fauji fertilizer company limited ffcl
DESCRIPTION
FAUJI FERTILIZER COMPANY LIMITEDTRANSCRIPT
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Project of Managerial Finance
FAUJI FERTILIZER COMPANY LIMITED
Fawad Ur Rahman
International Islamic University Islamabad
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References: Corporate Affairs
Senior Manager Corporate Affairs/Company Secretary
Brig. Sher Shah (Retired). Email ID: [email protected]
Location: Head Office, 156-The Mall Rawalpindi
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COMPANY PROFILE
Vision
To be a leading national enterprise with global aspirations, effectively pursuing multiple growth
opportunities, maximizing returns to the stakeholders, remaining socially and ethically
responsible
Explanation:
In a nation of increasing population, there is substantial opportunity of growth for FFC in the
years to come. FFC’s vision is to play a leading role in the industrial and agricultural
advancement of the Country pursuing new growth opportunities offering the convenience of
multiple products, brands and channels within and beyond the territorial limits of Pakistan, to
the benefit of our customers and our shareholders, elevating our image as a socially responsible
and ethical company that is watched and emulated as a model of success.”
Mission
To provide our customers with premium quality products in a safe, reliable, efficient and
environmentally sound manner, deliver exceptional services and customer support, maximizing
returns to the shareholders through core business and diversification, providing a dynamic and
challenging environment for our employees.
Explanation:
FFC is a market-focused, process centered organization delivering successful performance
through a strong focus on quality. Our mission is to stand above the competition and provide
our customers with premium quality fertilizer products in a safe, reliable, efficient and
environmentally sound manner, deliver exceptional services and unparalleled customer
support, produce predictable earnings for our shareholders, and provide a dynamic and
challenging environment for our employees.”
Corporate Strategy:
Maintaining our competitive position in the core business, we employ our brand name, unique
organizational culture, professional excellence and financial strength diversifying in local and
multinational environments through acquisitions and new projects thus achieving synergy
towards value creation for our stakeholders.
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Company Ownership:
The company is a public company incorporated in Pakistan under the
companies Ordinance, 1984, and its shares are quoted on the stock exchange in Pakistan. FFC
was established in 1978 as a joint venture of Fauji Foundation and Haldor Topsoe. The first urea
complex was commissioned in 1982. Plant-1 was improved in 1992, and a second plant was built
in 1993. In the year 2002, FFC acquired ex Pak Saudi Fertilizers Limited (PSFL) Urea Plant
situated at Mirpur Mathelo, District Ghotki from National Fertilizer Corporation (NFC) through
a privatization process of the Government of Pakistan. This acquisition at Rs. 8,151 million
represents one of the largest industrial sector transactions in Pakistan. Fauji Fertilizer Bin Qasim
Limited, Karachi, Pakistan (FFBL) is another company where FFC has controlling shares – it
produces 1670 MTPD of granular urea plus 2250 MTPD DAP after revamping (1350 MTPD
before revamp) DAP. Ammonia and urea plants capacity factors right from the plants start-up
have been 100% or more. With a vision to acquire self - sufficiency in fertilizer production in the
country, FFC was incorporated in 1978 as a private limited company. This was a joint venture
between Fauji Foundation and Haldor Topsoe A/S.The initial share capital of the company was
813.9 Million Rupees. The present share capital of the company stands above Rs. 8.48 Billion.
Additionally, FFC has more than Rs. 8.3 Billion as long term investments which include stakes
in the subsidiaries FFBL, FFCEL and associate FCCL.
FFC participated as a major shareholder in a new DAPS/Urea
manufacturing complex with participation of major international/national institutions. The new
company Fauji Fertilizer Bin Qasim Limited (formerly FFC-Jordan Fertilizer Company Limited)
commenced commercial production with effect from January 01, 2000. The facility is designed
with an annual capacity of 551,000 metric tons of urea and 445,500 metric tons of DAP,
revamped to 670,000 metric tons of DAP.
