Financial Management Notes: Investment Decisions

Unit – III: Investment Decisions
Meaning of Capital Budgeting or Investment Decision
The term capital budgeting or investment decision means planning for capital assets. Capital budgeting decision means the decision as to whether or not to invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the various alternatives.
According to Milton “Capital budgeting involves planning of expenditure for assets and return from them which will be realized in future time period”.
According to I.M Pandey “Capital budgeting refers to the total process of generating, evaluating, selecting, and follow up of capital expenditure alternative”
Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast likely or expected return from the project and determine whether return from the project is adequate.
Nature / Features of Capital budgeting decisions
a)      Long term effect: Such decisions have long term effect on future profitability and influence pace of firms growth. A good decision may bring amazing returns and wrong decision may endanger very survival of firm. Hence capital budgeting decisions determine future destiny of firm.
b)      High degree of risk: Decision is based on estimated return. Changes in taste, fashion, research and technological advancement leads to greater risk in such decisions.
c)       Huge funds: Large funds are required and sparing huge funds is problem and hence decision to be taken after proper care .
d)      Irreversible decision: Reverting back from a decision is very difficult as sale of high value asset would be a problem.
e)      Most difficult decision: Decision is based on future estimates/uncertainty. Future events are affected by economic, political and technological changes taking place.
f)       Impact on firm’s future competitive strengths: These decisions determine future profit or cost and hence affect the competitive strengths of firm.
g)      Impact on cost structure – Due to this vital decision, firm commits itself to fixed costs such as supervision, insurance, rent, interest etc. If investment does not generate anticipated profit, future profitability would be affected.
Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to any organization as they include the decisions as to:
a)      Whether or not funds should be invested in long term projects such as setting of an industry, purchase of plant and machinery etc.
b)      Analyze the proposal for expansion or creating additional capacities.
c)       To decide the replacement of permanent assets such as building and equipments.
d)      To make financial analysis of various proposals regarding capital investments so as to choose the best out of many alternative proposals.
The importance of capital budgeting can be well understood from the fact that an unsound investment decision may prove to be fatal to the very existence of the concern. The need, significance or importance of capital budgeting arises mainly due to the following:
1)      Large Investments: Capital budgeting decisions, generally, involve large investment of funds. But the funds available with the firm are always limited and the demand for funds far exceeds the resources. Hence it is very important for a firm to plan and control its capital expenditure.
2)      Long-term Commitment of Funds: Capital expenditure involves not only large amount of funds but also funds for long-term or more or less on permanent basis. The long-term commitment of funds increases the financial risk involved in the investment decision. Greater the risk involved, greater is the need for careful planning of capital expenditure, i.e. Capital budgeting.
3)      Irreversible Nature: The capital expenditure decisions are on irreversible nature. Once the decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without incurring heavy losses.
4)      Long-term Effect on Profitability: Capital budgeting decisions have a long-term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investments in capital assets but also the future growth and profitability of the firm depends upon the investment decision taken today. An unwise decision may prove disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost importance to avoid over investment or under investment in fixed assets.
5)      Difficulties of Investment Decisions: The long term investment decisions are difficult to be taken because (i) decision extends to a series of years beyond the current accounting period, (ii) uncertainties of future and (iii) higher degree of risk.
6)      National Importance: Investment decisions though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.
This, we may say that without using capital budgeting techniques a firm may involve itself in a losing project. Proper timing of purchase, replacement, expansion and alternation of assets is essential.
There are many factors, financial as well as non-financial, which influence the capital expenditure decisions. The crucial factor that influences the capital expenditure decisions is the profitability of the proposal. Yet, there are many other factors which have to be taken into consideration while taking a capital expenditure decision. These are:
1.       Urgency: Sometimes an investment is to be made due to an urgency for the survival of the firm or to avoid heavy losses. In such circumstances, the proper evaluation of the proposal cannot be made through profitability tests. The examples of such an urgency are: breakdown of some plant and machinery, fire, accident etc.
2.       Degree of certainty: Profitability is directly related to risk, higher the profits, greater is the risk or uncertainty. Sometimes, a project with some lower profitability may be selected due to constant flow of income as compared to another project with an irregular and uncertain flow of income.
3.       Intangible factors: Sometimes a capital expenditure has to be made due to certain emotional and intangible factors such as safety and welfare of workers, prestigious project, social welfare, goodwill of the firm, etc.
4.       Legal factors: An investment which is required by the provisions of law is solely influenced by this factor and although the project may not be profitable yet the investment has to be made.
5.       Availability of funds: As the capital expenditure, generally, requires large funds, the availability of funds is an important factor that influences the capital budgeting decisions. A project, howsoever profitable, may not be taken for want of funds and a project with a lesser profitability may be sometimes preferred due to lesser pay-back period for want of liquidity.
