Financial Management

Class #6
…………………………………………………………………

Jimmi Sinton
Te a c h i n g S e r i e s
6-14 Financial Leverage

Topics LEVERAGE
Materials KEUANGAN
Covered
………… …… pengertian dan jenis leverage
leverage operasi: pengertian, menentukan tingkat DOL, analisa
BEP dalam mempelajari leverage operasi
leverage keuangan
Please read
each material hubungan leverage keuangan dengan operasi

before class menentukan tingkat leverage keuangan (DFL)

and rehearse it menentukan tingkat leverage kombinasi (DCL)
after class indifference point antara hutang dan saham biasa

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Leverage Analysis

Leverage Analysis
In physics, leverage refers to a multiplcation of a force into even larger
forces
In finance, it is similar, but we are refering to a multiplication of %
changes in sales into even larger changes in profitability measures

% ∆ Sales
% ∆ Sales
Financial

% ∆ Sales
Leverage
% ∆ Profits

FULCRUM

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Leverage Analysis

Types of Risk
There are two main types of risk that a company faces:
Business risk - the variability in a firm’s EBIT.
This type of risk is a function of the firm’s regulatory environment, labor
relations, competitive position, etc.
Note that business risk is, to a large degree, outside of the control of managers.

Financial risk - the variability in the firm’s EBT.

This type of risk is a direct result of management decisions regarding the relative
amounts of debt and equity in the capital structure

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Operating
Leverage

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Leverage Analysis - Operating Leverage

The Degree of Operating Leverage - DOL

The degree of operating leverage is directly proportional to a firm’s level
of business risk, and therefore it serves as a proxy for business risk

Refers to a multiplication of changes in sales into even larger changes in

EBIT

Note that operating leverage results from the presence of fixed costs in the
firm’s cost structure

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Leverage Analysis - Operating Leverage

OPERATING LEVERAGE
What is it? How is it Increased?

Operating leverage is:

The increased volatility in operating income caused by fixed operating costs.

Managers do make decisions affecting the cost structure of the firm.

Managers can decide to invest in assets that give rise to additional fixed costs
in intention to reduce variable costs.
Commonly accomplished by a firm choosing to become more capital
intensive and less labour intensive, thereby increasing operating leverage.

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Leverage Analysis - Operating Leverage

Operating Leverage
Advantages and Disadvantages
Advantages:
Magnification of profits to the shareholders if the firm is profitable.
Operating efficiencies (faster production, fewer errors, higher quality)
usually result increasing productivity, reducing ‘downtime’ etc.
Disadvantages:
Magnification of losses to the shareholders if the firm is not profitable.
Higher break even point
High capital cost of equipment and the illiquidity of such an investment
make it:
Expensive (more difficult to finance)
Potentially exposed to technological obsolescence, etc.

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Leverage Analysis - Operating Leverage

Calculating the DOL

The degree of operating leverage can be calculated as:

DOL with Two % E B IT

income statement: DOL
% S ales

DOL with One Q p v S ales VC

income statement: DOL
Q p v FC E B IT

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Financial
Leverage

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Capital Structure
The mix of debt, preferred stock, and common stock the firm plans to use
over the long-run to finance its operations

The proportions should be set in such a way as to balance risk/return

and thereby maximize the price of the stock

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Leverage Analysis

FINANCIAL LEVERAGE
What is it? How is it Increased?

Your textbook defines financial leverage as:

The increased volatility in operating income caused by the corporate
use of sources of capital that carry fixed financial costs.

Financial leverage can be increased in the firm by:

Selling bonds or preferred stock (taking on financial obligations with
fixed annual claims on cash flow)
Using the the debt to retire equity

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Leverage Analysis – Financial Leverage

Financial Leverage
Advantages and Disadvantages
Advantages:
Magnification of profits to the shareholders if the firm is profitable.
Lowering cost of capital to moderate levels of financial leverage, because
interest expense is tax-deductible.
Disadvantages:
Magnification of losses to the shareholders if the firm is not profitable.
Higher break even point.
At higher levels of financial leverage, the low after-tax cost of debt is offset
by other effects such as:
Present value of the rising probability of bankruptcy costs
Agency costs
Lower operating income (EBIT), etc.

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Leverage Analysis – Financial Leverage

Leverage Analysis GOOD SIDE of
Wolverine Corporation
($000)
debt
Leverage Scenarios The Degree of
1 2 3 Financial Leverage
0% Debt 50% Debt 80% Debt
(DFL)

Capital
Debt $ - $ 500 $ 800 As the firm’s debt
Equity 1,000 500 200 ratio rises, both EPS
Total $ 1,000 $ 1,000 $ 1,000
Shares @ $10 100,000 50,000 20,000
and ROE rise
Revenue $ 1,000 $ 1,000 $ 1,000 dramatically. While
Cost/expense 800 800 800 EAT falls, the
EBIT $ 200 $ 200 $ 200 number of shares
Interest (10%) 0 50 80
EBT $ 200 $ 150 $ 120
outstanding falls at a
Tax (40%) 80 60 48 faster rate as debt
EAT $ 120 $ 90 $ 72 replaces equity.
ROE 12% 18% 36%
EPS $ 1.20 $ 1.80 $ 3.60

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Leverage Analysis – Financial Leverage