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Product and Service Description:
1) Urea (Nitrogen) Fertilizer:
In grain and cotton crops, at the time of last cultivation before planting. In irrigated
crops, urea can be applied dry to the soil. During summer, often spread just before or during rain
to minimize losses from vitalization process.
Industrial: Raw material in manufacture of plastics, adhesives and industrial feedstock.
Percentage of use in Pakistan: 80%, Percentage of FFC Sales: 93%
2) DAP (Phosphate) Fertilizer:
Sona DAP is the most concentrated phosphatic fertilizer containing 46% P2O5 and
18% Nitrogen. From nutrients' concentration point of view, it has got the highest quantity of total
nutrients in a 50 KG bag i.e. 32 KG of nutrients / bag. The highest concentration of plant
nutrients in a bag helps saving costs of transportation, handling, storage and application. It is the
widely used phosphatic fertilizer in the world as well as Pakistan. The solubility of DAP is more
than 95%, which is highest among the phosphatic fertilizers available in the country. Due to high
solubility it can also be used through fertigation as well as by foliar application. Its nitrogen to
phosphoris ratio (1: 2.5) makes it an ideal fertilizer for Basal application to meet the initial
requirement of most of the crops. Having an ultimate acidic effect on the soil, it is well suited for
our alkaline soils.
Industrial: It is a fire retardant and is used in commercial firefighting products. Other uses are
as metal finisher, yeast nutrient, nicotine enhancer in cigarettes and sugar purifier.
Percentage of use in Pakistan: 19%, Percentage of FFC Sales: 6%
3) SOP (Potash) Fertilizer:
This fertilizer is an important source of Potash, which is a quality nutrient for production of
crops especially fruits and vegetables. Potash is an important nutrient for activation of enzymes
in the plant body and helps increasing sugar and starch contents. Potash improves the resistance
of the plants against pests, diseases and stresses like water / frost injury etc.
Industrial: Occasionally used in manufacture of glass.
Percentage of use in Pakistan: 1%, Percentage of FFC Sales: 1%
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4) SONA BORON:
Sona Boron is a crystalline fertilizer in the form of Sodium Tetra Borate Deca
hydrate in 3 Kg packing. It is an essential micronutrient required for plant nutrition, which pays
a vital role in a number of growth processes especially new cell development, pollination,
fruit/seed setting, translocation of sugars, starches, nitrogen and phosphorous, nodule formation
in legumes and regulation of carbohydrate metabolism. Boron deficiency results in curled leaves,
cracking and rotting of fruits, tubers or roots. Keeping in view increasing boron deficiency in
Pakistani soils FFCL is providing superior quality Sona Boron containing 11.3% Boron (Borax).
It is easily soluble in water and readily available to plants. It can be used as mixture with other
fertilizers.
