CA Intermediate · Financial Management and Strategic Management

Financing Decisions - Leverages: formula sheet

Full chapter guide

Key formulas

Contribution: Contribution = Sales − Variable cost; Fixed costs are not deducted here. Contribution is the base for operating leverage.
EBIT: EBIT = Contribution − Fixed operating cost; EBIT is earnings before interest and tax.
Degree of Operating Leverage (DOL): DOL = Contribution ÷ EBIT = % change in EBIT ÷ % change in sales; Measured at a given sales level. It is at least 1 when EBIT is positive and there is no negative fixed cost.
Degree of Financial Leverage (DFL): DFL = EBIT ÷ EBT = % change in EPS ÷ % change in EBIT; EBT = EBIT − Interest. If preference shares exist, use EBIT ÷ [EBIT − Interest − Preference dividend ÷ (1 − t)].
Degree of Combined Leverage (DCL): DCL = DOL × DFL = Contribution ÷ EBT = % change in EPS ÷ % change in sales; The three forms give the same answer for the same data.
EPS: EPS = (EBT − Tax − Preference dividend) ÷ Number of equity shares; Tax rate does not affect DFL when there is no preference dividend.
Contribution: Contribution = Sales − Variable cost = Sales × P/V ratio; Variable cost here means all variable operating costs, not interest.
EBIT: EBIT = Contribution − Fixed operating costs; Fixed operating costs exclude interest. Interest is a financing cost and sits below EBIT.
Degree of Operating Leverage: DOL = Contribution ÷ EBIT; Computed at one sales level. Valid only when EBIT is not zero.
DOL from percentage changes: DOL = % change in EBIT ÷ % change in sales; Use this when two sets of figures are given. Take the change over the base (starting) figure.
Forecasting EBIT: % change in EBIT = DOL × % change in sales; Works for sales changes within the range where fixed costs stay constant.
DOL and fixed cost: DOL = 1 + (Fixed operating costs ÷ EBIT); Follows from Contribution = EBIT + Fixed cost. Shows DOL is 1 when fixed cost is nil.
Degree of Financial Leverage (definition): DFL = % change in EPS ÷ % change in EBIT; Use when the question gives two EPS and EBIT figures at different levels.
DFL with interest only: DFL = EBIT ÷ (EBIT − Interest) = EBIT ÷ EBT; EBT is earnings before tax. Use when there are no preference shares.
DFL with preference dividend: DFL = EBIT ÷ [EBIT − Interest − Preference dividend ÷ (1 − t)]; t is the tax rate as a decimal. Preference dividend is grossed up because it is paid after tax.
EPS: EPS = (EBIT − Interest) × (1 − t) − Preference dividend, all ÷ Number of equity shares; Interest is deducted before tax. Preference dividend is deducted after tax.
Financial leverage (ratio form): Financial leverage = EBIT ÷ EBT; Same as the interest-only DFL. Some questions call this the financial leverage ratio.
Degree of Combined Leverage (definition): DCL = % change in EPS ÷ % change in Sales; Valid at a given base sales level. Use it to find the EPS change for a sales change.
DCL as product: DCL = DOL × DFL; Compute DOL and DFL separately first, then multiply.
Degree of Operating Leverage: DOL = Contribution ÷ EBIT; Contribution = Sales − Variable cost.
Degree of Financial Leverage: DFL = EBIT ÷ EBT = EBIT ÷ (EBIT − Interest); If preference shares exist, DFL = EBIT ÷ [EBIT − Interest − Preference dividend ÷ (1 − t)].
DCL direct formula: DCL = Contribution ÷ EBT; EBIT cancels out. With preference shares, use the tax-adjusted preference dividend in the denominator.
EPS: EPS = (EBIT − Interest − Tax − Preference dividend) ÷ Number of equity shares; Use this to verify the effect of a sales change.
Contribution: Contribution = Sales − Variable cost; EBIT = Contribution − Fixed operating cost.
Degree of Operating Leverage: DOL = Contribution ÷ EBIT = % change in EBIT ÷ % change in sales; Measured at a given sales level. Higher DOL means higher business risk.
Degree of Financial Leverage: DFL = EBIT ÷ EBT = EBIT ÷ (EBIT − Interest); With preference shares: DFL = EBIT ÷ [EBIT − Interest − Pref. dividend ÷ (1 − t)].
Degree of Combined Leverage: DCL = DOL × DFL = Contribution ÷ EBT; Shows % change in EPS for 1% change in sales.
Operating break-even (units): BEP (units) = Fixed cost ÷ Contribution per unit; In rupees: Fixed cost ÷ P/V ratio, where P/V ratio = Contribution ÷ Sales.
Financial break-even EBIT: Financial BEP = Interest + Pref. dividend ÷ (1 − t); EBIT at which EPS is zero.
Margin of safety: MoS = Actual sales − Break-even sales; MoS ratio = MoS ÷ Actual sales; For a single-product firm with fixed costs, DOL = 1 ÷ MoS ratio when fixed costs are the only fixed costs in EBIT.
EPS for a plan: EPS = [(EBIT − I)(1 − t) − PD] ÷ N; I = interest, t = tax rate, PD = preference dividend (not tax-deductible), N = number of equity shares. Subtract PD after multiplying by (1 − t), then divide the whole result by N.
Indifference point (two plans): [(X − I₁)(1 − t) − PD₁] ÷ N₁ = [(X − I₂)(1 − t) − PD₂] ÷ N₂; X is the indifference EBIT. Solve for X. Use total interest and total shares under each plan, including existing ones. This equation method works in every case, so prefer it.
Indifference point (no preference shares): X = (N₂ × I₁ − N₁ × I₂) ÷ (N₂ − N₁); Tax cancels out when PD is zero for both plans. Plan 2 is the plan with the larger share count (N₂ > N₁). This shortcut only works when there is no preference dividend.
Indifference point with preference shares: X = (N₂ × I₁ − N₁ × I₂) ÷ (N₂ − N₁) + [PD₁ × N₂ − PD₂ × N₁] ÷ [(1 − t)(N₂ − N₁)]; Use only if you are sure of the numbering: N₂ is the larger share count, and PD₁, I₁, N₁ belong to the same plan (plan 1). Preference dividend is paid after tax, so it is divided by (1 − t). In the exam, equating the two EPS expressions is safer than recalling this.
Decision rule: EBIT > X: choose plan with more fixed-cost funds. EBIT < X: choose plan with more equity.; Applies when comparing a debt-heavy plan with an equity-heavy plan.

