BABCOCK UNIVERSITY

LEVERAGE
PROF. S. I. OWUALAH

FNCE 821: FINANCIAL MANAGEMENT & POLICY.

DEPARTMENT OF FINANCE
MASTER OF SCIENCE(M.Sc.) FINANCE PROGRAMME

1
MEANING OF LEVERAGE AND TYPES

Leverage or gearing is the use of fixed cost asset

or sources of funds (debt or preference shares ) in
a firm’s operations in order to increase the returns
accruing to its share holders. The fixed cost asset
or source of fund is synonymous with the fulcrum
of a lever.

Changes in leverage give rise to changes in the

level of returns as well as the associated risk that
the firm may not be able to cover its fixed
payment obligations.

2
Financial leverage refers to the use of fixed
income securities in a firm’s operations in order
to increase returns to its share holders.

On the other hand, operating leverage refers to

the extent to which a firm’s total operating costs
vary with changes in operating earnings. That is,
the ability of using fixed operating costs to
increase the effect of changes in sales on a firm’s
earnings before interest and taxes (EBIT).
3
 EFFECT OF FINANCIAL LEVERAGE ON
EARNINGS PER SHARE

Illustration: Suppose Pico Ltd has a capital structure of

N10 million consisting of equity only and it is considering
raising additional N5 million for its expansion programme.
The management are looking at three possible options viz.
– Issuing ordinary shares only
– Issuing preference shares at 7% dividend
– Issuing debt at 9% per annum

The firm’s earnings before interest and taxes are N2 million

and it enjoys a corporate income tax rate of 50%. Its
ordinary shares outstanding are 200,000 each worth N50 in
the stock market which option would be preferred?

4
 Option 1 Option II Option III
Ordinary shares Preference share s Debt
N N N
Earnings before interest/taxes 2,000,000 2,000,000 2,000,000
Interest @ 9% - - 450,000
Earnings before tax 2,000,000 2,000,000 1,550,000
Tax @ 50% 1,000,000 1,000,000 775,000
Earnings after tax 1,000,000 1,000,000 775,000
Pref share dividend - 350,000 -
Earnings available to
shareholders 1,000,000 650,000 775,000
Number of ordinary shares
Outstanding 300,000 200,000 200,0000
Earnings per share (EPS) 1,000,000 650,000 775,000
300,000 200,000 200,000

N3.33 N3.25 N3.88

Option III – issuing debt at 9% interest per annum to raise the N5 million is
preferred because earnings per share (eps) is highest than with other
options. 5
 Illustration: Consider another firm Coba Ltd that currently has no
debt in its capital structure and its management is contemplating a
restructuring that would involve issuing debt to retire (buy back)
some of its outstanding equity as given below.

Capital Structure
Current Proposed
Assets N8,000,000 N8,000,000
Debt N 0 N4,000,000
Equity N8,000,000 N4,000,000
Debt-equity ratio 0 1
Share price N20 N20
Number of shares
outstanding 400,000 200,000
Interest rate 10% 10%

6
 Suppose the firm’s management have prepared
the proposed capital restructuring under three
scenarios reflecting different assumptions
about the firm's EBIT.
Current Capital Structure: No
Debt
Recession Expected Expansion
EBIT N500,000 N1,000,000 N1,500,000
Interest 0 0 0
Net Income N500,000 N1,000,000 N1,500,000
ROE 6.25% 12.5% 18.75%
EPS N1.25 N2.50 N3.75

7
 Proposed Capital Structure: Debt N4m.
Recession Expected Expansion
EBIT N500,000 N1,000,000 N1,500,000
Interest 400,000400,000400,000
Net Income N100,000 N600,000 N1,100,000
ROE 2.50% 15.00% 27.50%
EPS N0.50 N3.00 N5.50

It is evident that both the ROE and EPS for the

expansion scenario are better in the proposed
capital structure than in the current one. This can
only be attributed to the effect of leverage arising
from the use of debt.
8
 EBIT BREAK EVEN POINT
The impact of leverage is evident when the effect on EPS an
ROE is examined. Thus it is possible to determine the EBIT
break even or indifference points between the financing options
in the case of Pico Ltd example.