Fauji Fertilizer Company Limited Fluctuation for the Years 1996-
2013
Year Date High Date Low
1998 14-APR-98 89.00 21-OCT-98 31.55
1999 15-MAR-99 57.30 08-FEB-99 39.30
2000 21-JAN-00 67.50 19-OCT-00 36.50
2001 02-FEB-01 50.00 24-SEP-01 28.40
2002 26-DEC-02 73.95 22-May-02 38.85
2003 29-AUG-03 105.95 28-FEB-03 69.15
2004 29-DEC-04 143.90 01-JAN-04 95.75
2005 16-MAR-05 180.00 27-JUN-05 118
2006 31-JAN-06 144.90 29-DEC-06 105.50
2007 13-JUL-07 131.90 05-JAN-07 103.00
2008 02-APR-08 149.85 31-DEC-08 54.30
2009 14-DEC-09 109.90 01-JAN-09 58.90
2010 30-DEC-10 128.50 15-JUN-10 101.10
2011 18-OCT-11 198.35 25-FEB-11 109.82
2013 23-DEC-13 116 27-DEC-13 113
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Production and Sale at a Glance:
Urea Production (Met/Year) Sale (Met/Year)
Years Goth Machi M.Mathelo Total Urea Domestic Urea Export
Urea Imported
Phos*/ Potassic
Total
Plant-I Plant-II Plant-III Sona FFC
1987
632,079
- - 632,079
587,891
- - 2,907
- 590,798
1988
637,737
- - 637,737
642,857
- - 22,542
- 665,399
1989
632,972
- - 632,972
678,430
- - 2,605
162,113/14,086
857,234
1990
652,665
- - 652,665
645,188
- - 134,366
169,943/24,229
973,726
1991
629,266
- - 629,266
643,608
- - 206,244
148,753/18,945
1,017,550
1992
648,178
- - 648,178
647,460
- - 187,058
153,025/16,040
1,003,583
1993
657,376
477,339
- 1,134,715
1,176,611
- - 129,006
207,038/7,147
1,519,802
1994
678,114
659,526
- 1,337,640
1,288,811
- - 33,387
192,002/8,210
1,522,410
1995
680,062
700,031
- 1,380,093
1,422,666
- - 60,604
122,640/9,527
1,615,437
1996
710,862
695,749
- 1,406,611
1,413,907
- - 238,130
144,969/1,446
1,798,452
1997
773,048
734,275
- 1,507,323
1,482,948
- - 146,813
81,181/0
1,710,942
1998
742,599
682,969
- 1,425,568
1,449,201
- - 169,610
187,392/0
1,806,203
1999
726,723
734,689
- 1,461,412
1,581,655
- - 26,277
291,499/0
1,899,431
2000
729,864
695,938
- 1,425,802
1,793,554
- 63,350
0
321,977/9,269
2,188,150
2001
737,607
756,417
- 1,494,024
1,883,849
- - 34,035
340,301/9,377
2,267,562
2002
801,825
713,889
368,575**
1,884,289
2,033,883
328,147
57,000
- 285,776/7,718
2,712,524
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2003
784,826
738,327
626,716
2,149,869
2,065,459
598,792
18,500
- 475,491/10,947
3,169,189
2004
741,831
716,621
715,577
2,174,029
2,708,544
148,832
13,500
105,693
515,993/11,451
3,504,013
2005
820,454
772,825
709,526
2,302,805
2,891,882
- - 314,701
572,990/45,293
3,824,866
2006
809,373
760,442
725,839
2,295,654
2,888,668
- - 321,601
824,361/20,426
4,055,056
2007
829,250
810,673
680,442
2,320,365
2,771,861
- - 96,976
562,276/17,305
3,448,418
2008
841,117
797,108
683,986
2,322,211
3,027,245
- - 58,370
348,275/19,364
3,453,254
2009
807,221
846,613
810,323
2,464,157
3,088,382
- - - 708,886/41,128
3,838,396
2010
867,346
806,589
810,706
2,484,641
3,006,074
- - - 722,766
3,728,840
2011
841,755
782,752
711,195
2,395,702
2,839,162
662,387/9,588
3,511,353
2012
799,432
772,307
834,054
2,405,784
2,677,668
677,917/6,489
3,362,286
2013
749,000
784,000
787,000
2,320,000
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Capital Budgeting: Cash Flow Estimation
KEY DEFINATIONS:
Capital Budgeting:
Capital budgeting, which is also called "investment appraisal," is the planning
process used to determine which of an organization's long term investments such as new
machinery, replacement machinery, new plants, new products, and research development
projects are worth pursuing. It is to budget for major capital investments or expenditures.
Cost of Capital: The firm's Cost of Capital is the discount rate which should be used in Capital Budgeting.
The Cost of Capital reflects the firm's cost of obtaining capital to invest in long term assets. Thus
it reflects a weighted average of the firm's cost of debt, cost of preferred stock, and cost of
common stock.
