1

Analysis and Impact

of Financial Leverage
 2

Learning Objectives

• Understand the difference between business risk and

financial risk.
• Use the technique of break-even analysis in a variety of
analytical settings.
• Distinguish among the financial concepts of operating
leverage, financial leverage, and combined leverage.
• Calculate the firm’s degree of operating leverage, financial
leverage, and combined leverage.
• Explain why a firm with a high business risk exposure might
logically choose to employ a low degree of financial
leverage in its financial structure.
 3
Risk
Variability of revenues from expected revenue

Two types of Risk: Business Risk & Financial Risk

 4
Risk
Variability of revenues from expected
Two types of Risk: Business Risk & Financial Risk

Business Risk
Risk Due to Operations
 5
Risk
Variability of revenues from expected
Two types of Risk: Business Risk & Financial Risk

Business Risk
Risk Due to Operations

Measured by variability of EBIT (earnings before

interest and taxes)
 6
Risk
Financial Risk
Risk due to raising money with fixed income securities
Financial risk is high with high levels of debt financing
Financial leverage - the use of fixed income securities
to finance a portion of assets
Example
Firm A is an all equity firm -- it has no financial leverage
Firm B is financed by 50% debt and 50% equity -- it uses
financial leverage
 7
Income Statement

Revenue
-Variable Cost
Contribution margin
-Fixed cost
=EBIT/operating profits
-Interest
=NI
 8
Break-even Analysis
Assumptions
Fixed costs remain constant as quantity changes
Fixed Costs Includes:
Salaries, Depreciation, Rent
 Variable costs vary as quantity of output changes:
they are constant per unit of output
Variable Costs Includes:
Materials, Labor, Commissions

Drop Semivariable costs

 9
Break-even Analysis
Assumptions
Fixed costs remain constant as quantity changes

 Variable costs vary as quantity of output changes:

they are constant per unit of output
Costs
$

Variable Costs

Fixed Costs

Quantity Sold
 10
Break-even Analysis
Assumptions
Fixed costs remain constant as quantity changes
Fixed Costs Includes:
Salaries, Depreciation, Rent
 Variable costs vary as quantity of output changes:
they are constant per unit of output
Variable Costs Includes:
Materials, Labor, Commissions
 Revenues are quantity sold times price per unit
 11
Break-even Analysis
Calculation of Break-even Quantity

EBIT = Sales – Variable Costs - Fixed Costs

Find Quantity which results in EBIT = $0

 12
Break-even Analysis
Calculation of Break-even Quantity
Algebraic Analysis

QB = F
P–V
Where:
QB = Break-even Quantity
P = Price per Unit
F = Total Fixed Costs
V = Variable Costs per Unit
 13
Break-even Analysis
Calculation of Break-even Quantity
Example:

QB = F
P–V
Fixed Costs = $1,000,000 per year
Price = $800/unit
Variable Costs = $400/unit
 14
Break-even Analysis
Calculation of Break-even Quantity
Example:

QB = F
P–V
Fixed Costs = $1,000,000 per year
Price = $800/unit
Variable Costs = $400/unit
$1,000,000
QB =
$800 – $400
 15
Break-even Analysis
Calculation of Break-even Quantity
Example:

QB = F
P–V
Fixed Costs = $1,000,000 per year
Price = $800/unit
Variable Costs = $400/unit
$1,000,000
QB =
$800 – $400
= 2,500 Units
 16
Break-even Analysis
Calculation of Break-even Sales Level (S*)
To Find S* for a single product use Break-even Quantity (QB):

S* = QB x P
 17
Break-even Analysis
Calculation of Break-even Sales Level (S*)
To Find S* for a single product use Break-even Quantity (QB):

S* = QB x P

S* = 2,500 units x $800

 18
Break-even Analysis
Calculation of Break-even Sales Level (S*)
To Find S* for a single product use Break-even Quantity (QB):

S* = QB x P

S* = 2,500 units x $800

= $2,000,000
 19
Break-even Analysis
Graphical Analysis of Break-even Point
Sales
&
Costs
$