Applying the formula it is possible to determine the EBIT

break even point between equity and debt financing.
( EBIT  C1 )(1  t ) ( EBIT  C2 )(1  t )

S1 S2

C1 = dividend on ordinary shares (equity)

C2 = annual interest expense on debt
S1 = number of shares outstanding in the ordinary share option
S2 = number shares outstanding in the debt option
9
 ( EBIT  0)(1  0.50) ( EBIT  450,000)(1  0.50)

300,000 200,000

( EBIT  0) ( EBIT  450,000)


3 2
2 EBIT = 3EBIT – 1,350,000
EBIT = N1,350,000

The interpretation is that as long as Pico’s earnings before

interest and taxes are greater than N1,350,000, its EPS from
financing the expansion programme with debt will be higher
than financing with ordinary shares.

However at EBIT level of N1,350,000, the firm should be

indifferent financing the expansion by debt or ordinary shares
(because the same EPS will result). Implying also that below
this level of EBIT, debt financing should not be contemplated
at all.
10
Similarly the EBIT breakeven point for Coba
Ltd assuming a debt of N4 million and no debt
is given as
EBIT/400,000 EBIT – 400,00/200,000
EBIT = 2 x (EBIT - 400,000)
= N800,000

When EBIT is N800,000 the EPS is N2 under

either capital structure. Above this EBIT level,
leverage is beneficial and below, it is not.

11
Midwestern Co Ltd has decided on a capital
restructuring. Currently it uses no debt financing.
Following the restructuring debt will be N1 million
at 9%. The firm currently has 200,000 ordinary
shares outstanding and the price share is N20.

If the restructuring is expected to increase EPS,

what is the minimum level for EBIT that the firm’s
management must be expecting. Ignore taxes?

12
Under the old capital structure EPS =
EBIT/200,000 Under the new capital structure
interest expense is N90,000 (0.09 x 1,000,000). If
the firm repurchase its shares with N1 million at
N20 per share, it would retire 50,000 shares
leaving 150,000 still outstanding. As a result EPS
= (EBIT – 90000)/150,000.

EBIT/200,000 = (EBIT – 90,000)/150,000

EBIT = 4/3 x (EBIT – 90000)
= N360,000 (This gives an EPS of
N1.80 in each case)
13
 DEGREE OF FINANCIAL LEVERAGE (DFL)
The degree of financial leverage (DFL) at any particular level of
EBIT is the percentage change in earnings per share (EPS) in
relation to a percentage change in earnings before interest and
taxes (EBIT).

DFL = EBIT
EBIT – I
Where 1 = before tax interest expense.

If preference shares are issued in addition, then degree of financial

leverage becomes.

EBIT
DFL 
DFL 
EB IT
I  PD

EBIT  I  PD
EB IT 
1  t

1 t

Where PD = preference share dividend

14
The above equation can be rewritten as
X ( P  Vc)  Fc
DFL 
X ( P  Vc)  Fc  I  PD
1 t
Where X = units of output; p = price per unit; Vc = variable cost
per unit’ Fe = fixed cost.

The degree of financial leverage (DFL) for Pico Co. Ltd at the
EBIT level of N2 million and with 9% debt worth N5million
will be
DFL = 2,000,000/2,000,000 – 450,000
= 1.29
This implies that a 10% increase in EBIT will result in a 12.9%
increase in the firm’s EPS.
Similarly for Coba Co.Ltd, the restructuring that results in an
ABIT of N1.5 million and a debt of N4million will produce a
degree of financial leverage of
DFL = 1,500,000/1,500,000 – 400,000
= 1.36

15
 BREAK-EVEN ANALYSIS

Break even analysis is a commonly used tool for

analyzing the relationship between sales volume
and profitability. A usual question to ask is: How
bad do sales have to get before a firm actually
begins to lose money? Put differently, Is it likely
that things will get that bad?
Fixed Costs. These by definition are costs that do
not change during a specified time period. In
otherwords, they do not depend on the amount of
16
 BREAK-EVEN ANALYSIS

goods or services produced during a period. This

does not mean they are fixed forever, rather in the
long run they may become variable.