Net Present Value: Net present value (NPV) is used to estimate each potential project's value by
using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and
timing of all the incremental cash flows from the project. The NPV is greatly affected by the
discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making
the right decision.
Internal Rate of Return: The internal rate of return (IRR) is defined as the discount rate
that gives a net present value (NPV) of zero. It is a commonly used measure of investment
efficiency.
The IRR method will result in the same decision as the NPV method for non-mutually exclusive
projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at
the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive
projects, the decision rule of taking the project with the highest IRR, which is often used, may
select a project with a lower NPV.
Payback Period: Payback period in capital budgeting refers to the period of time required for the return on an
investment to "repay" the sum of the original investment. Payback period intuitively measures
how long something takes to "pay for itself." All else being equal, shorter payback periods are
preferable to longer payback periods.
Profitability Index: Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio
(VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking
projects, because it allows you to quantify the amount of value created per unit of investment.
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Equivalent Annuity: The equivalent annuity method expresses the NPV as an annualized
cash flow by dividing it by the present value of the annuity factor. It is often used when
comparing investment projects of unequal life spans. For example, if project A has an expected
lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper
to simply compare the net present values (NPVs) of the two projects, unless the projects could
not be repeated.
Real Options Analysis The discounted cash flow methods essentially value projects as if they were risky bonds, with the
promised cash flows known. But managers will have many choices of how to increase future
cash inflows or to decrease future cash outflows. In other words, managers get to manage the
projects, not simply accept or reject them. Real options analysis try to value the choices–the
option value–that the managers will have in the future and adds these values to the NPV.
Capital Budgeting: Cash Flow Estimation
Fauji Fertilizer Company Limited is considering purchase of new organic fertilizer machine by
replacing it with existing one. The existing unit cost 2,000,000 and is being depreciated under
MACRS using a five year recovery period. The existing unit is expected to have useful life of 5
more years. The new unit can be purchased at 2,809,000 and requires 65,000 installation cost, it
has a 5-year usable life and would be depreciated by using a five year recovery period. Fauji
Fertilizer Company can currently sell the exiting unit for Rs. 1,305,000 without incurring any
removal or cleanup cost. The new unit would be sold out to net 1,585,000, after removal and
cleanup cost and before taxes. The Firm is subject to a 35% tax rate. We have raised three
questions which are answered in this section. We will calculate initial investment associated with
the replacement of the existing asset by the new one. We shall find out the operating cash
inflows associated with the proposed asset replacement. The initial investment and operating
cash inflows are given below.
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Initial Investment:
Installed Cost Of New Asset
Cost of New Asset 2809000
Installation Cost 6500
Total Installed Cost 2815500
After tax sales proceeds from old asset
Net sales proceeds from old asset 1305000
Tax 243250
Total After Tax Sales Proceeds 1548250
Net working capital
Initial Investment 1267250
Operating cash flows CASH INFLOWS OF NEW MACHINERY
YEARS 1 2 3 4 5 6
Revenues 30000000 33000000 50000000 50050000 65000000 72000000
Expenses 1200000 1200000 1350000 1000000 987000 967000
Income before depreciation and tax
28800000 31800000 48650000 49050000 64013000 71033000
Depreciation 561800 898880 533710 337080 337080 140450
Income before tax
28238200 30901120 48116290 48712920 63675920 70892550
Tax 9883370 10815392 16840701.5 17049522 22286572 24812393
Net Income 18354830 20085728 31275588.5 31663398 41389348 46080158
Add Depreciation expense
561800 898880 533710 337080 337080 140450
Cash Flows 18916630 20984608 31809298.5 32000478 41726428 46220608
