Yarre, Ma. Kim Angela D.

BSBA FM 3-1
Financial Management 2

MODULE 2 LEVERAGE

CONTRIBUTION MARGIN
Contribution Margin
Contribution margin is the excess of sales over variable costs, as shown in the formula below. The measure
indicates how a particular product contributes to the overall profit of the company. It has a formula of:

Contribution Margin = Sales – Variable Costs

Contribution Margin Ratio

The contribution margin ratio, indicates the percentage of each sales dollar available to cover fixed costs and to
provide income from operations. It is computed as follows:

Contribution Margin
Contribution Margin Ratio =
Sales

DEGREE OF OPERATING LEVERAGE (DOL)

Operating Leverage
It is the extent to which fixed costs are used in firm’s operations.
Degree of Operating Leverage
It is a financial ratio that measures the sensitivity of a company’s operating income to its sales. This financial
metric shows how a change in the company’s sales will affect its operating income.
The degree of operating leverage may be computed in two ways:

Contribution Margin
Degree of Operating Leverage =
Net Operating Income

% Change in Operating Income

Degree of Operating Leverage =
% Change in Sales

Low DOL
Indicates that the company’s variable costs are larger than its fixed costs. That implies that a significant increase
in the company’s sales will not lead to a substantial increase in its operating income. At the same time, the
company does not need to cover large fixed costs.
High DOL
reveals that the company’s fixed costs exceed its variable costs. It indicates that the company can boost its
operating income by increasing its sales. In addition, the company must be able to maintain relatively high sales
to cover all fixed costs.
DEGREE OF FINANCIAL LEVERAGE (DFL)
Degree of Financial Leverage
A financial ratio that measures the sensitivity in fluctuations of a company’s overall profitability to the volatility
of its operating income caused by changes in its capital structure. The degree of financial leverage is one of the
methods used to quantify a company’s financial risk (the risk associated with how the company finances its
operations).
It is a leverage ratio that measures the sensitivity of a company’s earnings per share to fluctuations in its
operating income, as a result of changes in its capital structure. This ratio indicates that the higher the degree of
financial leverage, the more volatile earnings will be. The use of financial leverage varies greatly by industry
and by the business sector. It has a formula of:

EBIT
Degree of Financial Leverage =
EBIT - Interest

DEGREE OF TOTAL LEVERAGE

Leverage
It is a financial ratio of a Company’s debt or borrowed capital to its equity capital. Leveraging is a strategy of
borrowing money for a company’s operations, assuming that the returns from the operations will be higher than
the cost of the borrowed capital.
Degree of Total Leverage
It is a ratio that compares the rate of change in a company’s earnings per share (EPS) to a change in its revenues
from sales. Another way to calculate this ratio is to multiply the degree of operating leverage with the degree of
financial leverage. The degree of total leverage can also be referred to as the “degree of combined leverage”
because it considers the effects of both operating leverage and financial leverage. It has a formula of:

% Change in EPS
Degree of Total Leverage =
EBIT - Interest

Or
DTL = DOL x DFL
Where:
DOL= Degree of Operating Leverage
DFL= Degree of Financial Leverage

Components of the Degree of Total Leverage

Operating leverage
This part of a company’s fixed costs reveals how effectively revenue from sales is translated into operating
income. A business with a high level of operating leverage can increase its bottom line significantly with just a
relatively small increase in revenues because it has effectively leveraged its operating costs so as to maximize
profits.
Financial leverage
Financial leverage is a metric used to evaluate the extent to which a company uses debt to increase its assets and
net income. Examining a company’s financial leverage shows the impact on earnings per share of changes in
EBIT that result from taking on additional debt.
HAMADA EQUATION
Hamada Equation
It is a fundamental analysis method of analyzing a firm's cost of capital as it uses additional financial leverage,
and how that relates to the overall riskiness of the firm. This equation distinguishes the financial risk with the
business risk of a levered firm. A levered firm’s capital structure consists of both equity and debt. Unlevered
firms are firms that are financed by only equity. Hamada Formulas:

βL = βU [ 1+ (1-T) (D/E)] βU = βL / [ 1+ (1-T) (D/E)]

Where,
βL = Levered Beta
βU = Unlevered Beta
T = Tax rate
D/E = Debt to equity ratio.

Components of the Hamada Formula

Levered Beta calculates the risk associated with the proposed capital structure/funding pattern of the business
at various levels or composition of debt and equity.
Unlevered Beta calculates the risk with a capital structure not comprising any debt.
Debt to Equity Ratio shows the contribution, composition, and relationship of both these sources of finance –
equity and debt. The funding of the business happens through these two sources in one or the other form.

The Difference Between Hamada Equation and Weighted Average Cost of Capital (WACC)
The Hamada equation is part of the weighted average cost of capital (WACC). The WACC involves un-levering
the beta to relever it to find an ideal capital structure. The act of releveling the beta is the Hamada equation. So
this means the Hamada Equation is only a part of WACC.