc.
These sources include long-term debt (i.e., debentures, bonds etc.) and preference share capital.
Degree of Financing Leverage: Financing leverage is a measure of changes in operating profit or EBIT on the levels of
earning per share.
It is computed as:
Financial leverage = Percentage change in EPS / Percentage change in EBIT = Increase in EPS / EPS / Increase in
EBIT/EBIT
The financial leverage at any level of EBIT is called its degree. It is computed as ratio of EBIT to the profit before tax
(EBT).
Degree of Financial leverage (DFL) = EBIT / EBT
The value of degree of financial leverage must be greater than 1. If the value of degree of financial leverage is 1, then
there will be no financial leverage
 The importance of financial leverage
1.It helps the financial manager to design an optimum capital structure. The optimum capital structure implies
that combination of debt and equity at which overall cost of capital is minimum and value of the firm is
maximum.

2. It increases earning per share (EPS) as well as financial risk.

3. A high financial leverage indicates existence of high financial fixed costs and high financial risk.
4. It helps to bring balance between financial risk and return in the capital structure.

5. It shows the excess on return on investment over the fixed cost on the use of the funds.
6. It is an important tool in the hands of the finance manager while determining the amount of debt in the capital
structure of the firm.
 Difference between Operating Leverage and
Financial Leverage
• Operating leverage is related to the firm’s operating cost structure while Financial leverage is related to
the firm’s capital structure.
• Operating Leverage is helpful in measuring the business risk of the firm while Financial Leverage is
helpful in measuring the financial risk of the firm.
• Operating Leverage is determined by the relationship between Sales revenue and EBIT (Operating
Income) of the firm while Financial Leverage is determined by the relationship between EBIT (Operating
Income) and EPS (Earning Per Share) of the firm.
• Higher Degree of Operating Leverage (DOL) shows the higher degree of Business risk to the firm while
Higher Degree of Financial Leverage (DFL) shows the higher degree of Financial risk of the firm.
 3. Combined Leverage
Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to
percentage change in sales.
The financial leverage shows the financial risk and is measured by the percentage change in EPS due to
percentage change in EBIT.
The combined leverage can be measured with the help of the following formula:
Combined Leverage = Operating leverage x Financial leverage
If a firm has both the leverages at a high level, it will be very risky proposition. Therefore, if a
firm has a high degree of operating leverage the financial leverage should be kept low as proper
balancing between the two leverages is essential in order to keep the risk profile within a
reasonable limit and maximum return to shareholders
 Importance of Combined Leverage
1. It indicates the effect that changes in sales will have on EPS.
2. It shows the combined effect of operating leverage and financial leverage.
3. A combination of high operating leverage and a high financial leverage is very risky situation because the
combined effect of the two leverages is a multiple of these two leverages.
4. A combination of high operating leverage and a low financial leverage indicates that the management should be
careful as the high risk involved in the former is balanced by the later.
5. A combination of low operating leverage and a high financial leverage gives a better situation for maximizing
return and minimising risk factor, because keeping the operating leverage at low rate full advantage of debt
financing can be taken to maximise return. In this situation the firm reaches its BEP at a low level of sales with
minimum business risk.
6. A combination of low operating leverage and low financial leverage indicates that the firm losses profitable
opportunities.
 Conclusion
• The measurement of leverages is the technique used by the business firms to measure the Risk – Return
relationship of the firm operating and financial activities.
• Leverage is the term which is commonly used to describe the organizations’ ability to utilize the assets
which are having fixed costs (or) different sources of funds to increase the returns to the firm.
• It is important to do timely and accurate leverage analysis for success of a firm.
• The value of degree of financial leverage must be greater than 1. If the value of degree of financial
leverage is 1, then there will be no financial leverage
CAPITAL BUDGETING
“Capital budgeting is the long term investment decision for functioning of acquires, upgrades,
replaces the assets such as land and buildings, plant and machinery and different types of long
term projects.”

“According to Charles T Horngren “Capital budgeting is the long term planning to make and
finance proposed capital analysis.”

