Leverage is the ability of a firm to use fixed cost assets or funds to magnify the return to its owners. There are two leverages associated with the capital structure i.e. operating leverage and financial leverage. Operating leverage exists when a firm has a t51 fixed cost that must be incurred regardless of volume of business. On the other hand, financial leverage is a mix of debt and equity in the capitalisation of the firm. In order to decide proper financial policy, operating leverage may be taken into consideration as the financial leverage is a superstructure built on the operating leverage. The operating profits i.e. earnings before interest and taxes (EBIT) serves as a function in defining these two leverages. Financial leverage represents the relationship between the firms earnings before interest and taxes and earnings available for equityholders. When there an increase in EBIT there is a corresponding increase in market price of equity shares. However, increased use of debt in the capital structure has certain limitations. If debt capital is employed in greater proportion, marginal cost of debt will also increase and share price may fall as investors may find it risky. On the other hand, in spite of increased risk, market price of shares may increase due to speculation. Therefore, before using financial leverage, its impact on Earning Per Share (EPS) must be considered. A company having higher operating leverage should use low financial leverage and vice versa otherwise, it may face problems of insolvency and inadequate liquidity. Illustration 2: GTL Ltd, a widely held company is considering a major expansion of its production facilities and the following alternatives are available: Alternatives (Rs. lakhs) A B 50 20 10 Share Capital (Rs. 10) 14% Debentures Loan from financial Institution @15% 20 15 10 25 Expected rate of return before tax is 25%. The rate of dividend of the company is not less than 20%. The company at present has low debt. Corporate tax is 30%. Which of the alternatives you would choose