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Ch11: Leverage and Capital Structure: Table 11.1, P. 422

This document discusses leverage and capital structure. It defines leverage as using fixed-cost assets or funds to magnify returns to owners. There are three types of leverage: operating, financial, and total. Operating leverage looks at earnings before interest and taxes (EBIT), financial leverage looks at earnings per share (EPS), and total leverage considers EPS relative to sales. Degrees of leverage are also defined to quantify the impact of changes in sales, EBIT, and EPS. Breakeven analysis and an example comparing two firms' leverage are provided.

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49 views2 pages

Ch11: Leverage and Capital Structure: Table 11.1, P. 422

This document discusses leverage and capital structure. It defines leverage as using fixed-cost assets or funds to magnify returns to owners. There are three types of leverage: operating, financial, and total. Operating leverage looks at earnings before interest and taxes (EBIT), financial leverage looks at earnings per share (EPS), and total leverage considers EPS relative to sales. Degrees of leverage are also defined to quantify the impact of changes in sales, EBIT, and EPS. Breakeven analysis and an example comparing two firms' leverage are provided.

Uploaded by

Chelsea Wulan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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Ch11: Leverage and capital structure

 Leverage  use of fixed-cost assets or funds to magnify returns to firm’s owners.


 Leverage results from the use of fixed-cost assets or funds.
 Fixed-cost assets include purchased machines, equipments, plants, etc. vis-à-vis variable-
cost inputs such as labor, raw materials, etc.
 Fixed-cost funds include debts whereas variable-cost funds include common stocks.
Reason: interest payments on debts are fixed whereas dividend payments of common
stocks are contingent.
 Unlike other forms of risk, management has complete control over the risk incurred
through the use of leverage.
 Generally, higher leverage raises risk and returns whereas lower leverage lowers risk and
returns.
 Three forms of leverage: (i) operating leverage; (ii) financial leverage, and (iii) total
leverage.
 Discuss Table 11.1, p. 422 on the types of leverage in relation to the income statement.

Breakeven analysis
The operating portion of a firm’s income statement starts from sale revenue (product of price
P, and quantity sold, Q) and ends with EBIT such that:

EBIT = PQ – Q*VC – FC

For breakeven quantity, set EBIT = 0, and we have

0  Q * ( P  VC )  FC
FC
Q* 
P  VC
where Q* is the operating breakeven quantity;
FC = fixed cost
VC = unit variable cost
P = unit price.

The above breakeven quantity is oftentimes also known as cash breakeven. Two other
breakeven quantities of interest are:
Accounting breakeven = (fixed costs + depreciation) / (price – variable cost)
Financial breakeven = (fixed costs + OCF*) / (price – variable cost)
*OCF ≡ level of cash flows that results in zero NPV.

Comparative-static analyses of the breakeven quantity:


Increase in variable Effect on operating breakeven point
Fixed cost, FC +
Unit price, P -
Unit variable cost, VC +
2

The three types of leverage are:


i. operating leverage
ii. financial leverage
iii. total leverage

( P VC )Q
Degree of operating leverage, DOL = (%  in EBIT) / (%  in sales) = ( P  VC )Q  FC
Degree of financial leverage, DFL = (%  in eps) / (%  in EBIT) =
EBIT
 1 
EBIT  I  
 PD * 1  T 

 
Degree of total leverage, DTL = (%  in eps) / (%  in sales) =
( P  VC )Q
 1 
( P  VC )Q  FC  I  
 PD * 1  T 

 

Obviously, DTL = DFL * DOL.

Example: Firm R has sales of 100,000 units at $2 per unit, variable operating costs of $1.70
per unit, and fixed operating costs of $6,000. Interest is $10k per year. Firm W has sales of
100,000 units at $2.50 per unit, variable operating costs of $1 per unit, and fixed operating
costs of $62.5k. Interest if $17.5k per year. Assume that both firms are in the 40% tax
bracket.
a. Compute the DOL, DFL, and DTL for firm R.
b. Compute the DOL, DFL, and DTL for firm W.
c. Compare the relative risks of the two firms
d. Discuss the principles of leverage that your answers illustrate.

Solutions:
a. DOLR = [(2 – 1.70)100,000] / [(2 – 1.70)100,000 – 6000] = 30k/24k = 1.25
DFLR = 24000 / [24000 – 10000] = 1.71
DTLR = 1.25 * 1.71 = 2.14

b. DOLW = [(2.50 – 1)100,000] / [(2.50 – 1)100,000 – 62500] = 150k/87.5k =1.71


DFLW = 87.5k / (87.5k – 17.5k) = 1.25
DTLW = 1.71 * 1.25 = 2.14

c. Firm R has less operating (business) risk but more financial risk than Firm W.

d. Two firms with differing operating and financial structure may be equally leveraged.
Since total leverage is the product of operating and financial leverage, each firm may
structure itself differently and still have the same amount of total leverage.

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