$1,000,000 Fixed Costs

Quantity of Units
 20
Break-even Analysis
Graphical Analysis of Break-even Point
Sales
&
Costs
$

Variable Costs

$1,000,000 Fixed Costs

Quantity of Units
 21
Break-even Analysis
Graphical Analysis of Break-even Point
Sales
&
Costs
$ Total Costs

Variable Costs

$1,000,000 Fixed Costs

Quantity of Units
 22
Break-even Analysis
Graphical Analysis of Break-even Point
Sales
&
Sales
Costs
$ Total Costs

Variable Costs

$1,000,000 Fixed Costs

Quantity of Units
 23
Break-even Analysis
Graphical Analysis of Break-even Point
Sales
&
Sales
Costs
$ Total Costs

$2,000,000 Variable Costs

$1,000,000 Fixed Costs

QB = 2,500 Quantity of Units

 24
Break-even Analysis
Limitations:
1. The sales-volume-cost-profit relationship is
assumed to be linear—it may not be. In the real
world It is not, except for a small range of sales.
2. Cost-price structure of the firm is assumed to
remains constant. It generally does not.
3. Sales price per unit is assumed to be constant
regardless of the output. This is not the case in the
real world—you have to ? Price if you want to sell
more.
 25
Operating Leverage
• Operating leverage is the study of the impact of fixed
cost on the earnings of the firm.
• Presence of fixed cost magnifies earnings of the firm.
Earnings are
better under favourable business conditions, and
poorer if conditions are unfavourable.
• as compared to firms with no or smaller fixed cost.
 26
Operating Leverage
Degree of Operating Leverage
• With FIXED operating costs, there will be operating
leverage
• DOL measures the sensitivity of EBIT to changes in
sales. It is a relationship between the % change in EBIT with
1% change in sales.
• DOL of a company is different at different levels of sales.
• High DOL implies that a relatively small change in
sales will result in large change in the operating
income (EBIT)
The minimum value of DOL is 1.00
This makes earnings riskier too.
It is a measure of business risk
 27
Operating Leverage

Degree of Operating Leverage

Measurement of Operating Leverage
For a unique level of sales, DOL changes as sales
change.

DOLS = % Change in EBIT

% Change in Sales

Unique Level of Sales

 28
Operating Leverage
Measurement of DOL
Calculation using per unit information:

Q(P – V)
DOLS =
Q(P – V) – F
 29
Operating Leverage
Measurement of DOL
Calculation using per unit information:

Q(P – V)
DOLS =
Q(P – V) – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
 30
Operating Leverage
Measurement of DOL
Calculation using per unit information:

Q(P – V)
DOLS =
Q(P – V) – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
3,750(800 – 400)
DOL3,750 units = 3,750(800 – 400) – 1,000,000
 31
Operating Leverage
Measurement of DOL
Calculation using per unit information:

Q(P – V)
DOLS =
Q(P – V) – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
3,750(800 – 400)
DOL3,750 units = 3,750(800 – 400) – 1,000,000

= 3 times
 32
Operating Leverage
Measurement of DOL
Calculation using per unit information:

Q(P – V)
DOLS =
Q(P – V) – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
3,750(800 – 400)
DOL3,750 units = 3,750(800 – 400) – 1,000,000
Interpretation: If sales change 1%, then
= 3 times EBIT will change 3% in the same direction.
 33
Operating Leverage
Measurement of DOL
Calculation using Income Statement Information

S – VC
DOLS =
S – VC – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
 34
Operating Leverage
Measurement of DOL
Calculation using Income Statement Information

S – VC
DOLS =
S – VC – F
Example: Q = 3,750 units x Sales
$3,000,000
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
 35
Operating Leverage
Measurement of DOL
Calculation using Income Statement Information

S – VC
DOLS =
S – VC – F
Example: Q = 3,750 units
Price = $800 per unit x Variable Costs
Variable costs = $400 per unit $1,500,000
Fixed Costs = $1,000,000 per year.
 36
Operating Leverage
Measurement of DOL
Calculation using Income Statement Information

