10/20/2022

Leverage
Financial management and control systems (Lecture 2)
Dr. Mahmoud Otaify
Assistant Professor of Finance

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Define Differentiate Calculate Calculate Measure
between degree of degree of Impact of
leverage operating and
financial operating financial Financial
leverage leverage leverage leverage

Dr. Mahmoud Otaify - FMCS: Lec. 4 Leverage

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What is Leverage?
Sales Revenues
Less: Cost of Goods Sold (COGS)
Operating
Gross Profit
Leverage
Less: Operating Exp.
Earnings Before Interest & Taxes (EBIT)
EBIT
Less: interest
Total
EBT Leverage
Less: taxes
Financial
Net income after tax
Leverage
Less: Preferred Stock Dividends
Earnings Available for Common stocks (EACS)
Divide: Number of Shares
Earnings Per shares
Dr. Mahmoud Otaify - FMCS: Lec. 4 Leverage 3

What is Leverage?
Operating Leverage
the use of fixed
costs in a
company’s cost Depreciation, rents,
structure. wages for salaried
employees

Leverage
Interest on bank
loans/bonds, preferred
Regardless sales stock dividends

Financial Leverage

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How to Calculate Degree of Leverage?

Sales Revenues
𝐷𝑂𝐿 Less: Cost of Goods Sold (COGS)
%∆ in EBIT Gross Profit
=
% ∆ 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 Less: Operating Exp.
Earnings Before Interest & Taxes (EBIT)
EBIT 𝐷𝑻𝐿
Less: interest %∆ in 𝐄𝐏𝐒
=
EBT % ∆ 𝑖𝑛 𝑺𝒂𝒍𝒆𝒔
𝐷𝑭𝐿 Less: taxes
%∆ in 𝐄𝐏𝐒 Net income after tax
=
% ∆ 𝑖𝑛 𝑬𝑩𝑰𝑻 Less: Preferred Stock Dividends
Earnings Available for Common stocks (EACS)
Divide: Number of Shares
Earnings Per shares
Dr. Mahmoud Otaify - FMCS: Lec. 4 Leverage 5

Example on Operating Leverage

 Using the data for ALEX (sales, 1000 units, sale price, P
= $10 per unit; variable operating cost, VC = $5 per
unit; fixed operating cost, FC = $2,500).
 Calculate the degree of operating leverage under the
following cases:
 Case 1: an increase in the firm’s sales increase from
1,000 to 1,500 units
 Case 2: a decrease in the firm's sales from 1,000 to 500
units
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Base Case Case 1 Case 2

Sales (in units) 1000 1,500 500
Sales revenue 1000*10=10,000 1,500*10=15000 500*10=5000
Less: Variable 1000*5=5000 1500*5=7,500 500*5=2,500
operating costs
Less: Fixed 2,500 2,500 2,500
operating costs
Earnings before 2,500 5,000 $0
interest and
taxes (EBIT)
% ∆ 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔 1500-1000/1000 = 0.5 = 50% 500-1000/1000 = -0.5
=-50%
%∆ 𝐢𝐧 𝐄𝐁𝐈𝐓 5000-2,500/2,500 = 1 =100% 0 – 2,500/2500 = -1
= -100%
%∆ 𝐢𝐧 𝐄𝐁𝐈𝐓 100 −100
𝑫𝑶𝑳 = 𝐷𝑂𝐿 = =2 𝐷𝑂𝐿 = =2
% ∆ 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔 50 −50

comment A 50% increase in sales (from A 50% decrease in sales (from 1,000 to
1,000 to 1,500 units) results in a 500 units) results in a 100% decrease
100% increase in earnings before in earnings before interest and taxes
interest and taxes (from $2,500 (from $2,500 to $0).
Dr. Mahmoud Otaify - FMCS: Lec. 4 Leverage to $5,000).
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Example on Financial Leverage

 Borg Foods, a small food company, expects EBIT of
$10,000 in the current year. It has a $20,000 bond with
a 10% (annual) coupon rate of interest and an issue of
600 shares of $4 (annual dividend per share) preferred
stock outstanding. It also has 1,000 shares of common
stock outstanding. Assume that the firm is in the 40%
tax bracket. Calculate the degree of financial leverage
under the following cases:
 Case 1 An increase in EBIT to 14,000
 Case 2 A decrease in EBIT to 6,000