Quick revision

Leverage is the effect of fixed cost in magnifying a change in one item into a bigger change in the next.
DOL = Contribution ÷ EBIT. It is also % change in EBIT ÷ % change in sales.
DFL = EBIT ÷ PBT when there is no preference dividend. It is also % change in EPS ÷ % change in EBIT.
With preference shares, divide the preference dividend by (1 − tax rate) to get its pre-tax equivalent.
DCL = DOL × DFL = % change in EPS ÷ % change in sales. When there is no preference dividend, DCL = Contribution ÷ PBT.
If there is no fixed operating cost, DOL = 1. If there is no interest or preference dividend, DFL = 1.
Break-even point in units = Fixed cost ÷ Contribution per unit.
Higher fixed cost raises the break-even point and increases operating risk.
Higher debt raises financial risk, because interest must be paid whatever EBIT is.
Indifference point: the EBIT at which two financing plans give the same EPS.
For two plans with a single indifference point, when EBIT is above it the plan with higher financial leverage (more debt or preference capital and fewer equity shares) gives higher EPS. Below it, the equity-heavy plan gives higher EPS. Preference dividend is not tax-deductible, so it is deducted after tax: EPS = [(EBIT − I)(1 − t) − PD] ÷ N. If you equate on a pre-tax basis instead, gross up the preference dividend as PD ÷ (1 − t) and subtract it, along with interest, from EBIT.
Always write the full statement first. Step marks come from the layout.

Common mistakes

Using sales instead of contribution in the DOL formula. Fix: DOL always uses Contribution on top and EBIT below. Sales never appears in the formula.
Deducting fixed cost when finding contribution. Fix: Contribution = Sales − Variable cost only. Fixed cost comes off after contribution.
Using EBIT ÷ Contribution instead of Contribution ÷ EBIT. Fix: When EBIT is positive and contribution exceeds EBIT, DOL is 1 or more, so contribution (the larger figure) goes on top.
Deducting interest before computing DOL. Fix: Stop at EBIT. Interest matters only for financial leverage (DFL) and combined leverage.
Subtracting the preference dividend directly from EBIT without grossing it up Fix: Divide preference dividend by (1 − t) before subtracting. The dividend is paid after tax, interest before tax.
Using EBT or PAT in the numerator instead of EBIT Fix: The numerator is always EBIT. EBT appears only in the denominator, in the interest-only case.
Using EBIT instead of EBT in the DCL denominator. Fix: Remember: DOL uses EBIT, DCL uses EBT. Contribution is always the numerator.
Using Sales instead of Contribution as the numerator. Fix: Always compute Contribution = Sales − Variable cost first.
Using interest only in DFL when the firm also has preference shares. Fix: Convert preference dividend to pre-tax by dividing by (1 − t) and subtract it along with interest.
Treating DOL as constant for all sales levels. Fix: State that DOL applies at the given sales level and changes when sales or cost structure change.

Exam tips

Practical questions usually give a profit statement. Build it down to EBT first, then compute all three degrees.
State the formula before substituting. ICAI-style marking gives marks for formula, working and interpretation.
Write one line of interpretation, such as higher DCL means higher total risk.
In theory questions, define leverage, name the three types and link each to a risk: business risk for operating, financial risk for financial.
Remember the answer is valid only at the sales level given. Degrees change when sales change.
Read the question for the word 'operating'. Ignore interest and tax when you compute DOL.
Show contribution and EBIT as separate lines. Many marks go to these steps even if the final DOL slips.
Add one line of interpretation. ICAI-style answers often reward it.