6.       Future Earnings: A project may not be profitable as compared to another today, but it may promise better future earnings. In such cases it may be preferred to increase earnings.
7.       Obsolescence: There are certain projects which have greater risk of obsolescence than others. In case of projects with high rate of obsolescence, the project with a lesser pay-back period may be preferred than one which may have higher profitability but still longer pay-back period
8.       Research and Development Projects: It is necessary for the long-term survival of the business to invest in research and development projects though it may not look to be profitable investment.
9.       Cost Considerations: Cost of the capital project, cost of production, opportunity cost of capital, etc. are other considerations involved in the capital budgeting decisions.
Techniques used in Investment decision making
Most commonly used technique in investment decision making are given below:
1) Payback period Method: It is one of the simplest methods to calculate period within which entire cost of project would be completely recovered. It is the period within which total cash inflows from project would be equal to total cash outflow of project. Here, cash inflow means profit after tax but before depreciation.
Merits of Payback period Method
a) This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. This method is particularly suitable in the case of industries where risk of technological services is very high.
b) In case of routine projects also, use of payback period method favours projects that generates cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to increase with futurity.
c) By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of liquidity crunch and high cost of capital.
d) Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to commence.
e) The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that uncertainty with respect to project is resolved faster.
Limitations of payback period
a) It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback period.
b) This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.
c) This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply added.
d) Post-payback period profitability is ignored totally.
2) Accounting rate of return (Average rate of return – ARR): ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven cents out of each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects. It is calculated with the help of the following formula:
ARR=Average Profit / Investment
Merits of ARR
a)      It is simple, common sense oriented method.
b)      Profits of all years taken into account.
c)       It considers actual net profit of the project.
Demerits of ARR
a)      Time value of-money is not considered
b)      Risk involved in the project is not considered
c)       Annual average profits might be same for different projects but accrual of profits might differ having significant implications on risk and liquidity
d)      The ARR has several variants and that it lacks uniform understanding.
3) Net present value (NPV) method: The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present values of all cash inflows as reduced by the  present values of all cash outflows associated with the proposal. Each project involves certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be calculated by adding depreciation to profit after tax arising out of that particular project.
Merits of NPV method:
1) NPV method takes into account the time value of money.
2) The whole stream of cash flows is considered.
3) NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial objectives.
4) NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's of different projects therefore can be compared. It implies that each project can be evaluated independent of others on its own merits.
Limitations of NPV method:
1) It involves different calculations.
2) The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in reality.
3) The ranking of projects depends on the discount rate.
Meaning of Capital Structure
Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e. what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds in total amount of capital which an undertaking may raise for establishing its business.
In the words of Robert H. Wessel “The term capital structure is frequently used to indicate the long-term sources of funds employed in a business enterprise”.
In the words of John J. Hampton “Capital structure is the combination of debt and equity securities that comprise a firm’s financing of its assets”.
In simple words, Capital structure of a company is the composition of long-term sources of funds, such as ordinary shares, preference shares, debentures, bonds, long-term funds.
Factors Determining the Capital Structure of a Company
The following factors are considered while deciding the capital structure of the firm.
a)      Leverage: It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing such as debt, equity and preference share capital. It is closely related to the overall cost of capital.
b)      Cost of Capital: Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of capital.
c)       Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital.
d)      Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can manage the financial requirements with the help of internal sources. But if it is small size, they will go for external finance. It consists of high cost of capital.
e)      Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure of a firm. For example, banking companies are restricted to raise funds from some sources.
f)       Requirement of investors: In order to collect funds from different type of investors, it will be appropriate for the companies to issue different sources of securities.
g)      Flexibility: The capital structure must have flexibility as to increase or decrease the funds as per requirements of the enterprise. Excessive dependence on fixed cost securities make the capital structure rigid due to fixed payment of interest or dividend.
h)      Regularity of Income: Capital structure is affected by the regularity of income. If a company expects regular income in future, debenture and bonds should be issued. Preference shares may be issued if a company does not expect regular income.
i)        Certainty of Income: If a company is not certain about any regular income in future, it should never issue any type of securities other than equity shares.
j)        Government policy Promoter contribution is fixed by the company Act. It restricts to mobilize large, long term funds from external sources. Hence the company must consider government policy regarding the capital structure.
Meaning of Optimum capital structure
The capital structure is said to be optimum, when the company has selected such a combination of equity and debt, so that the company's wealth is maximum. At this, capital structure, the cost of capital is minimum and market price per share is maximum. But, it is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital structure. In reality, however, instead of optimum, an appropriate capital structure is more realistic.
Features of an appropriate capital structure are as below:
1)      Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per equity share.
2)      Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.
3)      Conservation: Debt content in capital structure should not exceed the limit which the company can bear.
