2015, Study Session # 11, Reading # 37

MEASURE OF LEVERAGE
Q = Units Sold
V = Variable Cost per Unit
DFL = Degree of Financial
Leverage
DTL = Degree of Total Leverage

C =
F =
P =
DOL =

1. INTRODUCTION
Leverage use of fixed cost in companys cost structure.
Fixed cost

Operating fixed cost

Financial fixed cost

Analysts use fixed costs as leverage, leverage magnifies earnings both
and
.

Three reasons why analyst must understand a companys use of leverage:
o Degree of Leverage is important in assessing companys risk and return.
o Exact information about companys business and future prospects about
operating and financial leverage.
o Understanding leverage helps in assessing companys cash flows &
selecting appropriate discount rate.

Total leverage is the sensitivity of to a given % change in unit sold.

2. LEVERAGE
COST STRUCTURE
Fixed cost

Same expense regardless of production / sales

Salaries, rent, interest on debt etc.

Variable cost

Fluctuate with level of production

Purchase, shipping, delivery charges etc.

Companys valuation is affected by the degree of leverage.

Leverage
risk and
discount factor.

Leverage
chances of significant losses in downturn financial distress and bankruptcy.
Companies with same earnings may not have same valuation due to difference in leverage.

Reference (Curriculum level I Volume 4 Page No. 81 Reading 38)

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Fixed Financial Cost

Fixed Operating Cost
Price per Unit
Degree of Operating
Leverage

2015, Study Session # 11, Reading # 37

3. BUSINESS RISK AND FINANCIAL RISK

3.1 Business Risk and Its Components

Business risk

Associated with operating earnings

Operating Risk

Operating earnings risk due to risky revenues

Associated with cost structure

Uncertainty about prices of goods & services offered

Uses fixed cost of operation

Different sales than expected

Fixed cost relative to variable cost

Sales risk

Operating risk

Economic condition
Industry dynamics
Government regulation
Demographics

3.2 Sales risk

3.3 Operating Risk

Associated with operating earnings.

Companies having same cost structure with
differing sales risk will affect variability of
companys profitability.

Combination of variable cost & fixed cost

Fixed cost,
difficulties for business to adjust operating cost to in
sales.
%   



 =
%    

Relatively similar concept as elasticity in economics

DOL is dependent on level of units sold being considered

Operating Income
= Q (P-V)-F

Per unit contribution margin = amount of each unit sold covering fixed cost
=PV

Contribution Margin
= Q ( P V)
= Units sold per unit contribution margin
= Revenue Total Variable Cost
()


 =
 

Management has more opportunity to manage & control operating risk than
sales risk.

Sales risk is usually same irrespective of what equipment is used to produce
the product.

Analysts consider how operating cost structure affects companys risks.

Industries having
operating leverage focus on investing up front to
produce the product.

Retailers having  operating leverage more variable cost in cost of sales.

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2015, Study Session # 11, Reading # 37

3.4 Financial Risks

Owning Securities

Variability of operating earnings

Having claims in business

Cash paid to claimants

Income

Assets

Fixed financial cost

Variable financial
cost

Creditors/lenders

Shareholders

How company finances its operations

Debt or lease payments
financial risk
variability in NI

 =

%  
%   !"#$% &'!

 = =

DFL is not affected by tax rate.

DFL is different at different levels of operating income.
DFL can be managed & in control of management.
Companies with
investment in tangible assets
financial leverage.

DFL
ROE (only favorable for profitable company)

DFL
Risk of ownership of stakeholders

DFL
Chances of default.

3.5 Total Leverage

It is the combined effect of operating & financial leverage.

Degree of total leverage (DTL) = DOL DFL
It tells about the total risk associated with future cash flows.
Management considers it as it tells about how it would increase owners wealth.

DTL = sensitivity of cash flows to in no. of units produced & sold

%  
% (')!" * ($+ +,1./ 0 2
./ 0
=

1./ 0  32
./ 0 
. / 0
=
./ 0  3

Both fixed operating & financial costs
variability of earnings to owners.
=

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2015, Study Session # 11, Reading # 37

3.6 Breakeven Points & Operating Breakeven Points

QBE (Breakeven Point) revenues - costs & NI = 0

PQ = VQ + F+ C
PQBE = VQBE +F+C
QBE = F+C / (P-V)
QOBE (Operating breakeven point) revenues - operating cost & operating profit =0
PQ0BE = VQOBE + F
QOBE = F / (P-V)

Breakeven points for companies with  Op. & Fin. leverage are less important & vice versa.

Greater total leverage
revenue to meet fixed cost (F&C).

Reference (Curriculum level I Volume 4 Page No. 96 Reading 38)

3.7 The Risk of Creditors & Owners

The risk of equity capital and debt capital differs.

Lenders have prior claim as compared to shareholders.
Unable to pay contractual payments may cause business to go bankrupt.
In US negotiated reorganization allow business to re-organize and continue to
exist.
Non-viable businesses are liquidated (2nd stage of bankruptcy).
Difference b/w re-organization & liquidation is often due to difference between
after to operating & financial leverage.

Operating leverage gives less flexibility in making changes.

Financial leverage companies use bankruptcy laws and protection to
change their capital structure.
Investors / owners avoid companies going towards bankruptcy but evaluate
opportunities among companies already in bankruptcy.
Debtholders get a portion of their capital but payments are delayed (both
interest + capital) during period of bankruptcy protection.

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