Leverage
• The use of fixed charge obligations with the
goal of enhancing returns to the firm (while
also exposing the firm to additional risks.)
• Two types of leverage
– Operating leverage (depends on use of fixed
operating costs—Plant &Equipment, salaries,
etc.);
– Financial leverage (depends on use of fixed
financing costs--interest)
Operating Leverage (OL) and Financial
Leverage (FL) are Manifest in the
Income statement as FC and I
Income Statement
Sales (aka Revenue)
less Variable Costs (aka Cost of Goods Sold--COGS)
OL--> less Fixed Costs (Admin & Selling expenses)
=Operating Income (aka Earnings Before Interest and Taxes--EBIT)
FL--> less Interest
=Taxable Income (aka Earnings Before Taxes--EBT)
less Taxes
=Net Income (aka Earnings After Taxes--EAT)
Why do we care about leverage?
Consider a sole proprietor making and selling baskets by the road...
BasketWeaver, Inc.
Quantity Sold 5 100 18 30
Price 5 5 5 5
Variable Cost 1 1 1 1
Fixed Costs 0 100 100 100
Income Statement
$ Sales 25 500 90 150
-VC 5 100 18 30
-FC 0 100 100 100
EBIT 20 300 -28 20
…
To calculate BEQ generally,
We know that TC=TR at BEQ.
Therefore,
(VC X BEQ) + FC = P X BEQ
Solving for BEQ, we get
BEQ = FC/(P-VC)
In our case, that means
BEQ=100/(5-1)=25
Quantifying Operating Leverage and
Financial Leverage
• The Degree of Operating Leverage (DOL) is calculated as
DOL=(Sales-VC)/EBIT
– What does a higher DOL indicate? (consider the next slide)
•
– What is the lowest we would expect DOL to be and when would we see
that?
•
– DOL can be used to forecast EBIT as follows:
• (%change in EBIT)=DOL X (% change in Sales)
• The Degree of Financial Leverage (DFL) is calculated as
DFL=EBIT/(EBIT-I)
– What does a higher DFL indicate? (consider the slide after next)
•
– What is the lowest we would expect DFL to be and when would we see
that?
•
– DFL can be used to forecast NI as follows:
• (% change in NI)=DFL X (% change in EBIT)
Consider two firms: LOL and HOL
Calculate and compare the relative levels of DOL
and the impact of operating leverage on EBIT
(double click on spreadsheet)
Exhibit 1
LOL Corp HOL Corp NOL Corp
100 110 100 110 100 110
50 55 10 11 60 66
10 10 50 50 0 0 0
40 45 40 49 40 44
Consider two more firms: LFL and HFL
Calculate and compare the relative levels of DFL
and the impact of financial leverage on NI
Exhibit 2
LFL Corp HFL Corp NFL
Income Statement
(Sales
-COGS
-FC)
EBIT 100 110 100 110 100
-Interest 5 5 30 30
Your Assignment:
• For your firm:
– Calculate your DOL, DFL, and debt ratio
– Compare them to industry norms (your
teammates)
– Choose a new debt ratio you could move to
• Indicate specific steps you would take to get
to new ratio, and
• Indicate the impact this change would have
on the risk/return profile of the firm