Leverage Analysis BAD SIDE of
Wolverine Corporation
($000)
debt
Leverage Scenarios
The Degree of
1 2 3 Financial Leverage (DFL)
0% Debt 50% Debt 80% Debt

Capital
Debt $ - $ 500 $ 800 Wolfie is now
Equity 1,000 500 200
Total $ 1,000 $ 1,000 $ 1,000
doing rather
Shares @ $10 100,000 50,000 20,000 poorly—ROE are
Revenue $ 800 $ 800 $ 800 quite low. As the
Cost/expense 720 720 720
EBIT $ 80 $ 80 $ 80 firm adds leverage,
Interest (10%) 0 50 80 EPS and ROE
EBT $ 80 $ 30 $ -
decrease.
Tax (40%) 32 12 0
EAT $ 48 $ 18 $ -
ROE 4.8% 3.6% 0%
EPS $ 0.48 $ 0.36 $ -

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Leverage Analysis – Financial Leverage

The Degree of Financial Leverage (DFL)

The DFL is a measure of the % changes in EBT that result
from changes in EBIT, it is calculated as:

DFL with Two % EBT

income statement: D FL
% E B IT

DFL with One E B IT

income statement: D FL
EBT

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Leverage Analysis – Financial Leverage

The Degree of Combined Leverage (DCL)

The degree of combined leverage is a measure of the total leverage (both
operating and financial leverage) that a company is using:

% EB T % EB IT % EB T
DCL DOL D FL
% Sales % Sales % EB IT

It is important to note that DCL is the product (not the sum) of both DOL
and DFL

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Leverage Sa le s
Bas e Cas e
1000
Sale s Down 10% Sale s up 10%
900 1100
Analysis – Va r ia b le Costs
Fixe d Costs
450
300
405
300
495
300
Financial De p r e cia tion
EBIT
100
150
100
95
100
205
Leverage Inte r e st Exp e nse 30 30 30
EBT 120 65 175

Pe rc e ntag e Chang e s Re lative to the Bas e Cas e

Calculating
Sa le s -10.000% 10.000%
EBIT -36.667% 36.667%
EBT -45.833% 45.833%

Leverage Le ve rag e M e as ure s

Measures
Us ing a s ing le inc om e s tate m e nt:
DOL 3.67 5.21 2.95
DFL 1.25 1.46 1.17
DCL 4.58 7.62 3.46

Us ing two inc om e s tate m e nts :

DOL 3.67
DFL 1.25
DCL 4.58
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Leverage Analysis – Financial Leverage

Comparing Operating and Financial Leverage
FL and OL are similar in that both can enhance results while increasing
variation
FL involves substituting debt for equity in the firm’s capital structure
OL involves substituting fixed costs for variable costs in the firm’s cost
structure
Both substituting fixed cash outflows for variable cash outflows
Both kinds of leverage make their respective risks larger as the levels of
leverage increase
However, financial risk is non-existent if debt is not present, while business
risk would still exist even if no operating leverage existed
FL is more controllable than OL

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Leverage Analysis – Financial Leverage

Effects of Operating and Financial Leverage

Summary
Equity holders bear the added risks associated with the use of
leverage.
The higher the use of leverage (either operating or financial) the
higher the risk to the shareholder.
Leverage therefore can and does affect shareholders required rate
of return, and in turn this influences the cost of capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITAL

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Indifference Point
The level of sales at which EPS will be the same whether the firm
uses debt or equity or prefered stock

The indifference point between any two financing methods can be

expressed mathematically:

( EBIT*- I1) (1-T) (EBIT*- I2) (1-T)

=
S1 S2

I1,I2= annual interest expenses or preferred dividends on a before tax basis

S1,S2=number of common shares outstanding for methods 1 and 2.
T= tax rate

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Indifference Curve

6 Debt
5
Earnings per Share ($)

Indifference point
between debt and
4 common stock Common
financing
3

0
0 100 200 300 400 500 600 700

EBIT ($ thousands)
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EXAMPLE 1:
A company with long-term capitalization of $ 10 million consisting entirely of
common stock wishes to raise another $5 million for expansion through one of the
two possible financing plans.The company may finance with

1.All common stock

2.All debt at 9%

EBIT is $ 1,400,000 and tax rate is 50%.

200,000 shares of stock are presently outstanding.
Common stock can be sold at $ 50 per share.( 100,000 additional shares)
In this example, the hypothetical level of EBIT is $ 2million.
All Common All Debt

EBIT 2,000,000 2,000,000

Interest 0 450,000
Earnings before taxes 2,000,000 1,550,000
Taxes 1,000,000 775,000
Net Income 1,000,000 775,000
Earnings available to
Shareholders 1,000,000 775,000
Number of shares 300,000 200,000

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Indifference level of EBIT between debt and common stock financing:

( EBIT*- 0) (1-0.50)= (EBIT* –450,000) (1-0.50)
300,000 200,000

EBIT*(0.5) (200,000)= (EBIT (0.50)-450,000 (0.50)) 300,000

100,000EBIT*=135,000,000
EBIT*= $ 1,350,000

The indifference point between debt and common alternatives is at

$ 1,350,000. If EBIT is below this amount, common stock financing will give
higher EPS. If EBIT is above this amount debt financing will provide higher
EPS.

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