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388 Corporate Finance BRILLIANT’S

(b) Variability of Expenses: Variability of (b) ì``m| _| n[adV©Z: EBIT _| n[adV©Z {\$ŠñS> Ed§
EBIT is also affected by the composition of fixed do[aE~b EŠgn|gog H$s H$ånmo{OeZ go ^r à^m{dV hmoVm
and variable expenses. Higher the proportion h¡Ÿ& `{X {\$ŠñS> EŠgn|gog H$m AZwnmV A{YH$ hmoJm Vmo
of fixed expenses, higher will be the degree of Am°naoqQ>J brdaoO ^r A{YH$ hmoJmŸ& BgHo$ n[aUm_ñdê$n
operating leverage. When the sales are falling,
{dH«$` _| {JamdQ> H$s VwbZm _| EBIT _| hmoZo dmbr {JamdQ>
EBIT declines at a greater rate than fall in sales.
Operating expenses may also vary due to Vrd« J{V go hmoJrŸ& Am°naoqQ>J EŠgn|gog _| n[adV©Z BZnwQ>
change in input prices and may also contrib- àmBg _| n[adV©Z Ho$ H$maU ^r hmo gH$Vm h¡ŸVWm BZgo
ute to the variability of EBIT. EBIT _| ^r n[adV©Z hmo gH$Vm h¡Ÿ&
Financial Risk \$m`ZopÝe`b [añH$

When the financial leverage is more, the O~ \$m`ZopÝe`b brdaoO CÀM hmoVm h¡ Vmo EBIT _|
variability of EPS increases with the variabil- hmoZo dmbo n[adV©Z H$s VwbZm _| EPS _| hmoZo dmbm n[adV©Z
ity of EBIT. The variability of EPS caused by A{YH$ hmoVm h¡Ÿ& \$m`ZopÝe`b brdaoO Ho$ Cn`moJ Ho$
the use of financial leverage is called financial H$maU EPS _| hmoZo dmbm n[adV©Z, \$m`ZopÝe`b [añH$
risk. If the firm has not borrowed money from H$hbmVm h¡Ÿ& `{X \$_© {H$gr ~mhar òmoV go CYma Zht
outside, there is no financial risk. But when debt boVr h¡ Vmo \$m`ZopÝe`b [añH$ {~ëHw$b Zht hmoJr & {H$ÝVw
is used, the firm adds financial risk. So two firms O~ G$U {b`m Om`oJm Vmo \$m`ZopÝe`b [añH$ ^r gmW _|
with same operating risk may have different Ow‹S> Om`oJrŸ& Bg H$maU {H$Ýht Xmo \$_m] H$s Am°naoqQ>J
financial risk, if they have financed their assets [añH$ g_mZ hmoVo hþE ^r CZH$s \$m`ZopÝe`b [añH$ AbJ
differently. Financial risk is, thus, an avoidable hmo gH$Vr h¡Ÿ& Bg àH$ma, \$m`ZopÝe`b [añH$ H$mo Q>mbm
risk if the firm decides not to use any debt in Om gH$Vm h¡ `{X \$_© AnZo H¡${nQ>b ñQ´>ŠMa _| {H$gr
its capital structure. ^r S>oãQ> H$m Cn`moJ Zht H$aoŸ&
Financial leverage increases the chance or \$m`ZopÝe`b brdaoO AË`{YH$ ~‹T>Zo na BÝgm°ëdoÝgr
probability of insolvency. Suppose two firms H$s g§^mdZm ~‹T> OmVr h¡Ÿ& _mZ br{OE Xmo g_mZ \$_© h¢
are identical except that one is levered and
another is not. Each firm has an expected EBIT {H$ÝVw EH$ Zo ~mhar òmoV go G$U bo aIm h¡ O~{H$ Xygam
of ` 50,000. The interest burden of levered firm ZhtŸ& àË`oH$ \$_© H$m g§^m{dV EBIT ` 50,000 h¡Ÿ&
is ` 20,000. If the actual EBIT happens to be brdaoO aIZo dmbr \$_© na ã`mO H$m ^ma ` 20,000 h¡Ÿ&
` 10,000 in one year for both firms, the levered
firm will not be able to meet its obligation to `{X {H$gr df© dmñV{dH$ EBIT Ho$db ` 10,000 hr hmoVm
pay interest. The non-levered firm's sharehold- h¡ Vmo brdaoO dmbr \$_© AnZo ã`mO H$m ^wJVmZ Zht H$a
ers still get a return of ` 10,000 (taxes are ig- gHo$JrŸ& {~Zm brdaoO dmbr \$_© Ho$ eo`a hmoëS>g© H$mo
nored). The levered firm can legally be forced ` 10,000 [aQ>Z© {_boJmŸ& {Og H$ånZr Zo G$U bo aIm h¡
into liquidation for non-payment of interest. If
the insolvency proceedings actually follow, the CgH$m ã`mO H$m ^wJVmZ Z H$a nmZo Ho$ H$maU g_mnZ
levered firm will have to incur costs in the form {H$`m Om gH$Vm h¡Ÿ& `{X g_mnZ H$s à{H$`m dmñVd _|
of liquidation fees and other legal expenses. If hmoVr h¡ Vmo brdaoO dmbr \$_© H$mo g_mnZ ì`` d AÝ`
the firm is not liquidated, it may be re-orga-
nized. During the re-organization period, its H$mZyZr ì`` ^r dhZ H$aZo hm|JoŸ& `{X \$_© H$mo g_mßV Zht
earnings will be reduced, because of the addi- {H$`m OmVm h¡ Vmo Bgo ar-Am°J}ZmBO {H$`m Om gH$Vm h¡Ÿ&