Corporate Finance Chapter4

CHAPTER 4
MEASURES OF LEVERAGE
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Presenters title
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1. INTRODUCTION
Leverage is the use of fixed costs in a companys cost structure.
- Operating leverage relates to the companys operating cost structure.
- Financial leverage relates to the companys capital structure.
Copyright 2013 CFA Institute 2
Fixed
Costs
Fixed
Costs
WHY WORRY ABOUT LEVERAGE?
1. A companys use of leverage affects its risk and return.
2. Operating leverage and financial leverage provide insight into a companys
business and its future.
3. Leverage helps us understand a companys future cash flows and the risk
associated with those cash flows and, hence, its valuation.
2. LEVERAGE
Leverage increases the volatility of earnings and cash flows hence, it
increases risk to suppliers of capital (creditors and owners).
Consider two companies, Company One and Company Two, with the following
information:

Company
One
Company
Two
Number of units produced and sold 1,000 1,000
Sales price per unit 250 250
Variable cost per unit 125 25
Fixed operating cost 50,000 100,000
Fixed financing expense 5,000 55,000
Debt 50,000 550,000
Equity 700,000 200,000
Total assets 750,000 750,000
WHAT DOES LEVERAGE DO EXACTLY?
- 150,000
- 100,000
- 50,000
0
50,000
100,000
150,000
200,000
Net
Income
Number of Units Produced and Sold
Company One Company Two
Company Two uses more operating and financial leverage than Company One.
3. BUSINESS RISK AND FINANCIAL RISK
Business risk is the risk associated with the volatility in operating earnings.
- Business risk is composed of both operating and sales risk.
Sales risk is the uncertainty associated with the number of units produced and
sold, as well as the sales price.
Business
Risk
Sales
Risk
Operating
Risk
OPERATING RISK
Operating risk is the risk associated with the mix of variable and fixed
operating expenses.
- Operating risk is the sensitivity (i.e., elasticity) of operating earnings to
changes in unit sales.
The degree of operating leverage (DOL) is the ratio of the percentage
change in operating income to the percentage change in units sold.
The per unit contribution margin is the difference between the sales price
and the variable cost per unit. This difference is available to cover fixed
operating costs.
- Overall, for all units sold, the contribution margin is the difference between
total revenues and variable operating costs.

DOL
The DOL is at Q units produced and sold:

DOL=
Q (P V)
Q P V F
(4-2)
where
Q is the number of units
P is the price per unit
V is the variable operating cost per unit and
F is the fixed operating cost
EXAMPLE: COMPANY ONE AND COMPANY TWO
COMPANY ONE

DOL
1,000
=
1,000(250 125)
1,000 250 125 50,000

DOL
1,000
=
125,000
75,000

DOL
1,000
= 1.667%
COMPANY TWO

DOL
1,000
=
1,000 (250 25)
1,000 250 25 100,000

DOL
1,000
=
225,000
125,000

DOL
1,000
= 1.800

FINANCIAL RISK
Financial risk is the risk associated with the choice of financing the business.
- The greater the reliance on fixed-cost obligations, such as debt, the greater
the financial risk.
- Similar to operating risk, financial risk elasticity is the sensitivity of income
available to owners to a change in operating earnings.
The degree of financial leverage (DFL) is the ratio of the percentage change
in net income to the percentage change in operating income.
DFL
At a specific level of operating earnings (and, therefore, Q):
DFL=
Q(P V) F
Q P V F C
(4-4)
where Q, P, V, and F are as before, and C is the fixed financial cost.
C
o
m
p
a
n
y

O
n
e

DFL
1,000
=
1,000(250 125) 50,000
1,000 250 125 50,000 5,000

DFL
1,000
=
75,000
70,000

DFL
1,000
= 1.071%
C
o
m
p
a
n
y

T
w
o

DFL
1,000
=
1,000(250 25) 100,000
1,000 250 25 100,000 55,000

DFL
1,000
=
125,000
70,000

DFL
1,000
= 1.786%

RETURN ON EQUITY AND THE DFL
The greater the degree of financial leverage, the greater the financial risk.
We can see the leveraging effect by looking at the return on equity (ROE) for
different levels of units produced and sold.
The greater the DFL, the more sensitive the ROE is to changes in the units
produced and sold.
EXAMPLE: RETURN ON EQUITY
Consider the example of Company One and Company Two:

-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
Return on
Equity
Units Produced and Sold
Company One Company Two
DEGREE OF TOTAL LEVERAGE
Total leverage is the combined effect of operating leverage and financial
leverage.
The degree of total leverage (DTL) is the product of the degree of operating
leverage and the degree of financial leverage:
DTL =
Q(P V)
Q P V F C
(4-6)
Or, equivalently:
DTL = DOL DTL
If DOL is 3 and DFL is 2, DTL = 2 3 = 6.
- So, a 1% change in the units produced and sold results in a 6% change in
the earnings to owners.

C
o
m
p
a
n
y

O
n
e

DTL
1,000
=
1,000(250 125)
1,000 250 125 50,000 5,000

DFL
1,000
=
125,000
70,000

DFL
1,000
= 1.786
C
o
m
p
a
n
y

T
w
o

DTL
1,000
=
1,000(250 25)
1,000 250 25 100,000 55,000

DFL
1,000
=
225,000
70,000

DFL
1,000
= 3.214

BREAKEVEN QUANTITY
The breakeven point (Q
BE
) is the level of units produced and sold at which the
costs (both variable and fixed) are just coveredthat is, net income is zero.
The breakeven point is
=
+

(4-7)
The operating breakeven point (Q
OBE
) is the level of units produced and sold
at which the operating costs are covered.

C
o
m
p
a
n
y

O
n
e

Breakeven=
55,000
250 125
= 440 units

Operating breakeven=
50,000
250 125
= 400 units
C
o
m
p
a
n
y

T
w
o

Breakeven=
155,000
250 25
= 689 units

Operating breakeven=
100,000
250 25
= 444 units

RISKS TO CREDITORS AND OWNERS
Business risk is affected by demand uncertainty, output price uncertainty, and
cost uncertainty.
Financial risk adds to the companys business risk, increasing the risk to
creditors and owners.
The creditor claims are fixed, whereas the equity claims are residual.
In the event that creditor claims cannot be satisfied, there may be legal
statuses that help sort out the claims:
- Reorganization is the restructuring of claims, with the expectation that the
company will be able to continue, in some form, as a going concern.
- Liquidation is the situation in which assets are sold and then the proceeds
distributed to claimants.
4. SUMMARY
Leverage is the use of fixed costs in a companys cost structure.
Business risk is the risk associated with operating earnings and reflects
- sales risk (uncertainty with respect to the price and quantity of sales) and
- operating risk (the risk related to the use of fixed costs in operations).
Financial risk is the risk associated with how a company finances its operations
(i.e., the split between equity and debt financing of the business).

SUMMARY (CONTINUED)
The degree of operating leverage (DOL) is the sensitivity of operating earnings
to changes in units produced and sold.
The degree of financial leverage (DFL) is the sensitivity of cash flows to
owners to changes in operating earnings.
The degree of total leverage (DTL) is the sensitivity of the cash flows to owners
to changes in unit sales.
The breakeven point, Q
BE
, is the number of units produced and sold at which
the companys net income is zero.
The operating breakeven point, Q
OBE
, is the number of units produced and sold
at which the companys operating income is zero.


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