S – VC
DOLS =
S – VC – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
3,000,000 – 1,500,00
DOL3,750 units = 3,000,000 – 1,500,000 – 1,000,000
 37
Operating Leverage
Measurement of DOL
Calculation using Income Statement Information

S – VC
DOLS =
S – VC – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
3,000,000 – 1,500,00
DOL3,750 units = 3,000,000 – 1,500,000 – 1,000,000

= 3 times
 38
Operating Leverage
Measurement of DOL
Calculation using Income Statement Information

S – VC
DOLS =
S – VC – F
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year.
3,000,000 – 1,500,00
DOL3,750 units = 3,000,000 – 1,500,000 – 1,000,000

= 3 times Same Answer as before

 39
Operating Leverage
Degree of Operating Leverage
Degree of Operating Leverage is highest when the firm
is closest to break-even point--DOL falls as sales rise.
If Fixed Costs = $0, Degree of Operating Leverage = 1

Quantity DOL
2,500 (QB) Undefined
3,250 4.33
3,750 3
5,000 2
 40
Properties Of DOL
• DOL always has a value in excess of 1.0. The value of
1 signifies that entire cost is variable and any change
in sales will result in an equivalent change in the
earnings.
• The value of DOL is unique at each level of operation.
• At break even point the DOL is undefined.
• Negative values of DOL signify that the firm is
operating below break-even point. It does not signify
inverse relationship.
• While operating above break-even point the value of
DOL declines and approaches 1 as firm moves away
from break-even point. This is because the fixed cost
per unit becomes lesser and lesser as nos. of units
increase.
 41
Financial leverage
• Financial leverage is the study of impact of fixed cost
of interest on the earnings for the shareholders.
• Degree of Financial Leverage (DFL) is the % change
in the Earnings per Share with 1% change in the
EBIT level. The minimum value of DFL is 1.00
 42
Financial Leverage
Degree of Financial Leverage
Finance a portion of the firm’s assets with securities
that have fixed financial costs
Debt
Preferred Stock
 43
Financial Leverage
Degree of Financial Leverage
Finance a portion of the firm’s assets with securities
that have fixed financial costs
Debt
Preferred Stock
Financial Leverage measures changes in earnings per
share (NI) as EBIT changes.
 44
Financial Leverage
Degree of Financial Leverage
Finance a portion of the firm’s assets with securities
that have fixed financial costs
Debt
Preferred Stock
Financial Leverage measures changes in earnings per
share as EBIT changes.
Degree of Financial Leverage (DFL) at one level of
EBIT:

% Change in EPS
DFLEBIT =
% Change in EBIT

Unique Level of EBIT

 45
Financial Leverage
Measurement of DFL

EBIT
DFLEBIT =
EBIT – I
 46
Financial Leverage
Measurement of DFL

EBIT
DFLEBIT =
EBIT – I Total Fixed
Financing
Costs
 47
Financial Leverage
Measurement of DFL

EBIT
DFLEBIT =
EBIT – I
Example: EBIT = $500,000
Interest Charges = $200,000
 48
Financial Leverage
Measurement of DFL

EBIT
DFLEBIT =
EBIT – I
Example: EBIT = $500,000
Interest Charges = $200,000

500,000
DFLEBIT=500,000 = 500,000 – 200,000
 49
Financial Leverage
Measurement of DFL