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CASH INFLOWS OF OLD MACHINERY
YEARS 1 2 3 4 5 6
Revenues 20700000 23700000 26300000 29400000 25900000 23900000
Expenses 800000 800000 900000 750000 987000 967000
Income before depreciation and tax
19900000 22900000 25400000 28650000 24913000 22933000
Depreciation 400000 640000 380000 240000 240000 100000
Income before tax
19500000 22260000 25020000 28410000 24673000 22833000
Tax 6825000 7791000 8757000 9943500 8635550 7991550
Net Income 12675000 14469000 16263000 18466500 16037450 14841450
Add Depreciation expense
400000 640000 380000 240000 240000 100000
Cash Flows 13075000 15109000 16643000 18706500 16277450 14941450
INCREMENTAL CASH INFLOWS
YEARS NEW OLD INCREMENTAL CASH INFLOWS
1 18916630 13075000 5841630
2 20984608 15109000 5875608
3 31809298.5 16643000 15166299
4 32000478 18706500 13293978
5 41726428 16277450 25448978
6 46220607.5 14941450 31279158
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RISK AND REFINEMENTS IN CAPITAL BUDGETING:
RISK AND CASH FLOWS:
In the context of capital budgeting, the term risk refers to the uncertainty
surrounding the cash flows that a project will generate. More formally, risk in capital budgeting
is the degree of variability of cash flows. Projects with a broad range of possible cash flows are
more risky than projects that have a narrow range of possible cash flows.
NPV is used in capital budgeting to analyze the profitability of an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project
will yield. If the NPV of a prospective project is positive, it should be accepted. However, if
NPV is negative, the project should probably be rejected because cash flows will also be
negative.
NPV is an indicator of how much value an investment or project adds to the firm. With a
particular project,
If Means Then
NPV > 0 The investment would add value to the firm.
The project may be accepted.
NPV < 0 The investment would subtract value from the firm.
The project should be rejected.
NPV = 0 The investment would neither gains nor loss value for the firm.
We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.
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ILLUSTRATION:
Fauji Fertilizing company an urea retailer with a 9% cost of capital, is considering investing in
either of two mutually exclusive projects, X and Z. Each requires a $1500000 initial investment,
and both are expected to provide equal annual cash inflows over their 10-years lives. For either
to be acceptable according to the net present value technique, its NPV must be greater than
zero. If we let CF equal the annual cash inflow and let CF0 equal the initial investment , the
following condition must be met for projects with annuity cash inflows , such as X and Z, to be
acceptable.
NPV= [CF (PVIFA k, n)]-CFO
K=9% n=10years CFO=150000, we can find the breakeven cash inflow necessary for
Fauji projects to be acceptable.
NPV= [CF (PVIFA 9%, 10)-$1500000
NPV=CF (6.418)-$1500000
CF=$1500000/6.418
CF=$233717.66
I n this example we didn’t say that project x is less risky than project z in this example clearly
identifies risk as it is related to the chance that a project is acceptable, but it doesn’t address the
issue of cash flow variability because both project has equal net present value so the project x
has greater chance of loss than project z or vise versa or it might result in higher potential NPVs.
SENSITIVITY AND SCENARIO ANALYSIS:-
Sensitivity analysis can be used to deal with project risk to capture the variability of cash inflows
and NPVs. Sensitivity analysis is a behavioral approach that uses several possible alternative
outcomes (scenarios), to obtain a sense of the variability of returns, measured here by NPV. This
technique is often useful in getting a feel for the variability of return in response to changes in a
key outcome. In capital budgeting, one of the most common scenario approaches is to estimate
the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best)
estimates of cash inflow. The range can be determined by subtracting the pessimistic-outcome
NPV from the optimistic-outcome NPV.
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The Scenario analysis is also a behavioral approach similar to sensitivity analysis but broader in
scope.
EXAMPLE: Fuji fertilizing company, assume that the financial manager made in pessimistic,
most likely, and optimistic estimates of the cash inflows for each project. The cash inflows
estimates and resulting NPV’s in each case are summarized in below table.