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Base Case Case 1 Case 2

EBIT 10,000 14,000 6,000
Less Interest 0.1*20,000 =2000 2000 2000

EBT 8,000 12,000 4,000

Taxes (40%) 8000*0.4 12,000*0.4 = 4,800 4000*0.4 = 1600
=3,200
Net profit after taxes 4,800 7,200 2,400
Less preferred stock 4*600 2,400 2,400
dividends =2,400
Earnings available for 2,400 4,800 0
common (EAC)
Earnings per share 2,400/1000 4,800/1000 = 4.8 0/1000 = $0
(EPS) =2.4
% ∆ 𝒊𝒏 𝑬𝑩𝑰𝑻 14,000-10,000/10,000 = 40% 6000-10,000/10000 = -40%
%∆ 𝒊𝒏 𝑬𝑷𝑺 4.8-2.4/2.4 = 1 = 100% 0-2.4/2.4 = -1 = -100%
Comment A 40% increase in EBIT (from A 40% decrease in EBIT (from $10,000 to
$10,000 to $14,000) results in $6,000) results in a 100% decrease in
a 100% increase in earnings earnings per share (from $2.40 to $0).
per share (from $2.40 to
$4.80).
%∆ 𝒊𝒏 𝑬𝑷𝑺 𝟏𝟎𝟎 −𝟏𝟎𝟎
𝑫𝑭𝑳 = 𝑫𝑭𝑳 = = 𝟐. 𝟓 𝑫𝑭𝑳 = = 𝟐. 𝟓
% ∆ 𝒊𝒏 𝑬𝑩𝑰𝑻 𝟒𝟎 −𝟒𝟎
Dr. Mahmoud Otaify - FMCS: Lec. 4 Leverage
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What is risk of
Leverage?

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The greater the firm’s fixed The more fixed financing—debt

(including financial leases) and
operating costs (operating preferred stock—a firm has in its
leverage) capital structure

The higher its business risk the greater its financial risk

The risk to the firm of being The risk to the firm of being
unable to cover its operating unable to cover its financing
costs costs

Greater probability of bankruptcy

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Breakeven Point

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Operating Breakeven Point Breakeven Point

Q Q
Item Value Item Value
Fc 2500 Interest 2000
Price 10
Vc 5

Q= = = 500 Q= = = 900
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How many units to achieve profits

and pay preferred dividends
Item Value
Fc 2500 𝟏

Q
Price 10 𝟏 𝑻𝑪
Vc 5
Interest 2000
Preferred Dividends (PD) 2,400

Q = 1700
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Equity Percentage of
equity used to
E/V
capital fund the firm’s
assets

Financial Leverage
Debt Percentage of

capital
debt used to
fund the firm’s
assets
D/V
Capital Structure Decision
Capital Percentage of

Structure
debt and equity
used to fund the
firm’s assets
D/E
RD RE WACC

Financial Leverage D/E

EPS P0 V0
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Capital Structure Decision

(Debt/Equity Ratio)
Increase Debt Increase Debt
To buyback portion of
To purchase Assets
common shares outstanding

D increase and E is D increase and E decrease,

constant, D/E increase D/E increase

Capital Restructuring
Capital Raising Decision
Decision
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The Impact of Financial Leverage

financial leverage can dramatically alter the payoffs to shareholders in the firm

When we increase the amount of debt financing, we

increase the fixed interest expense

If we have a really good year, we pay our fixed costs and

we have more left over for our shareholders

If we have a really bad year, we still have to pay our fixed

costs and we have less left over for our shareholders.

we describe the impact of leverage in terms of its effects

on earnings per share, EPS, and return on equity, ROE.
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EBIT–EPS approach to Capital

