Submitted By:

Samarth Gupta

18MBAIB14

Financial Management

PSMBAIBTC0204

International Centre for Cross Cultural Research & Human

Resource Management

What is Leverage?

In general terms, leverage means the use of forceand effects to produce a more than normal resultsfrom a given action

In other words, leverage is the advantage generated by using a lever

Example, using a jack to lift a car

In Finance, leverage is the use of fixed costs to magnify the potential return to a firm

2 types of fixed costs: fixed operating costs = rent, salaries, etc. fixed financial costs = interest costs from debt

What is Leverage?

Leverage can magnify returns to common stockholders but can also increase risk

Management has almost complete control over this riskintroduced through the use of leverage (fixed costs)

The degree in the use of leverage depends on management’s attitude toward risk and the nature of its business, among others.

Three types of leverage with reference to the firm’s income statement: Operating leverage, Financial leverage, and Combined (Total) leverage.

Leverage is measured on the profitability range of operations.

What is Leverage?

Sales

Less: Total variable Costs

Contribution Margin

Less: Fixed Cost

Earnings Before Interest and Taxes (EBIT)

Less: Interest

Earnings Before Taxes

Less: Taxes

Earnings After Taxes (EAT)

Number of Shares Outstanding

Earnings Per Share

Operating

leverage

Financial

leverage

Operating Leverage

The use of fixed operating costs as opposed to variable operating costs.

A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

Degree of Operating

Leverage (DOL)

Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income.

This “multiplier effect” is called the degree of operating leverage.

DOLs = % change in EBIT

% change in sales

change in EBIT

EBIT

change in sales

sales

=

Degree of Operating Leveragefrom Sales Level (S)

If we have the data, we can use this formula:

Degree of Operating Leveragefrom Sales Level (S)

DOLs = Sales - Variable Costs

EBIT

Financial

Leverage

The use of fixed-cost sources

of financing (debt, preferred

stock) rather than variable-

cost sources (common

stock).

Financial Risk

The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

FIRMEBIT EPSStock-

holders

Degree of Financial

Leverage (DFL)

Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share.

This “multiplier effect” is called the degree of financial leverage.

DFL = % change in EPS

% change in EBIT

change in EPS

EPS

change in EBIT

EBIT

Degree of Financial

Leverage

=

Degree of Financial

Leverage If we have the data, we can use this

formula:

DFL = EBIT

EBIT - I

What does this tell us?

If DFL = 3, then a 1% increase in

operating income will result in a

3% increase in earnings per share.

Stock-

holdersEBIT EPSSales

Based on the following information on

Levered Company, let us try to answer

these questions:

1) If sales increase by 10%, what should

happen to operating income?

2) If operating income increases by 10%,

what should happen to EPS?

Levered Company

Sales (100,000 units) $1,400,000

Variable Costs $800,000

Fixed Costs $250,000

Interest paid $125,000

Tax rate 34%

Common shares outstanding 100,000

EPS

Financial

leverage

Operating

IncomeSales

Operating

leverage

Levered Company

Degree of Operating

Leverage from Sales Level (S)

1,400,000 - 800,000

350,000

= 1.714

=

DOLs = Sales - Variable Costs

EBIT

EPSOperating

IncomeSales

Operating

leverage

10%

17.14%

Levered Company

Degree of Financial

Leverage

DFL = EBIT

EBIT - I

= 350,000

225,000

= 1.556

EPS

Financial

leverage

Operating

IncomeSales

10%15.56%

Levered

Company

Sales (110,000 units) 1,540,000

Variable Costs (880,000)

Fixed Costs (250,000)

EBIT 410,000 ( +17.14%)

Interest (125,000)

EBT 285,000 (+26.67%)

Taxes (34%) (96,900)

Net Income 188,100

EPS $1.881 ( +26.67%)

Levered Company10% increase in sales