Types of Leverage

Degree of Operational Leverage (DOL)

Degree of Financial Leverage (DFL)
Degree of Combined Leverage (DCL)
DOL = Q(SP-VC)/(Q(SP-VC)-FC)
DFL = Q(SP-VC)-FC/(Q(SP-VC)-FC-IC)
DCL = Q(SP-VC)/(Q(SP-VC)-FC-IC) OR DOL x DFL

$ $
Sales Revenue xxx
Less: Variable Cost xxx
Less: Fixed Cost xxx (xxx)
Operating Income/EBIT/PBIT xxx
Less: Interest Expense (xxx)
EBT/PBT xxx
Less: Tax (xxx)
EAT/PAT xxx

Example No.1

Sales Volume 8000 units,Selling Price Per Unit $30, Variable Cost Per Unit $20, Fixed Cost $60000,
Interest Charges $10000, Tax 40%, Compnay is planning to increase sales volume by 10% next year.
Implicate the leverage consequencies
DOL = 8000(30-20)/(8000(30-20)-60000) = 4 Times
DFL = 8000(30-20)-60000/(8000(30-20)-60000-10000) = 2 Times
DCL = 8000(30-20)/(8000(30-20)-60000-10000) = 8 Times OR 4 x 2 = 8 Times

$ $ Change
Sales Volume Increase By 10% 8000 8800 10% 10%
Sales Revenue 240000 264000
Variable Cost -160000 -176000 4X
Fixed Cost -60000 -60000
Operating Income/EBIT/PBIT 20000 28000 40% 8X
Interest Expense -10000 -10000
EBT/PBT 10000 18000 2X
Tax 40% -4000 -7200
EAT/PAT 6000 10800 80% 80%

Example No.2

Sales Volume 500000 units,Selling Price Per Unit $0.45, Variable Cost Per Unit $0.25, Fixed Cost
$50000, Interest Charges $10000, Tax 40%, Compnay is plannig to increase sales volume by 20%
next year. Implicate the leverage consequencies
DOL = 500000(0.45-0.25)/(500000(0.45-0.25)-50000) = 2 Times
DFL = 500000(0.45-0.25)-50000/(500000(0.45-0.25)-50000-10000) = 1.25 Times
 DCL = 5000000(0.45-0.25)/(500000(0.45-0.25)-50000-10000) = 2.5 TImes OR 2 x 1.25 = 2.5

$ $ Change
Sales Volume Increase By 20% 5000000 6000000 20% 20%
Sales Revenue 225000 270000
Variable Cost -125000 -150000 2X
Fixed Cost -50000 -50000
Operating Income/EBIT/PBIT 50000 70000 40% 2.5X
Interest Expense -10000 -10000
EBT/PBT 40000 60000 1.25X
Tax 40% -16000 -24000
EAT/PAT 24000 36000 50% 50%

Impact on Earning Per Share

Net Income(PAT) - Preference Dividend/Number of Common Shares

Setting up a new company requires an investment of $200000. Financial

manager have three options depending on the basis of leverage.
1. Common Stock $200000.
2. Bond 8% $100000, Common Stock $100000.
3. Preferred Stock 8% $100000, Common Stock $100000.
In each case common stock will be issued at $20/share.
Expected EBIT $80000.
Tax Rate 50%.

1. Common Stock
EPS = EAT - Preference Dividend/Number of Common Shares
EPS = $40000 - $0/($200000/$20 per shares) = $4 per share

$
EBIT 80000
Less: Interest Expense 0
EBT 80000
Less: Tax 50% -40000
EAT 40000

2. Bond 8% $100000, Common Stock $100000

EPS = EAT - Preference Dividend/Number of Common Shares
EPS = $36000 - $0/($100000/$20 per shares) = $7.2 per share

$
EBIT 80000
Less: Interest Expense $100000 x 8% 8000
 EBT 72000
Less: Tax 50% -36000
EAT 36000

Preferred Stock 8% $100000, Common Stock $100000

EPS = EAT - Preference Dividend/Number of Common Shares
EPS = $40000 - $8000($100000 x 8%)/($100000/$20 per shares) = $6.4 per share

$
EBIT 80000
Less: Interest Expense 0
EBT 80000
Less: Tax 50% -40000
EAT 40000

Options Description EAT

1 Common Stock $200000 $40,000
2 Bond 8% $100000, Common Stock $100000 $36,000
3 Preferred Stock 8% $100000, Common Stock $100000 $40,000
DOL Fixed Cost
DFL Debt Finance
DCL

DOL
DFL
DCL
DOL
DFL
DCL
# of Shares EPS
10000 4
5000 7.2
5000 6.4