Comparing the ranges of cash inflows ($100000 for project X and $150000 for Z) and more
important, the range of NPV’s ($624700 for project X and $863850 for Z ) makes it clear that
project X is less risky than project Z. Given that both projects have the same most likely NPV’s
of $450000 the assumed risk averse decision maker will take project X because it has less risk or
smaller NPV range and no possibility of losses (all NPVs>$0).
Sensitivity analysis of Fauji fertilize of project X and Z.
Note: The Present Values are calculated keeping the discount rate of 8% for project X and 10%
for Project Z and 9 years of Project life for both Projects.
Project X Project Z
Initial Investment 500000 500000
Outcome:-
Pessimistic 800000 700000
Most likely 450000 450000
Optimistic 900000 850000
Range 100000 150000
Outcome:-
Pessimistic 4497600 3531300
Most likely 2311150 2091550
Optimistic 5122300 4395150
Annual Cash inflows
Net Present Values
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APPLYING THE RISK ADJUSTED DISCOUNT RATE:
An estimation of the present value of cash for high risk investments is known as risk-adjusted
discount rate.
A very common example of risky investment is the real estate. Risk adjusted discount rate is
representing required periodical returns by investors for pulling funds to the specific property. It
is generally calculated as a sum of risk free rate and risk premium. The variation of risk premium
is depending on the risk aversion of investor and the perception of investor about the size of
property’s investment risk.
Under Capital Asset Pricing Model
Risk-adjusted discount rate = Risk free rate + Risk premium
Risk premium= (Market rate of return - Risk free rate) x beta of the project
The risk-adjusted discount rates declare for that by altering the rate depending on possibility of
risks of investment projects. For higher risk investment project a higher rate will be used and for
a lower risk investment project, a low rate will be used. The net present value is inversely
proportional to risk-adjusted discount rate as an increase in adjusted rate will decrease net
present value, representing that the task is less acceptable and perceived as riskier one.
Plus points of adjusted rate
It is quite simple and easy to understand.
Risk adjusted rate has a good deal of intuitive appeal in the eyes of risk averse business person.
It integrates an attitude towards uncertainty.
The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given
project to compensate the firm’s owners adequately—that is, to maintain or improve the firm’s
share price. The higher the risk of a project, the higher the RADR, and therefore the lower the
net present value for a given stream of cash inflows.
For assets traded in an efficient market, the diversifiable risk, which results from uncontrollable
or random events, can be eliminated through diversification. The relevant risk is therefore the no
diversifiable risk—the risk for which owners of these assets are rewarded. No diversifiable risk
for securities is commonly measured by using beta, which is an index of the degree of movement
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of an asset’s return in response to a change in the market return. Using beta, bj, to measure the
relevant risk of any project, the CAPM is
Any security that is expected to earn in excess of its required return would be acceptable, and
those that are expected to earn an inferior return would be rejected.
Risk adjusted discount rate for the projects by using the CAPM
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Project A: Project E:
Risk free rate 9.32% Risk free rate 9.32 %
Market rate 20% Market rate 10%
Beta 1. Beta 0.90
CAPM 20% CAPM 10%
Project B: Project F:
Risk free rate 9.32% Risk free rate 9.32%
Market rate 17% Market rate 07%
Beta 1.10. Beta 0.50
CAPM 18% CAPM 08%
Project C: Project G:
Risk free rate 9.32% Risk free rate 9.32%
Market rate 15% Market rate 05%
Beta 1.05. Beta 0.75
CAPM 15% CAPM 06%
NPV at the Risk Adjusted Discount Rate:
Project CFO RADR PVIFA Cash Flow PV NPV
A 750000 20% 2.990 300000 897000 147000
B 660000 18% 3.127 350000 1094450 434450
C 450000 15% 3.352 400000 1340800 890800
E 550000 10% 3.790 550000 2084500 1534500
F 325000 8% 3.992 700000 2794400 2469400
G 200000 6% 4.212 450000 1895400 1695400
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LEVERAGE AND CAPITAL STRUCTURE
Leverage in finance is a general term for any technique to multiply gains and losses.
