CFA Level I Corporate Finance

Measures of Leverage

www.irfanullah.co

1
 Contents
1. Introduction

2. Leverage

3. Business and Financial Risk

www.irfanullah.co 2
 1. Introduction
Leverage is the use of fixed costs in a companys cost structure

Operating fixed costs operating leverage

Financial fixed costs financial leverage

For highly leveraged firms a small change in sales will have a big impact on
earnings

www.irfanullah.co 3
 2. Leverage
Consider two companies, HL and LL, with the same revenue and net income but a
different cost structure.
Operating Performance Income Statement
HL LL HL LL
Number of units sold 100 100 Revenue 100 100
Sales price per unit 1 1 Operating costs 70 75
Variable cost per unit 0.2 0.6 Operating income 30 25
Fixed operating cost 50 15 Financing expense 10 5
Fixed financing cost 10 5 Net income 20 20

How is the cost structure different?

What is the impact on net income if sales numbers change?

www.irfanullah.co 4
 Impact of Leverage
Net
Income
HL LL
Number of units sold 100 100
Sales price per unit 1 1
Variable cost per unit 0.2 0.6 Number of Units Sold
Fixed operating cost 50 15
Fixed financing cost 10 5

Leverage increases volatility of a companys earnings and cash flows and also increases the risk of lending
to or owning a company. The valuation of a company and equity is affected by the degree of leverage.

High High Discount

High Risk
Leverage Rate

www.irfanullah.co 5
 3. Business and Financial Risk

Sales risk: variability in profits due to uncertainty of

sales price and volume
Business Risk
Operating risk: risk due to operating cost structure
(fixed vs. variable costs)

Financial risk: risk due to debt financing

www.irfanullah.co 6
 Operating Risk
Degree of Operating Leverage (DOL) is a quantitative measure of operating risk
DOL = % change in operating income / % change in sales
It can be shown that DOL = Q (P V) / [Q (P V) F]
Example: Compute the DOL for HL and LL

HL LL
Number of units sold (Q) 100 100
Sales price per unit (P) 1 1
Variable cost per unit (V) 0.2 0.6
Fixed operating cost (F) 50 15
Fixed financing cost (C) 10 5

Example 1

www.irfanullah.co 7
 Financial Risk
Degree of Financial Leverage (DFL) is a quantitative measure of financial risk
DFL = % change in net income / % change in operating income
It can be shown that DFL = [ Q (P V) F ] / [Q (P V) F C]
Example: Compute the DFL for HL and LL

HL LL
Number of units sold (Q) 100 100
Sales price per unit (P) 1 1
Variable cost per unit (V) 0.2 0.6
Fixed operating cost (F) 50 15
Fixed financing cost (C) 10 5

Example 2

www.irfanullah.co 8
 Effect of Financial Leverage on NI and ROE
High leverage leads to higher ROE volatility and potentially higher ROE levels
This is illustrated through a simple example

Assets = 200, Equity = 200 Assets = 200, Equity = 100,

Tax = 0% Debt = 100, Interest = 10%

EBIT NI ROE NI ROE

0 0 0 -10 -10%

20 20 10% 10 10%

40 40 20% 30 30%

60 60 30% 50 50%

80 80 40% 70 70%

Example 3
www.irfanullah.co 9
 Total Leverage
Degree of Total Leverage (DTL) combines DOL and DFL
DTL = % change in net income / % change in units sold
It can be shown that DTL = DOL x DFL = Q (P V) / [Q (P V) F C]
Example: Compute the DTL for HL and LL

HL LL
Number of units sold (Q) 100 100
Sales price per unit (P) 1 1
Variable cost per unit (V) 0.2 0.6
Fixed operating cost (F) 50 15
Fixed financing cost (C) 10 5

Example 4

www.irfanullah.co 10
 Breakeven Points and Operating Breakeven Points
Breakeven point: number of units produced and sold at which NI = 0
QBE = [F + C] / [P V]

Operating breakeven point: number of units produced and sold at which EBIT = 0
QOBE = F / [P V]
What are the break-even points for HL and LL?
HL LL
Sales price per unit (P) 1 1
Variable cost per unit (V) 0.2 0.6
Fixed operating cost (F) 50 15
Fixed financing cost (C) 10 5 What are the operating break-even points?

Example 5
www.irfanullah.co 11
 Summary
DOL = % change in operating income
% change in sales

DFL = % change in net income High financial leverage leads to higher ROE
% change in operating income volatility and potentially higher ROE levels

DTL = % change in net income DTL = DOL x DFL

% change in sales

QBE = [F + C] / [P V] QOBE = F / [P V]

www.irfanullah.co 12
 Conclusion
Read summary

Review learning objectives

Examples are good

Practice problems: good but not enough

Practice questions from other sources

www.irfanullah.co 13