LOS a Define/Explain/Classify Measures of Leverage

Definitions
Leverage: Effect of fixed elements in cost structure
 Operating leverage: Fixed operating expenses
Corporate Finance (2)  Financial leverage: Fixed financing costs

Business risk: Variability in EBIT, affected by

Measures of Leverage operating leverage
Financial risk: Variability of EPS from fixed interest
costs of debt financing
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LOS b Calculate/Interpret Measures of Leverage LOS b Calculate/Interpret Measures of Leverage

Degree of Operating Leverage (DOL) Degree of Operating Leverage (DOL)

% change in EBIT Example: Firm produced 5,000 units last year, fixed
Definition/Interpretation: DOL = costs were $70,000, selling price was $75, and
% change in sales variable unit cost was $50. What was the firm’s DOL at
sales − TVC 5,000 units?
Calculation: DOL =
sales − TVC − fixed Sales − TVC Q(P − VUnit )
DOL = =
Sales − TVC − Fixed Q(P − VUnit ) − Fixed
When fixed costs are zero, DOL = 1, there is no
operating leverage: %∆ EBIT = %∆ sales 5,000(75 − 50)
= = 2.27
5,000(75 − 50) − 70,000
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LOS b Calculate/Interpret Measures of Leverage LOS b Calculate/Interpret Measures of Leverage

Degree of Financial Leverage (DFL) Degree of Financial Leverage (DFL)

% change in EPS Example: A firm has EBIT of $55,000 and interest
Definition/Interpretation: DFL =
% change in EBIT expense of $20,000. If EBIT increases by 3%, what
will be the effect on earnings per share?
EBIT
Calculation: DFL = 55,000
EBIT − interest DFL = = 1.57
55,000 − 20,000
When fixed financing costs are zero, DFL = 1, there EPS will increase by 3% × 1.57 = 4.71%
is no financial leverage: %∆ EPS = %∆ EBIT
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LOS b Calculate/Interpret Measures of Leverage LOS b Calculate/Interpret Measures of Leverage

Degree of Total Leverage (DTL) Degree of Total Leverage (DTL)

% change in EPS Example: Sales last year $375,000, TVC of $250,000,
DTL = DTL = DOL × DFL fixed costs of $70,000, and interest expense of $20,000.
% change in sales
Calculate DTL.
sales – TVC
Q(P – V) DTL =
DTL= Two sources sales – TVC – fixed – interest
Q(P – V) – fixed – interest of leverage
375,000 – 250,000
= = 3.57
sales – TVC 375,000 – 250,000 – 70,000 – 20,000
=
sales – TVC – fixed – interest DOL × DFL = DTL; 2.27 × 1.57 = 3.57
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LOS c Analyze Measures of Leverage LOS c Analyze Measures of Leverage

Firm Characteristics and Leverage Financial Leverage Example

With no financial leverage:
Three rules of leverage:
Expected EBIT EBIT +10% EBIT –10%
1. High fixed costs = high operating leverage EBIT $80,000 $88,000 $72,000
Interest expense at 6% 0 0 0
2. High debt ratio = high financial leverage EBT 80,000 88,000 72,000
Taxes at 40% 32,000 35,200 28,800
3. High fixed costs + high debt ratio Net income 48,000 52,800 43,200
= high total leverage Shareholders’ equity $500,000 $500,000 $500,000
ROE 9.60% 10.56% 8.64%

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LOS c Analyze Measures of Leverage LOS d Calculate/Determine Measures of Leverage

Financial Leverage Example Breakeven Quantity of Sales

With 50% financial leverage: Breakeven quantity is the level of sales at which a
Expected EBIT EBIT +10% EBIT –10% firm’s net income is zero
EBIT $80,000 $88,000 $72,000 Total fixed costs
Interest expense at 6% 15,000 15,000 15,000 QBE =
Price − Variable cost per unit
EBT 65,000 73,000 57,000
Taxes at 40% 26,000 29,200 22,800 Example: If P = $4; V = $3; and FC = $40,000,
Net income 39,000 43,800 34,200
what is the firm’s breakeven quantity of sales?
Shareholders’ equity $250,000 $250,000 $250,000
ROE 15.60% 17.52% 13.68% QBE = 40,000 / (4 – 3) = 40,000 units
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LOS d Calculate/Determine Measures of Leverage LOS e Calculate/Interpret Measures of Leverage

Net Income at Various Sales Levels Operating Breakeven Quantity of Sales

Example: Assume the following for a firm: Operating breakeven quantity is the level of sales
P = $4; V = $3; FC = $10,000; Int = $30,000; no taxes that just covers a firm’s fixed operating costs
Fixed operating costs
What is the firm’s net income at sales levels of QOBE =
55,000 units and 35,000 units? Price − Variable cost per unit
NI = Q(P – V) – fixed costs – interest = Example: P = $4, V = $2, FC = $80,000
55,000(4 – 3) – 10,000 – 30,000 = $15,000 QOBE = 80,000 / (4 – 2) = 40,000 units
35,000(4 – 3) – 10,000 – 30,000 = –$5,000
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