Variable Costs. These by definition are costs that

change as the quantity of output changes and could
be zero when production is also zero. For example,
direct labour costs or quantity of fuel consumed in
transportation. Assuming variable
17
 BREAK-EVEN ANALYSIS

costs are a constant amount per unit of output,

then total variable cost is equal to the cost per
unit multiplied by the number of units.
Total variable cost = Total quantity of output x Cost per unit of output
Vc = Q x V

Total Costs. Total costs for a given level of

output are the sum of variable and fixed cost.
TC = Vc + Fc
= Q x v +Fc
18
 BREAK-EVEN ANALYSIS

Quantity Produced TVc Fc Tc

0 0 8000 8000
1000 3000 8000 11000
5000 15000 8000 23000
10000 30000 8000 38000
( Assuming variable cost of N3 per unit and fixed
cost of N8000 per period)

19
 BREAK-EVEN ANALYSIS

Average Cost. Suppose a firm has a variable cost per

unit of service of N55 and that the lease payment on the
facility runs at N50,000 per month. If the firm provides
10,000 units per annum, the total cost of providing the
service will be
Tc = Q x v + Fc Tc = 10,000 x 55 + 50,000 x 12
= 550,000 + 600,000 = N1,150,000
The average cost per unit of service is 1150000/10000
= N115

20
 BREAK-EVEN ANALYSIS

Marginal Cost. This refers to the change in revenue

that occurs when there is a small change in output.
Suppose the firm in the previous example gets an order
for 5,000 units of the service provided. It can provide
them in addition to the 10,000 units without incurring
additional fixed costs.
If it gets (say) N75 per unit and since it costs N55 to
provide a unit of the service, then N75 marginal revenue
exceeds the N55 marginal cost hence the firm should
take the order.
21
 BREAK-EVEN ANALYSIS

Accounting Break Even.

The break even level or point is that sales level at which net
income is zero. It is equal to the sum of fixed cost and
depreciation divided by price per unit less variable cost per unit.
Let P = selling price per unit v = variable cost per unit
Q = Total units sold S = Total sales or (P x Q)
Vc = Total variable cost Fc = Fixed cost
Dep = Depreciation t = Tax rate
Suppose a project’s net income is given as
Net income =(Sales-Variable cost –Fixed cost-Depreciation)(1- t)

22
 BREAK-EVEN ANALYSIS

If we set net income equal to zero

Net income = 0 = (S – Vc – Fc – Dep)(1 –t)
Dividing both sides by (1 – t)
S – Vc – Fc – Dep = 0 = S – Vc – Fc – Dep
P x Q – Q x v = Fc + Dep
(P – v) x Q = Fc + Dep
Q = Fc + Dep
P-v
23
 BREAK-EVEN ANALYSIS

Illustration: Suppose a boat manufacturing firm is considering

whether or not to launch its new boat series. The selling price will
be N4 million per boat. The variable cost will be about half that of
the selling price (that is, N2 million) and fixed costs will be N50
million per year. The total investment needed to undertake the
project is N350 million. This amount will be depreciated straight
line to zero over a 5 year life of the equipment. Salvage value is
zero and no working capital will be required. The firm requires a
return of 20 percent on its new project. Based on market surveys
and historical experience, total sales for the 5 year period are
projected at 425 boats (that is, 85 boats per year). Ignoring taxes
should the firm launch the project?

24
 BREAK-EVEN ANALYSIS

Operating Cash flow = EBIT + Dep – Taxes

= (S – Vc – Fc – Dep) + Dep -0
= 85 x (4,000,000 – 2,000,000) – 50,000,000
= 340,000,000 – 170,000,000 – 50,000,000
Annual Operating Cash flow = N120,000,000
At 20% rate of return
NPV = 120,000,000(2.9906) – 350,000,000
= 358,872,000 – 350,000,000
= N8,872,000
25
 BREAK-EVEN ANALYSIS

Accounting Break-Even Level. Suppose we are

interested in knowing how many new boats the firm needs
to sell to break-even on an accounting basis and if it breaks
even, what the annual cash flow from the project will be.
Variable cost N2,000,000
Fixed cost N50,000,000
Sales N4,000,000
Depreciation N70,000

26
 BREAK-EVEN ANALYSIS

Q = Fc + Dep
P–v
= 50,000,000 + 70,000,000
2,000,000
= 60 boats
This is 25 boats less than the projected sales of 85. If the
project breaks even, the cash flow for the period will be
equal to the depreciation of N70 million.