Operating Leverage:
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs. A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with lower fixed
costs and higher variable costs are said to employ less operating leverage.
Financial Leverage:
Financial leverage is the degree to which a company uses fixed-income securities such as debt
and preferred equity. The more debt financing a company uses, the higher its financial leverage.
A high degree of financial leverage means high interest payments, which negatively affect the
company's bottom-line earnings per share.
Break Even Analysis of FFC:
Break Even Analysis is an analysis to determine the point at which revenue received equals the
costs associated with receiving the revenue. Break-even analysis calculates what is known as a
margin of safety, the amount that revenues exceed the break-even point. This is the amount that
revenues can fall while still staying above the break-even point. Break-even analysis is a supply-
side analysis; that is, it only analyzes the costs of the sales. It does not analyze how demand may
be affected at different price levels.
FFC uses the following rates for its production of Urea bags: the Selling Price per bag is
Rs.1700, with a variable cost of Rs.500 per bag. The Operating Fixed Cost is Rs.48000000.
The formula used to determine the breakeven point is:
Breakeven Point = Fixed Costs/ (Unit Selling Price - Variable Costs)
In our case:
B.E = 48000000/ (1700-500)
= 40,000 Bags of Urea.
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Changing Costs and Operating Breakeven Points
The breakeven Point varies with different elements such as the Fixed Cost, the Sales Price per
unit, and the variables operating costs per unit. In order to assess the effects of increase or
decrease in these variables, we consider the following scenarios.
Assume that FFC wants to assess the effects of the following scenario: (1) to keep the variables
as where mentioned above, that is: the Selling Price per bag is Rs.1700, with a variable cost of
Rs.500 per bag. The Operating Fixed Cost is Rs.48000000. (2) to increase the Fixed Cost up to
Rs.52000000. (3) to increase the selling price to Rs.1800. (4) to increase the variable cost per bag
up to Rs.700. (5) to perform all the mentioned changes simultaneously.
We calculate the effects of the above changes:
B.E = 48000000/ (1700-500) = 40,000 bags.
B.E = 52000000/ (1700-500) = 43,333 bags.
B.E = 48000000/ (1800-500) = 36,923 bags.
B.E = 48000000/ (1700-700) = 48,000 bags.
B.E = 52000000/ (1800-700) = 47272 bags.
The following table summarizes the changes and the effects of each:
Situation S.P F.C V.C Revenue Explanation Break Even
Point
Scenario 1 1700 48000000 500 68000000 Normal scenario 40000
Scenario 2 1700 52000000 500 73666666.67 Increased FC 43333.33333
Scenario 3 1800 48000000 500 66461538.46 Increased SP 36923.07692
Scenario 4 1700 48000000 700 81600000 Increase VC 48000
Scenario 5 1800 52000000 700 85090909.09 All three changes 47272.72727
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Operating Leverage:
Referring to the data used in the previous illustration, here we show EBIT for various levels of
sales, and what are the effects of each level:
Case 2 Base Case 1
Sales in
Units
40,000
60,000
80,000
Sales
Revenue
68,000,000
102,000,000
136,000,000
Less: V.C
20,000,000
30,000,000
40,000,000
Less: F.C
48,000,000
48,000,000
48,000,000
EBIT
-
24,000,000
48,000,000
We used the sales of 60000 in units as a reference point. It is evident how operating leverage
works in both directions, either in increasing or decreasing the sales level:
Case 1: a 33 percent increase in sales level (from 60,000 to 80,000) results in a in a 100 percent
increase in EBIT.
Case 2: a 33 percent decrease in sales level (from 60,000 to 40,000) results in a 100 percent
decrease in EBIT.
