Leverage

By Prabath S Morawakage
Lecturer
Department of Finance
University of Kelaniya
Learning outcome
define and explain leverage, business risk, sales risk, operating
risk, and financial risk, and classify a risk, given a description;
calculate and interpret the degree of operating leverage, the
degree of financial leverage, and the degree of total leverage;
describe the effect of financial leverage on a companys net
income and return on equity;
calculate the breakeven quantity of sales and determine the
company's net income at various sales levels;
calculate and interpret the operating breakeven quantity of sales.
Leverage
Leverage results from the use of fixed cost assets or funds to magnify
returns to the owners
Increase in leverage results in increase in return and risk (High DCF)
Decrease in Leverage results in decrease in return and risk(Less DCF)
Risk associated with future earnings & cash flows of a company are
affected by the companys cost structure
VC & FC
Business Risk & Financial Risk
Business Risk- Risk associated with operating earnings
Sales Risk
Operating Risk
Financial Risk
Financial leverage is the use of debt and preferred stock.
Financial risk is the additional risk concentrated on
common stockholders as a result of financial leverage
Demand
variability
Sales price
variability
Ability to
develop
new
products
Input cost
variability
Foreign
exchange
exposure
Operating
leverage
Example of Business Risk
Suppose 10 people decide to form a corporation to manufacture
disk drives.
If the firm is capitalized only with common stock and if each
person buys 10% -- each investor shares equally in business risk
5
Example of Relationship Between
Financial and Business Risk
If the same firm is now capitalized with 50% debt and
50% equity with five people investing in debt and five
investing in equity
The 5 who put up the equity will have to bear all the
business risk, so the common stock will be twice as risky
as it would have been had the firm been all-equity
(unlevered).
6
Operating Leverage
Operating Income Elasticity
Operating leverage is the use of fixed costs rather than variable
costs
If most costs are fixed, hence do not decline when demand falls,
then the firm has high operating leverage.
Effect of operating leverage
More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
What happens if variable costs change?
Sales
Rs
Rev.
TC
FC
Q
BE
Sales
Rs
Rev.
TC
FC
Q
BE
}
Profit
8
Using operating leverage
Typical situation: Can use operating leverage
to get higher E(EBIT), but risk also increases.
Probability
EBIT
L
Low operating leverage
High operating leverage
EBIT
H
9
DOL
% change in Operating income (EBIT) that results from a given %
change in sales
Interpretation of DOL
DOL is a quantitative measure of the sensitivity of a firms
operating profit to a change in the firms sales.
The closer that a firm operates to its break-even point, the higher
is the absolute value of its DOL.
When comparing firms, the firm with the highest
DOL is the firm that will be most sensitive to a change in sale
DOL is only one component of business risk and becomes active
only in the presence of sales and production cost variability
e.g.
Calculate and interpret the DOL for A and B
Assume As sales dropped to 300,000. Comment on your observations
A B
Price $4 $4
Variable cost $3 $2
Fixed cost $40,000 $120,000
Revenue $400,000 $400,000
DFL
% change in net income or EPS to the % change in EBIT
e.g.
From the previous example As operating income for selling
100,000 units is $ 60,000. Assume that A company has an annual
interest expense of $ 18,000. If As EBIT increases by 10% by how
much will its earnings per share increases.
DTL
DTL combines the DOL and DFL