27
 BREAK-EVEN ANALYSIS

Cash Break Even. This implies the sales level that

results in a zero operating cash flow (OCF)
Q = Fc
P –v
= 50,000,000
2,000,000
= 25 boats
The interpretation is that the firm has to sell 25 new
boats to cover the fixed costs.
28
 BREAK-EVEN ANALYSIS

Financial Break Even. That is the sales level that

results in a zero NPV.
Q = Fc + OCF
P–v
(OCF is the level of operating cash flow that results in
zero NPV)
350,000,000 = OCF (PVIFA 20%, 5 years)
OCF = 350,000,000
2.9906
29
 BREAK-EVEN ANALYSIS

= N117,033,371
The interpretation is that the firm will need an operating
cash flow of N117,033,371 annually to break even.
Therefore Q = Fc + OCF
P–v
= 50,000,000 + 117,033,371
2,000,000
= 83.52
Thus the firm needs to about 84 new boats per year.
30
 OPERATING LEVERAGE
Firms that use fixed cost assets are subject to meeting fixed
operating costs in their firms’ income stream. Such a situation
makes operating leverage inevitable.

Low operating leverage implies low fixed costs and vice

versa. Thus projects with relatively heavy investment in plant
and equipment will have relatively high degree of operating
leverage. Whenever a firm is thinking of a new project, it is
important to consider alternative ways. For instance, a boat
manufacturing firm can purchase the necessary

31
 OPERATING LEVERAGE

equipment and build all components of the boats

in-house or some of the work could be farmed
out to other firms.

The first option entails a greater investment in

plant and equipment, greater fixed costs and
depreciation and as a result a higher degree of
operating leverage

32
 OPERATING LEVERAGE

However an increase in sales will result in a more than

proportionate increase in earnings before interest and
taxes (EBIT) and vice versa. For this reason a firm that
has a large fixed operating cost will have a high degree
of operating leverage as well as high business risk.

Fixed costs act like a “lever” in that a small percentage

change in operating revenue (sales) can be magnified
into a large percentage change in operating cash flow
and NPV.
33
 DEGREE OF OPERATING LEVERAGE (DOL)

The degree of operating leverage (DOL) at any

level of sales is defined as the percentage
change in operating earnings to a percentage
change in sales.
DOL at any level of sales = Percentage change in operating earning
Percentage change in sales.

Sales – Variable cost = Contribution

Margin
Sales – Variable Cost – Fixed cost EBIT

The above equation can be xrewritten

( P  Vc) as
x( P  Vc)  Fc
34
 Illustration: Suppose Lagoon Ltd is considering
whether or not to launch its new product estimated to
sell at N40,000 per unit. The variable costs are
estimated to be half the selling price (i.e N20,000)
per unit and fixed costs will be N500,000 per annum.
What is its degree of operating leverage if 50 units of
the product are sold?
DOL = 50 (40,000 – 20,000)_____= 1,000,000
50 (40,000 – 20,000)- 500,000 500,000
= 2.0

The interpretation is that at DOL of 2, a 10% increase

in sales will produce a 20% increase in the firm’s
operating earnings.

35
Illustration: Sasha Ltd currently sells its
special doughnuts for N350 per unit. The
variable cost is N10 per unit and the packaging
and marketing operations have fixed costs of
N360,000 per year. Depreciation is N60,000
per year.

What is the breakeven point (ignoring taxes)?

What will be the increase in operating earnings
if the quantity sold rise to 10% above the
breakeven point?

36
 Q = FC + Dep
P - Vc

Where Q = Total units sold (breakeven quantity)

P = Selling price per unit
Dep = Depreciation
Vc = Variable cost

Q = 360,000 + 60,000
350 – 10
= 420,000 = 1,235 units
340

DOL = x (P – Vc)
x (P – Vc) – Fc

= 1,359 (350 – 10) = 1,359 (340)

1,359 (350 – 10) – 360,000 1,359 (340) – 36000

= 462,060 = 4.53
102,060

37
Illustration: Suppose in the example of Lagoon
Ltd, the total investment required to undertake the
project of launching its new product is N3.5 million.
This amount will be depreciated on straight line basis
to zero over the 5 year life of the equipment. The
salvage value is zero and there are no working capital
requirements. Lagoon Ltd requires a return of 20% on
its new projects. Based on market surveys and
historical experience, the total sales for the 5 years
are estimated at 4,250 units or about 850 units per
year.
Ignoring taxes, should the firm launch the new
project?