4)      Solvency: Capital structure should be such that the business does not run the risk of insolvency.
5)      Control: Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the company.
Importance of Optimal Capital Structure
a)      Minimized Cost: The primary objective of a company is to maximize the shareholder’s wealth through minimization of cost. A well-advised capital structure enables a company to raise the requisite funds from various sources at the lowest possible cost in terms of market rate of interest, earning rate expected by prospective investors, expense of issue etc. this maximize the return to the equity shareholders as well as the market value of shares held by them.
b)      Maximized Return: The primary objective of every corporation is to promote the shareholders interest. A balanced capital structure enables company to provide maximum return to the equity shareholders of the company by raising the requesting capital funds at the minimum cost.
c)       Minimize Risks: A sound capital structure serves as an insurance against various business risks, such as interest in costs, interest rates, taxes and reduction in prices. These risks are minimized by making suitable adjustments in the components of capital structure. A balanced capital structure enables the company to meet the business risks by employing its retained earnings for the smooth business operations.
d)      Controlled: Though the management of a company  is apparently in the hands of the directors, indirectly, a company is controlled by equity shareholders carry limited voting rights and debentures holders do not have any voting right, a well-devised capital structure ensures the retention of control over the affairs of the company with in the hands of the existing equity shareholders by maintaining a proper balance between voting right and non-moving right capital.
e)      Liquid: An object of a balanced capital structure is to maintain proper liquidity which is necessary for the solvency of the company. A sound capital structure enables a company to maintain a proper balance between fixed and liquid assets and avoid the various financial and managerial difficulties.
f)       Optimum Utilization – Optimum utilization of the available financial resources is an important objective of a balanced financial structure. An ideal financial structure enables the company to make full utilization of available capital by establishing a proper co-ordination between the quantum of capital and the financial requirements of the business. A balanced capital structure helps a company to estimate both the states of overcapitalization and under-capitalization which are harmful to financial interests of the company.
g)      Simple: A balanced capital structure is aimed at limiting the number of issues and types of securities, thus, making the capital structure as simple as possible.
h)      Flexible: Flexibility or capital structure enables the company to raise additional capital at the time of need, or redeem the surplus capital. it not only helps is fuller utilization of the available capital but also eliminates the two undesirable states of over-capitalization and under – capitalization.
Meaning and Definition of Cost of Capital and Weighted Average cost of capital
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result in the reduction of overall wealth of the shareholders.
According to the definition of John J. Hampton “ Cost of capital is the rate of return the firm required from investment in order to increase the value of the firm in the market place”.
According to the definition of Solomon Ezra, “Cost of capital is the minimum required rate of earnings or the cut-off rate of capital expenditure”.
Weighted average cost of capital (WACC) is the average of the minimum after-tax required rate of return which a company must earn for all of its security holders (i.e. common stock-holders, preferred stock-holders and debt-holders). It is calculated by finding out cost of each component of a company’s capital structure, multiplying it with the relevant proportion of the component to total capital and then summing up the proportionate cost of components. WACC is a very useful tool because it tells whether a particular project is increasing shareholders’ wealth or just compensating the cost.
Formula: For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula: WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
Cost of equity: In the formula for WACC, r(E) is the cost of equity i.e. the required rate of return on common stock of the company. It is the minimum rate of return which a company must earn to keep its common stock price from falling. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).
Weights: w(E) is the weight of equity in the company’s total capital. It is calculated by dividing the market value of the company’s equity by sum of the market values of equity and debt. w(D) is the weight of debt component in the company’s capital structure. It is calculated by dividing the market value of the company’s debt by sum of the market values of equity and debt.
Significance of Cost of Capital
Computation of cost of capital is a very important part of the financial management to decide the capital structure of the business concern.
a)      Importance to Capital Budgeting Decision: Capital budget decision largely depends on the cost of capital of each source. According to net present value method, present value of cash inflow must be more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
b)      Importance to Structure Decision: Capital structure is the mix or proportion of the different kinds of long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to take decision regarding structure.
c)       Importance to Evolution of Financial Performance: Cost of capital is one of the important determine which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial performance of the firm.
d)      Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in some other areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial management.
Problems in Determination of the cost of capital
The determination of the cost of capital of a firm is not an easy task. The finance manager is confronted with a large number of problems, both conceptual and practical, while determining the cost of capital of a firm. These problems in determination of cost of capital can briefly be summarized as follows:
1.       Controversy regarding the dependence of cost of capital upon the method and level of financing: There is a, major controversy whether or not the cost of capital dependent upon the method and level of financing by the company. According to the traditional authors, the cost of capital of a firm depends upon the method and level of financing. On the other hand, the modern authors such as Modigliani and Miller the firm’s total cost of capital argue that is independent of the method and level of financing. An important assumption underlying MM approach is that there is perfect capital market. Since perfect capital market does not exist in practice, hence the approach is not of much practical utility.