Definition of 'Degree of Operating Leverage - DOL'
A type of leverage ratio summarizing the effect a particular amount of operating leverage has on
a company's earnings before interest and taxes (EBIT). Operating leverage involves using a large
proportion of fixed costs to variable costs in the operations of the firm. The higher the degree of
operating leverage, the more volatile the EBIT figure will be relative to a given change in sales,
all other things remaining the same. The formula is as follows:
Degree of Operating Leverage of FFC
The degree of operating leverage (DOL) is a numerical measure of the firm’s operating leverage.
It can be derived using the following equation:
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DOL= Percentage change in EBIT/Percentage change in Sales
Whenever the percentage change in EBIT resulting from a given percentage change in sales is
greater than the percentage change in sales, operating leverage exists. This means that as long as
DOL is greater than 1, there is operating leverage.
Taking in consideration the previous illustration at FFC, we get the following results:
Case 1: +100% / +33% = 3.
Case 2: -100% / -33% = 3
Financial Leverage
The use of fixed financial costs to magnify the effects of changes in
earnings before interest and taxes on the firm’s earnings per share. Financial leverage results
from the presence of fixed financial costs that the firm must pay. The two most common fixed
financial costs are (1) interest on debt and (2) preferred stock dividends. These charges must be
paid regardless of the amount of EBIT available to pay them.
The effect of financial leverage is such that an increase in the firm’s EBIT results in a more-than-
proportional increase in the firm’s earnings per share, whereas a decrease in the firm’s EBIT
results in a more-than-proportional decrease in EPS.:
Case 2 Base Case 1
EBIT
14,400,000
24,000,000
33,600,000
Less: Interest
4,000,000
4,000,000
4,000,000
Net Profit Before Tax
10,400,000
20,000,000
29,600,000
Less: Tax
3,640,000
7,000,000
10,360,000
Net Profit
6,760,000
13,000,000
19,240,000
Less: Pref. Dividend 3,000,000 3,000,000 3,000,000
Earnings Available for
C.S
3,760,000
10,000,000
16,240,000
No of CS outstanding
10,000,000
10,000,000
10,000,000
Earnings Per Share 0.376 1 1.624
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We used the EBIT of 24,000,000 in units as a reference point. The interest payable on Bonds
equals to Rs.4000, 000. The annual dividends on preferred stock are Rs.3, 000,000. The tax rate
applies is 35%. The previous table shows EPS for various EBIT levels. Two Scenarios are
shown:
Case 1: a 40% increase in EBIT (from 24,000,000 to 33,600,000) resulting in a 62% increase in
EPS (from 1 to 1.624).
Case 2: a 40% decrease in EBIT (from 24,000,000 to 14,400,000) resulting in a 62% decrease in
EPS (from 1 to 0.376).
The degree of Financial Leverage of FFC
The degree of financial leverage (DFL) is a numerical measure of the firm’s financial leverage.
Computing it is much like computing the degree of operating leverage. The following equation
presents one approach for obtaining the DFL. Whenever the percentage change in EPS resulting
from a given percentage change in EBIT is greater than the percentage change in EBIT, financial
leverage exists. This means that whenever DFL is greater than 1, there is financial leverage.
The formula used to calculate the degree of financial leverage is as follows:
DFL= Percentage change is EPS/Percentage change in EBIT
Refereeing to the data illustrated in the table above; we can calculate the degree of financial
leverage at FFC:
Case 1: +62%/+40% = 1.55.
Case 2: -62%/-40% = 1.55.
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Total Leverage:
The combined effect of Operating and financial leverage on the firm’s risk is called Total
leverage. It can be defined as the potential use of fixed costs, both operating and financial to
magnify the effects of changes in sales on the firm’s earnings per share. Total leverage can
therefore be viewed as the total impact of the fixed costs in the firms’ operating and financial
structure.
To calculate the degree of total leverage, we use the following formula:
DTL=DOL * DFL
If we take cases 1 of each leverage consideration, we will end up with a DOL of 3 and a DFL of
1.55
Hence:
DTL = 3 X 1.55 = 4.65