38
 Operating earnings = EBIT + Depreciation -Taxes
= sales – Variable cost – Fixed cost – Depreciation – Taxes
= (S – Vc – Fc – Dep)(1-t )
To convert to cash flow
= (S – Vc – Fc – Dep)(1-t )+ Dep
= 850 (40,000 –20,000) -500,000 –700,000 + 700,000
= N16,500,000 per year
At 20% required rate of return
NPV = - 3,500,000 + 16,500,000 (2.9906)
= N45,844,900
The project should be launched.

39
Illustration: Suppose the management is
considering whether to subcontract production
of a component of the new product. If the firm
does this the investment in the equipment falls
to N3.2 million and fixed operating costs to
N180,000. However variable cost will rise to
N25,000 per unit because subcontracting is
estimated to be more expensive than in-house
production.
Ignoring taxes, should Lagoon’s management
subcontract the component?
40
 (S - Vc – Fc – Dep)(1-t)
To convert to cash flow
= (S – Vc – Fc – Dep)(1-t )+
Dep
= 850(40,000 –25,000) -
180,000 –64,000 + 64,000

= N12,570,000 per year

At 20% required rate of
return
NPV = - 3,200,000 +
12,570,000 (2.9906)
= N34,391,842 41
Lagoon Plc’s degree of operating leverage if the quantity sold is 850
units
DOL = 850(20,000) / 850(20,000) -500,000
= 17,000,000/16,500,000
=1.03

If subcontracting is done
DOL = 850(15,000)/850 (15,000) -180,000
= 12,750,000/12,570,000
= 1.01
Lagoon Plc’s degree of operating leverage if the quantity sold is 850
units
DOL = 850(20,000) / 850(20,000) -500,000
= 17,000,000/16,500,000
=1.03

42
Lagoon Plc’s DOL is lower in the subcontracting
option. If it is concerned about the possibility of an
overly optimistic projection, it might prefer to
subcontract.

The subcontract option could also be considered

because if sales improved better than projected, in-
house production could be undertaken at a later date.
For practical purposes, it is a lot easier to increase
operating leverage by purchasing equipment than to
decrease it by selling off equipment
43
TOTAL OR COMBINED DEGREE OF
LEVERAGE
The combined effects of operating leverage and
financial leverage on a firm that uses both can be
determined by examining the effect of changes in the
level of sales on its earnings per share.
TDL = DOL x DFL

DOL =
X ( P  Vc)
x( P  Vc )  Fc

X ( P  Vc)  Fc
DFL 
X ( P  Vc)  Fc  I  PD
1 t

44
 TOTAL OR COMBINED DEGREE OF
LEVERAGE

X ( P  Vc) X ( P  Vc)  Fc
x( P  Vc)  Fc X ( P  Vc)  Fc  I  PD
1 t

X ( P  Vc)
DTL 
X ( P  Vc)  Fc  I  PD
1 t

45
TOTAL OR COMBINED DEGREE OF
LEVERAGE

HealthPlus (Nig)Ltd manufactures various brands of

body care products for the Nigerian market. Currently it
produces and sells 200,000 units per annum. For each
item produced and sold, it incurs a variable operating
cost of N2.20 and sells at N3.80. Fixed operating costs
are N33,000. The firm incurs interest charges ofN7,200
per annum on its long-term loans and pays preference
share dividends of N3000 to its preference shareholders.
Its corporate tax rate is 40% per annum.
Calculate its degree of total or combined leverage
46
 TOTAL OR COMBINED DEGREE OF
LEVERAGE
X ( P  Vc)
DTL 
X ( P  Vc)  Fc  I  PD
1 t

200,000(3.80 – 2.20)
200,000(3.80 – 2.20) – 33,000 – 72,000 – (3,000 x 1/0.40)

= 320,000
274,800
= 1.16

Alternatively
DTL = Dol x DFL
= 1.12 x 1.04
= 1.16
The interpretation is that a 100 percent increase in the firm’s sales from 200,000
units to 400,000 units will result in its earnings per share increasing to 116
percent. Similarly a 10 percent increase in sales will bring about 11.6 percent
47
increase in its EPS.