2.       Computation of cost of equity: The determination of the cost of equity capital is another problem. In theory, the cost of equity capital may be defined as the minimum rate of return that accompany must earn on that portion of its capital employed, which is financed by equity capital so that the market price of the shares of the company remains unchanged. This means that determination of the cost of equity capital will require quantification of the expectations of the equity shareholders. This is a difficult task because the equity shareholders value the equity shares on the basis of a large number of factors, financial as well as psychological.
3.       Computation of cost of retained earnings and depreciation funds: The cost of capital raised through retained earnings and depreciation funds will depend upon the approach adopted for computing the cost of equity capital. Since there are different views, therefore, a finance manager has to face difficult task in subscribing and selecting an appropriate approach.
4.       Future costs versus historical costs: It is argued that for decision-making purposes, the historical cost is not relevant. The future costs should be considered. It, therefore, creates another problem whether to consider marginal cost of capital, i.e., cost of additional funds or the average cost of capital, i.e., the cost of total funds.
5.       Problem of weights: The assignment of weights to each type of funds is a complex issue. The finance manager has to make a choice between the risk value of each source of funds and the market value of each source of funds. The results would be different in each case.
Meaning of Leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.
James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.
Types of leverages: Commonly used leverages are of the following type :
1) Operating Leverage: The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis. Operating leverage can be calculated with the help of the following formula:
Where ,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Degree of Operating Leverage: The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula:
DOL = Percentage change in profits/Percentage change in sales
Uses of Operating Leverage
a)      Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.
b)      If any change in the sales, it will lead to corresponding changes in profit.
c)       Operating leverage helps to identify the position of fixed cost and variable cost.
d)      Operating leverage measures the relationship between the sales and revenue of the company during a particular period.
e)      Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.
f)       Operating leverage describes the overall position of the fixed operating cost.
2) Financial Leverage: Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Financial leverage can be calculated with the help of the following formula:
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm.  This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”
The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ratio can be used to judge as to whether the company is trading on thin or thick equity.
Degree of Financial Leverage: Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earnings before interest and tax (EBIT). This can be calculated by the following formula:  DFL= Percentage change in taxable Income / Percentage change in EBIT 
Effect of Financial Leverage on Capital Structure
The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.
Factors affecting financial leverage: (VVVI Section)
Financial leverage is PBIT/ PBT. Therefore as interest increases, financial leverage will increase.  Interest, in turn, being the cost of borrowed funds, will increase with increase in the proportion of debt used for financing assets. That is why, the ratio of borrowings to assets is also called financial leverage. The higher the degree of financial leverage of a firm, the greater is the sensitivity of its profits before tax to changes in PBIT.
The combined leverage factor which is the product of operating leverage and financial leverage determines the overall sensitivity of profits before tax to change in sales. As income taxes are calculated as a percentage of profit before tax, the net profit will normally be proportionate to the profit before tax. Therefore, fluctuations in profit before tax will bring about corresponding fluctuations in net profits which in turn will bring about fluctuations in earnings per share (EPS) as EPS equals net profit divided by the number of equity shares. Therefore, the combined leverage factor influences the extent to which net profits and EPS will fluctuate for a given fluctuation in sales.
It is important to remember that additional benefits will accrue only when the return on assets is higher than the cost of borrowings. If however, the cost of borrowings is higher than the return on assets; the return on net worth will be even less than the return on assets.
Uses of Financial Leverage
a)      Financial leverage helps to examine the relationship between EBIT and EPS.
b)      Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
c)       Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
d)      Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.
e)      If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.
3) Combined leverage: When the company uses both financial and operating leverage to magnification of any change in sales into a larger relative changes in earning per share. Combined leverage is also called as composite leverage or total leverage. Combined leverage express the relationship between the revenue in the account of sales and the taxable income. Combined leverage can be calculated with the help of the following formulas:
CL = OL × FL or CL =C / PBT
CL = Combined Leverage
OL = Operating Leverage
FL = Financial Leverage
C = Contribution
PBT= Profit Before Tax
Degree of Combined Leverage: The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales. Degree of contributed coverage = Percentage change in EPS / Percentage change in sales
Difference between Operating Leverage and Financial Leverage
1)      Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.
2)      Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes (EBIT). Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.
3)      Operating Leverage = Contribution/EBIT and Financial Leverage = EBIT/EBT
4)      Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet.
5)      Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.
6)      Operational Leverage involves operating risk of being unable to cover fixed operating cost, whereas Financial Leverage involves financial risk of being unable to cover fixed financial cost.
7)      Operational Leverage is concerned with investment decisions, whereas Financial Leverage is concerned with financing decisions.
8)      Operating Leverage is described as a first stage leverage, whereas Financial Leverage is described as a second stage leverage.

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