EFFECTS OF OPERATING LEVERAGE AND FINANCIAL Determining the Optimal Capital Structure

LEVERAGE
Initially, EPS will rise as the use of debt increases, at
some point EPS will reach its peak. Beyond this point,
OPERATING LEVERAGE interest rates will rise so fast that EPS is depressed in
-the degree to which a firm uses fixed costs in its spite of the fact that the number of shares
production processes. outstanding is falling. Expected stock price likewise
will initially increase with financial leverage, will then
 The higher the firm’s operating leverage, the reach a peak and finally will decline.
higher the business risks.

DEGREE OF OPERATING LEVERAGE

Illustrative Case:
-the percentage change in operating income or EBIT that
results from a given percentage change in sales.
Brown Products is a new firm just starting operations.
 A high degree of operating leverage other things The firm will produce backpacks which will sell for
held constant, means that a relatively small P22.00 per piece. Fixed costs are P500,000 per year
change in sales will result in a large change in and variable costs are P2.00 per unit of production.
operating income. The company expects to sell 50,000 backpacks per
FORMULA: year, and its effective tax rate is 40%. Brown needs
P2,000,000 to build facilities, obtain working capital,
DOL: Percentage change in EBIT and start operations. If Brown borrows part of the
Percentage change in Sales money, the interest charges will depend on the
amount borrowed as follows:
Or
DOL: Contribution Margin Amount borrowed % of Debt in Capital Structure Interest Rate

EBIT 200,000 10% 9.00

400,000 20% 9.50
FINANCIAL LEVERAGE 600,000 30% 10.00
-refers to the firm’s use of fixed charge securities such 800,000 40% 15.00
1,000,000 50% 19.00
as debt and preference share in its capital structure. 1,200,000 60% 26.00

 Financial leverage will cause EPS to rise if the Assume that stock can be sold at a price of P20 per
return on assets is greater than the cost of share on the initial offering, regardless of how much
debt. debt the company uses. Then after the company
begins operating, its price will be determined as a
DFL: EBIT multiple of its earnings per share. The multiple (or the
EBIT-Interest P/E ratio) will depend upon the capital structure as
follows:
To compute the effect on income available to
ordinary shareholders: Debt/Assets P/E
0.0 12.5
“Multiply the Percentage of Change in EBIT by DFL” 10.0 12.0
20.0 11.5
DEGREE OF TOTAL LEVERAGE 30.0 10.0
In summary, operating leverage and financial 40.0 8.0
leverage are interrelated. A reduction in operating 50.0 6.0
leverage would normally lead to an increase in the 60.0 5.0
optimal amount of financial leverage, while an
increase in operating leverage would lead to a Required:
decrease in the optimal amount of debt.
1. What is Brown’s optimal capital structure, which
FORMULA: maximizes stock price, as measured by the
debt/assets ratio?
DTL: Contribution Margin 2. What is Brown’s DOL at the expected level of
EBIT- Interest sales?
3. What is Brown’s DFL at the expected level of
Or sales?
4. What is Brown’s DTL at the expected level of sales
DTL: (DOL) (DFL) and optimal structure?