Question

What are the effects of using leverage on cash flows?

Answer 1

Ans ) Leverage : 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.

Type of leverage : 1 ) Operating leverage

2 ) Financial leverage

3) Composite leverage

for understanding the effect of leverage on cash flow one have knowledge about its type.

1 ) Operating leverage : arise due to the fixed cost bear by the business.operating leverage means business risk arise due to capital budgeting. Hence operating leverage arise due to the presence of fixed operating costs such as depreciation , fixed factory overhead etc. Due to OL a given % change in sales results into a more than proportionate change in EBIT and therefore

operating leverage in absolute term ia calculated by using the give formula :

= Contribution ÷ EBIT

Where contribution = sales - variable cost

and EBIT = sales - v.c. - fixed cost

Degrees of operating leverage is calculated by using following formula :

= % change in EBIT ÷ % change in sales

Operating leverage give rise to operating risk ( business risk )

higher the degree of leverage , higher the operating risk,higher the amount of fixed operating costs greater will be operating leverage and hence operating risk higher.

2 ) Financial leverage: FL exist wherever We have fixed financial cost such as, interest cost ,it magnify the effect of change in EBIT on EPS (earnings per share) given % change in EBIT will result into more than proportionate change in EPS .

higher the FL , greater the Financial risk of company and highest the amount of debt capital, greater is the FL and financial Risk .

the capital structure / financing decision give rise to financial leverage.

FL in absolute term = EBIT ÷ EBT

where EBT = sale - v.c.- f.c.- interest

DFL = % change in EPS ÷ % in EBIT

​​​​3) Super leverage / Composite leverag

combination of financial leverage and operating leverage

= Operating leverage × Financial leverage

Degrees of Composite leverage  

= % change in EPS ÷ % change in sales

Effect of using leverage :. leverage effect explains a company's Return on Equity in terms of its Return on Capital employed and Cost of debt. The leverage effect is the difference between Return on Equity and Return on Capital employed. Leverage effect explains how it is possible for a company to deliver a Return on Equity exceeding the Rate of return on all the Capital invested in the business, i.e. its Return on Capital employed. When a company raises Debt and invests the funds it has borrowed in its industrial and commercial activities, it generates Operating profit that normally exceeds the Interest expense due on its borrowings. The company generates a surplus consisting of the difference between the Return on Capital employed and the Cost of debt related to the borrowing. This surplus is attributable to Shareholders and is added to Shareholders' equity. The leverage effect of Debt thus increases the Return on Equity. If the Return on Capital employed falls below the Cost of debt, then the leverage effect of Debt shifts into reverse and reduces the Return on Equity, which in turn falls below Return on Capital employed.Leverage effect is expressed in the following formula: ROE = ROCE + (ROCE- i ) D/E, where ROE is the Return on Equity, ROCE is the after-tax Return on Capital employed, i is the after-tax Cost of debt, D- Net debt, E Equity. The leverage effect itself is the (ROCE-i) x D/E.

2 ) Financial Leverage shows amount of used debt in structure of company's capital. Using debt affects agency cost through some ways. Firstly using debt of free cash flow decreases managers' authority (Jensen, 1986). It reduces available free cash flow for investment as payment of profit promised to the shareholders.

Hence if one use leverage upto a particular point it get tax benefits because the interest is tax deductible.and overall cost of capital decrease and on the other hand the value of firm increase.

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