“The capital budgeting decisions involve long term planning for selection and also financing the
investment proposals. Capital budgeting is the process of evaluating the relative worth of long
term investment proposals on the basis of their respective profitability.
 NATURE OF CAPITAL BUDGETING
Capital expenditure plans involve a huge investment in fixed assets.
Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved
in future.
The future benefits are expected and rate to be realized over a series of years.
The funds are invested in non-flexible long term funds.
Preparation of capital budget plans involve forecasting of several years profits in advance in order
to judge the profitability of projects.
In view of the investment of large amount for a fairly long period of time, any error in the
evaluation of investment projects, may lead to serious consequences, the problem will be followed a
series of years
SIGNIFICANCE OF CAPITAL BUDGETING
Substantial capital outlays: Capital budgeting decisions involve substantial capital outlays.
Long term implications: Capital budgeting proposals are of longer and hence have long term
implications. For instance the cash flows for next 5 to 15 years have to be forecast.
Strategic in nature: Capital budgeting decisions can affect the future of the company significantly
as it constitutes the strategic determinant for the success of the company. A right investment
decision is the secret of the success of many business enterprises.
Irreversible: Once the funds are committed to a particular project, we cannot take back the
decision. If the decision is to be reversed, we may have to lose a significant portion of the funds
already committed. If many involve loss of time and efforts. In other words, the capital budgeting
decisions are irreversible or may not be easily reversible.
PROCESS OF CAPITAL BUDGETING:
1. Organization of investment proposal: The first step in capital budgeting process is the
conception of a profit making idea. The proposals may come from rank and file worker of any
department or from any line officer. The department head collects all the proposals and reviews
them in the light of financial and risk policies of the organization in or to send them to the
capital expenditure planning committee for consideration.
2. Screening of proposals: In large organizations, a capital expenditure planning committee is
established for the screening of various proposals received by it from the heads of various
departments and the line officers of the company. From the heads of various departments and the
line officers of the company the committee screens the various proposals within the long-range
policy-frame work of the organization. It is to be ascertained by the committee whether the
proposals are within the criterion of the firm, or they do no lead to department imbalances or they
are profitable.
3. Evaluation of projects: The next step in capital budgeting process is to evaluate the different proposals
in term of the cost of capital the expected returns from alternative investment opportunities and the life of
the assets with any of the following evaluation techniques
Degree of urgency method (Accounting rate of return method)
Pay-back method
Discounted cash flow method
4. Establishing priorities: After proper screening of the proposals, uneconomic or unprofitable proposals
are dropped. The profitable projects or in other words accepted projects are then put in priority. It
facilitates their acquisition or construction according to the sources available and avoids unnecessary and
costly delay and serious and cot-overruns.
Generally, priority is fixed in the following order.
Current and incomplete projects are given first priority.
Safety projects and projects necessary to carry on the legislative requirements.
Projects of maintaining the present efficiency of the firm
Projects for supplementing the income
Projects for the expansion of new product.
5. Final approval: proposals finally recommended by the committee are sent to the top
management along with the detailed report, both of the capital expenditure and of the sources of
funds to meet them. The management affirms its final seal to proposals taking in view the
urgency, profitability of the projects and the available financial resources. Project are then sent to
the budget committee for incorporating them in the capital budget.

6. Evaluation: The important step in capital budgeting process is an evaluation of the program
after it has been fully implemented. Budget proposals and the net investment in the projects are
compared periodically and on the basis of such evaluation, the budget figures may be reviewer
and presented in a more realistic way.
Capital Budgeting decisions are used for;
1. Replacement
2. Expansion
3. Diversification
4. Research and development
METHODS OF CAPITAL BUDGETING
1. Traditional methods
a. Payback Period
b. Accounting Rate of Return
2. Discounted cash flow methods or modern methods
a. Internal Rate of Return (IRR)
b. Net Present Value (NPV)
c. Profitability Index (PI)
PAYBACK PERIOD
Payback period is the time period which we require to recover our initial investment.
Payback period refers to the period within which the original cost of the project is recovered. It is
calculated by dividing the cost of the project by the annual cash inflows.
Payback period = cost of the project Annual cash flows
The shorter the length of the payback period, the better is the project in terms of paying back the
original investment particularly where the future is uncertain the companies favour this method
the better it is in terms of safety and liquidity. Where the cash flows are uniform (even)
throughout, then we can measure the payback period like.
Payback period= cost of the project Annual cash flows
Where the cash flows are uneven Payback period = based year + amount to be recouped Next
year cash flows
ADVANTAGES

1) Easy to calculate an understand:- calculation of payback period does not involve any
complicated formulae. It is easy to calculate and understand.

2) Liquidity is emphasized:- it emphasizes on the earlier cash flows which are more likely to be
accurate than later cash flow, in other words a short payback period also reduces the risk.

3) Reliable technique in volatile business conditions:- it is a reliable technique for projects

appraisal, particularly in the areas of volatile business conditions such as change in technology,
changing fashions or customers fasts /preferences.
DISADVANTAGES

1) post-payback earnings ignored:- This method ignores the earnings after the payback period. It
ignores the total life of the project and the total profitability of the investment.

2)Timing of cash flows ignored:- This method does not consider the timing of cash flows, all the
cash flows are given equal weight age.

3) Liquidity is over-emphasized:- The liquidity of the proposal is over-emphasized by choosing

only the cash inflows. Other factors such as cost of the proposal or cost of the proposal are ignore
 ACCOUNTING RATE OF RETURN
Accounting rate of return refers to the ratio of annual profits after taxes to the average investment. The
average investment equal to half of the original investment. According rate of return is also called average
rate of return.
ARR = Average income / Average investment
Where the average investment is half of the outlay. Average capital employed is calculated to the usual
accounting convention that the original investment gets exhausted steadily to zero over the life of the project.
It is assumed that the asset is depreciated as per straight line method usually it is expressed in terms of
percentage.
The higher the ARR is the better is the profitability and hence the projects with higher accounting rate of
return are short listed for implementation
ADVANTAGES

1) It is easy to understand and calculate.

2) It can be compared with the cutoff point of return and hence the decision to accept or reject is
made easier.

