Meaning and Definition of Leverage: (With Example & Types) – A Guide

Meaning and Definition of Leverage: (With Example & Types) – IbusinessMotivation

Hello, What is the meaning and definition of levitation? The word levitation means ‘to lift’ or ‘to lift’. Leverage is the action of a lever and the mechanical gain achieved by it, that is, raise a given device with a small amount of power. It is the ability to multiply the effect of some efforts.

What is Meaning and Definition of Leverage?

In financial management, the term ‘leverage’ is used in a specific sense. Here is what it means. That by using certain costs, the firm increases its profitability. This implies the ability of a firm to use immovable assets or funds to increase the return to its shareholders. It can also be defined as a relative change in profits due to a change in sales.

Leverage is a practice. And which can help a business to drive its profit/loss? In business language, if a firm has fixed expenses in a P / L account or debt in a capital structure, the firm is called a leveraged. Nowadays, almost none of the businesses are far from leveraged, but very few have made a balance. In finance, leverage is very closely related to fixed expenditure. We can do it.

It has been safely stated that with the introduction of expenses fixed in nature, we are taking advantage of a firm. By fixed expenses, we refer to those expenses, the amount of which remains unchanged regardless of the activity of the business. For example, the number of interest paid on investments or loans made in fixed assets does not change with a simple change of sales. Neither they decrease with a decrease in sales nor increase with an increase in sales.

Also read: Primary Aims of Finance Function Present Value Definition

There is a separate basis for classifying business expenses. For us Convenience, we should classify fixed expenses such as salary on fixed expenses, operating fixed salary, and financial fixed expenses such as interest and dividends on preference shares. Similar to them, leverage is also of two types – financial leverage and operating leverage.

Financial leverage is leverage created with the help of a debt component in a company’s capital structure. Higher debt will have higher financial benefit as higher loan comes with a higher amount of interest which needs to be paid. There is both good and bad for a business based on leverage.

Situation. If a firm is able to generate a higher return on investment (ROI) than that interest rate, then leverage will have a positive impact on shareholder returns. The deeper side is that if the above situation is the opposite, then high leverage can lead a business to a worst-case scenario like bankruptcy.

Degree of financial leverage

It measures the change in earnings per share. Percent change in EBIT. This is known as the “degree of financial leverage” (DFL). It is a measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.

DFL = percentage change in EPS or EBIT

Percentage Change in EBIT EBIT Interest

A shortcut to keep in mind with DFL is that if interest is 0, then DLF will be equal to 1.

Leverage example?

Like you must have read well about Leverage. Like I told you. But I will explain it to you through 2 examples which should be easy to understand.

1. Example Question: With Newco’scurrent production, its sales are 70 Lakhs annually. The company’s variable costs of sales are 40% of sales, and its fixed costs are 24 Lakhs. The company’s annual interest expense amounts to Rs.100,000 annually. If we increase Newco’s EBIT by 20%, how much will the company’s EPS increase?

Solution: The company’s DFL is calculated as follows:

DFL = (7,000,000-2,800,000-2,400,000)/(7,000,000-2,800,000-2,400,000 – 100,000)

DFL = 1,800,000/1,700,000 = 1.058

Given the company’s 20% increase in EBIT, the DFL indicates EPS will increase by 21.2%.

2. Example Question: The two firms B and S are similar in all respects except to the degree of leverage. Firm B has 6% of the debt of Rs. 3.00 lakhs while firm S has no debt. Both firms were trading at Rs. Is earning an EBT of. 1,20,000 each. The equity capitalization rate is 10% and the corporate tax is 60%.

You are required to compute the market value of the two firms.

Solution:

Value of unlevered firm                                         (No debt content)

Formula: Vu =Profit available for equity shareholders/ Equity Capitalisation Rate

= 1 , 20,000 – 72,000 / 10/100

= 48,000 X 100/10

Vu = Rs. 4,80,000

NOTE:

Profit available for equity shareholders

Earnings before tax                                                     1,20,000

Less : Tax Rate (1,20,000 x 601100)                         72,000

Profit available for equity shareholders                  48,000

Value of levered firm

Vi = Vu + Bt                                                                   Vi =4,80,000 +3,00,000 x .6

Vi = Value of levered firm                                         =5,60,000

Vu = Value of unlevered firm                                    Vu =Rs. 4,80,000

B = Value of Debenture                                              Vi =Rs. 5,60,000

t = Tax rate

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