Structure
The EBIT–EPS approach to capital structure involves
selecting the capital structure that maximizes EPS over the
expected range of earnings before interest and taxes (EBIT).
To analyze the effects of a firm’s capital structure on the
owners’ returns, we consider the relationship between
earnings before interest and taxes (EBIT) and earnings per
share (EPS).
In other words, we want to see how changes in EBIT lead to
changes in EPS under different capital structures.
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 The Trans Corporation currently has Capital Structure

no debt in its capital structure. The Current Proposed
CFO, Ms. Morris, is considering a
restructuring that would involve Assets $8000,000 $8000,000
issuing debt and using the proceeds
Debt $0 $4000,000
to buy back some of the outstanding
equity. Table presents both the Equity
current and proposed capital
Debt-equity ratio
structures.
Share price $20 $20
 As shown, the firm’s assets have a
market value of $8 million. Because Shares
Trans is an all-equity firm and the outstanding
price per share is $20, there are Interest rate % 10% 10%
400,000 shares outstanding.
Interest $
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Table 13.1  To investigate the impact of the

proposed restructuring, Ms. Morris has
Current Proposed prepared Table 13.2, which compares
the firm’s current capital structure to
Assets $8,000,000 $8,000,000 the proposed capital structure under
Debt $0 $4,000,000 three scenarios. The scenarios reflect
different assumptions about the firm’s
Equity $8,000,000 $4,000,000 EBIT.
Debt/Equity Ratio 0.0 1.0  Under the expected scenario, EBIT is
$1 million.
Share Price $20 $20
 In the recession scenario, EBIT falls
Shares Outstanding 400,000 200,000 to $500,000.
Interest rate 10% 10%  In the expansion scenario, it rises to
$1.5 million.
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Ignore the effect of taxes, What happens to EPS

when we issue debt and buy back shares?

CURRENT CAPITAL STRUCTURE: NO DEBT Proposed CAPITAL STRUCTURE: With DEBT

Recession Expected Expansion Recession Expected Expansion

EBIT 500,000 1000000 1,500,000 EBIT 500,000 1000000 1,500,000

Interest 0 0 0 Interest 400,000 400,000 400,000

Net 500,000 1,000,000 1,500,000 Net 100,000 600,000 1,100,000

income income
EPS $0.5 $3.00 $5.5
EPS $1.25 $2.5 $3.75
Variability EPS ranges from $0.50 to $5.50
Variability EPS ranges from $1.25 to $3.75

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Choosing Capital Structure

In the no-debt case
𝑬𝑩𝑰𝑻 𝑬𝑩𝑰𝑻
 𝑬𝑷𝑺 = , 𝑬𝑷𝑺 =
# 𝒔𝒉𝒂𝒓𝒆𝒔 𝟒𝟎𝟎,𝟎𝟎𝟎
In the with-debt case
𝑬𝑩𝑰𝑻 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝑩𝑰𝑻 𝟒𝟎𝟎,𝟎𝟎𝟎
 𝑬𝑷𝑺 = , 𝑬𝑷𝑺 =
# 𝒔𝒉𝒂𝒓𝒆𝒔 𝟐𝟎𝟎,𝟎𝟎𝟎

Level of EBIT EPS

Current CS Proposed CS
(No Debt) (with debt)
$0 0 -2
$400,000 1 0
$800,000 2 2
$1,200,000 3 4
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EBIT EBIT  400,000


In the no-debt case 400,000 200,000
 400,000 
EBIT    EBIT  400,000
𝑬𝑩𝑰𝑻
 𝑬𝑷𝑺 =  200,000 
# 𝒔𝒉𝒂𝒓𝒆𝒔
𝑬𝑩𝑰𝑻 EBIT  2  EBIT  800,000
 𝑬𝑷𝑺 = EBIT  $800,000
𝟒𝟎𝟎,𝟎𝟎𝟎
800,000
In the with-debt case EPS 
400,000
 $2.00
𝑬𝑩𝑰𝑻 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
 𝑬𝑷𝑺 =
# 𝒔𝒉𝒂𝒓𝒆𝒔
If EBIT is above this level, leverage is
𝑬𝑩𝑰𝑻 𝟒𝟎𝟎,𝟎𝟎𝟎
 𝑬𝑷𝑺 = beneficial;
𝟐𝟎𝟎,𝟎𝟎𝟎 if EBIT is below this point, it is not.
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 https://www.youtube.com/watch?v=kadnjTgBmbA
 https://www.youtube.com/watch?v=Pz34ptgO5Bc

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