EBIT
DFLEBIT =
EBIT – I
Example: EBIT = $500,000
Interest Charges = $200,000

500,000
DFLEBIT=500,000 = 500,000 – 200,000

= 1.67 times
 50
Financial Leverage
Measurement of DFL

EBIT
DFLEBIT =
EBIT – I
Example: EBIT = $500,000
Interest Charges = $200,000

500,000
DFLEBIT=500,000 = 500,000 – 200,000

= 1.67 times
Interpretation: For 1% change in EBIT (from an existing
level of $500,000) Earnings Per Share will change 1.67%
 51
DFL
• Larger the value of DFL
greater is the change in earnings for the shareholders, and
greater is the risk.
• DFL is a measure of financial risk.
 52
Properties of DFL
• DFL always has a value in excess of 1.0. The value of
1 signifies that entire funding is done through equity.
The firm has no interest burden.
• The value of DFL less than 1 means the firm is unable
to meet its fixed operational cost and EBIT is negative.
• The value of DFL is unique at each level of operation
• At break even point the DFL is undefined. Financial
break even is level of EBIT enough to meet interest.
• Negative values of DFL signify that the earnings of the
firm are not enough to cover the interest cost.
Negative sign does not signify inverse relationship.
• Value of DFL declines and approaches 1 as firm
moves away from break even point.
 53
Combined Leverage
Degree of Combined Leverage
Measures changes in Earnings Per Share given
changes in Sales
 54
Combined Leverage
Degree of Combined Leverage
Measures changes in Earnings Per Share given
changes in Sales
Combines both Operating and Financial Leverage
 55
Combined Leverage
Degree of Combined Leverage
Measures changes in Earnings Per Share given
changes in Sales
Combines both Operating and Financial Leverage
Computed for a specific level of sales
 56
Combined Leverage
Degree of Combined Leverage
Measures changes in Earnings Per Share given
changes in Sales
Combines both Operating and Financial Leverage
Computed for a specific level of sales

% Change in EPS
DCLS =
% Change in Sales

Unique Level of Sales

 57
Combined Leverage
Measurement of DCL

DCLS = DOLS x DFLEBIT

 58
Combined Leverage
Measurement of DCL

DCLS = DOLS x DFLEBIT

Example:
DFLEBIT = 1.67
DOLS = 3.0
 59
Combined Leverage
Measurement of DCL

DCLS = DOLS x DFLEBIT

Example:
DFLEBIT = 1.67
DOLS = 3.0

DCL3,750 = 3.0 x 1.67

 60
Combined Leverage
Measurement of DCL

DCLS = DOLS x DFLEBIT

Example:
DFLEBIT = 1.67
DOLS = 3.0

DCL3,750 = 3.0 x 1.67

= 5.0 times
 61
Combined Leverage
Measurement of DCL

DCLS = DOLS x DFLEBIT

Example:
DFLEBIT = 1.67
DOLS = 3.0

DCL3,750 = 3.0 x 1.67

= 5.0 times

Interpretation: When sales change 1%, Earnings Per Share

(NI) will change 5.0%
 62
Combined Leverage
Measurement of DCL--Alternative Computation

DCLS = Q(P – V)
Q(P – V) – F – I
 63
Combined Leverage
Measurement of DCL--Alternative Computation

DCLS = Q(P – V)
Q(P – V) – F – I
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year
Interest = $200,000 per year
 64
Combined Leverage
Measurement of DCL--Alternative Computation

DCLS = Q(P – V)
Q(P – V) – F – I
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year
Interest = $200,000 per year
3,750(800 – 400)
DCLS = 3,750(800 – 400) – 1,000,000 – 200,000
 65
Combined Leverage
Measurement of DCL--Alternative Computation

DCLS = Q(P – V)
Q(P – V) – F – I
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year
Interest = $200,000 per year
3,750(800 – 400)
DCLS = 3,750(800 – 400) – 1,000,000 – 200,000
= 5 times
 66
Combined Leverage
Measurement of DCL--Alternative Computation

DCLS = Q(P – V)
Q(P – V) – F – I
Example: Q = 3,750 units
Price = $800 per unit
Variable costs = $400 per unit
Fixed Costs = $1,000,000 per year
Interest = $200,000 per year
3,750(800 – 400)
DCLS = 3,750(800 – 400) – 1,000,000 – 200,000
= 5 times
Interpretation: When sales change 1%, Earnings Per Share
will change 5.0%
 67

•Thank You

•Any Questions..