3) It considers all the cash inflows during the life of the projects, not like payback method.

4) It is a reliable measure because it considers net earnings after depreciation interest and taxes.
DISADVANTAGES

1. The concept of time value of money is ignored.

2. Unless we have a cutoff point of return, accounting rat of return cannot be meaningful and
effective.

3. The average concept is not reliable particularly in terms of high or wild fluctuations in the
returns.

4. The average concept dilutes the profitability of the project.

DISCOUNTED CASHFLOW METHODS

Discounted cash flows are the future cash inflows reduced to their present value based on a
discounting factor. The process of reducing the future cash inflows to their present value based on
a discounting factor or cut-off return is called discounting.
NET PRESENT VALUE
Net present value refers to the excess of present value of future cash inflows over and above the
cost of original investment.
ACCEPTANCE RULE

According to NPV method the project should be accepted, if the NPV is positive or equal to zero.

If the NPV is negative the project should be rejected.

NPV>1 which means that the project earns more than the discount rate.

NPV =1 which means that the project earns the same as the discount rate.

NPV<1 which means the project earns less than the discount rate
ADVANTAGES
1. since the PV factor tables are available determination of NPV is relatively easier. It is easy to
understand.
2. The goal of the financial management is wealth maximization and this method enables the
finance manager to pursue this goal.
3. It is based on the concept of time value and considers the total earnings and expenses of the
project.
4. NPV is a superior technique to IRR in case of mutually exclusive proposals.
5. Each project can individually be evaluated
DISADVANTAGES

1. It is difficult to determine the appropriate discount rate.

2. The calculations are easier when compared to IRR, but is beyond the comprehension of a
common businessman

3. It does not indicate the cost of capital.

4. Where projects differ in their duration and their cash flows, this method cannot be used
INTERNAL RATE OF RETURN
Internal rate of return is that rate of return at which the present value of expected cash flows of a
project exactly equals the original investment. In other words, it equals the present value of a
given project with its outlay.

This is the cut –off point at which the income equals the expenditure or the investment breaks
even. At IRR, the net present value of a project is zero.

The net present value refers to the excess of the present value of the future cash flows over and
above the original investment.
EVALUATON OF IRR

The internal rate of return is compared with the cost of the capital.

If the IRR is more than the cost of the capital the project is profitable otherwise it is not where
there are two projects with different IRR‟S select the project with higher IRR.
ADVANTAGES

1. IRR is based on the time value of money.

2. It is based on the earnings of all the years of the project.

3. It is a valuable tool to compare the projects with different cash flows and different life span.

4. It is independent of cost of capital.

5. Such projects with higher IRR are recommended. Hence it directly contributes to the “wealth
maximization goal” of the finance manage
DISADVANTAGES

1. It is difficult to understand and tedious to calculate IRR by even trial and error.

2. It is based on certain assumptions one of which is that the intermediate cash flows are
reinvested at IRR. This assumption may not hold good.

3. There could be cases of non-conventional projects with multiple IRR‟S which are difficult to
understand.

4. There are cases where higher IRR does not necessarily contribute to wealth maximization.
 PROFITABILITY INDEX
This is the ratio of the present value of cash inflows and the present value of cash outflows. It is used to
indicate the profitability at a glance. Where the projects differ in their duration and the cash flows these can
be compared based on the profitability Index.

INTERPRETATIONS

If the profitability index is less than one reject the proposal.

If the profitability index is equal to one, the proposal is just break even.

If the profitability is more than one accept the proposal.

The higher the index, the more profitable the proposal is

ADVANTAGES

1. It is easy to calculate given the present values of cash flows.

2. Projects of different magnitude in terms of duration and cash flows can be short listed based on
their profit is recommended for use particularly when there is shortage of funds because it
correctly ranks the proposal.
LIMITATIONS OF CAPITAL BUDGETING
Uncertainty in the future: The capital budgeting proposals are invested with the uncertainty in the
future .All data is used in evaluation of proposals is the estimates .the data is error phone more
with human judgment, bias or discretion in the identification of cash inflows and outflows. Even
advanced capital budgeting techniques such as sensitivity analysis cannot be useful if the data is
erroneous.

Qualitative factors ignored: in capital budgeting, we consider only such factors which can be
qualified in terms of money. factors such as improved morale employees as a result of
implementation of proposals are not focused the other factors in the business environment such as
social, political, economic conditions etc. are not reflected.
Volatile business conditions:
the factors influencing investment decision include The technological advancements ,government policies(
such as fiscal policy, monetary policy)sales forecast ,attitude of management(conservative
&progressive),estimated cash flows, discount factor &rate of return.
Unrealistic assumptions: There are certain unrealistic assumptions underlying capital budgeting processes
they are
1. There is no risk in uncertainty in the business environment this is not correct the future of business is full
of uncertainty &we apply the management techniques to minimize the risks.
2. The cash flows are received in lump sum at the end of given period .
3. The key variables such as sales revenue, cost, price or investment&….are taken based on past data
particularly in terms of rising prices , these seldom hold good for future.
4. The cost of the capital & discount rate are one and the same