LEVERAGE AND CAPITAL STRUCTURE

LEVERAGE = USE OF FIXED COSTS TO

MAGNIFY RETURNS TO FIRM'S OWNERS

3 TYPES OF LEVERAGE-
• OPERATING LEVERAGE
• FINANCIAL LEVERAGE
• TOTAL LEVERAGE

1. OPERATING LEVERAGE
MEASURES THE CHANGE IN EBIT FOR A GIVEN
CHANGE IN SALES;
CAUSED BY FIXED OPERATING COSTS

REMEMBER BREAKEVEN ANALYSIS?

BREAK EVEN = FIXED OPERATING COSTS

POINT PRICE-VARIABLE COSTS

e.g.
 OPERATING LEVERAGE

% ∆ SALES - 50% BASE +50%

SALES (UNITS) 1000 2000 3000
SALES ($) $10000 $20000 $30000
LESS: VC -5000 -10000 -15000
LESS: FC -5000 -5000 -5000

EBIT 0 5000 10000

% ∆ EBIT -100% BASE +100%

FIXED COSTS MAGNIFY THE IMPACT OF A

CHANGE IN SALES ON EBIT

DEGREE OF OPERATING = % ∆ EBIT

LEVERAGE (DOL) % ∆ SALES

AND AS FIXED COSTS GO UP, BREAKEVEN POINT

AND DEGREE OF OPERATING LEVERAGE GO UP
OPERATING LEVERAGE AND FIXED COST INCREASES

% ∆ SALES - 50% BASE +50%

SALES (UNITS) 1000 2000 3000

SALES ($) $10000 $20000 $30000
LESS: VC ($4.50) -4500 -9000 -13500
LESS: FC -6000 -6000 -6000
EBIT -500 5000 10500

% ∆ EBIT -110% BASE +110%

DOL = % ∆ EBIT =
% ∆ SALES

2. FINANCIAL LEVERAGE
MEASURES THE CHANGE IN EPS FOR A GIVEN
CHANGE IN EBIT;
CAUSED BY FIXED FINANCIAL COSTS

FIXED FINANCIAL COSTS MAGNIFY THE IMPACT

OF CHANGES IN EBIT ON EPS
 FINANCIAL LEVERAGE

% ∆ EBIT - 100% BASE +100%

EBIT $ 0 $ 5000 $10000

LESS: INTEREST -1000 -1000 -1000
PROFIT B4 TAX -1000 4000 9000
LESS: TAX@ 40% +400 -1600 -3600
PROFIT AFTER TAX -600 2400 5400
LESS: PREFERRED
STOCK DIVIDENDS -400 -400 -400
EARNINGS TO COMMON
SHAREHOLDERS -1000 2000 5000
EPS (1000 shares) -$1.00 $2.00 $5.00

% ∆ EPS -150% BASE +150%

DEGREE OF FINANCIAL = % ∆ EPS

LEVERAGE (DFL) % ∆ EBIT

e.g.

3. TOTAL LEVERAGE
 COMBINES EFFECTS OF USING FIXED OPERATING
AND FINANCIAL COSTS TO MAGNIFY IMPACT OF
CHANGES IN SALES ON EPS
DEGREE OF %∆ EBIT X %∆ EPS = %∆ EPS
TOTAL = %∆ SALES %∆ EBIT %∆ SALES
LEVERAGE
(DTL)
e.g.

DIFFERENT FIRMS CHOOSE DIFFERENT LEVELS OF

OPERATING AND FINANCIAL LEVERAGE,
ƒ (WILLINGNESS OF FIRM TO TAKE RISK)
FIRM ⇒ MAINTAIN LEVEL OF LEVERAGE
CONSISTENT WITH CAPITAL STRUCTURE THAT
MAXIMIZES SHARE VALUE
VALUE MAXIMIZED WHEN COST OF CAPITAL IS
MINIMIZED
RESULT = OPTIMAL CAPITAL STRUCTURE
OPTIMAL CAPITAL STRUCTURE BALANCES RISK AND
RETURN TO MAXIMIZE OWNER WEALTH.