Leverage and Capital Structure

Part One

Long Term Finance

 1. Leverage and Capital Structure
2. Types of Leverage
3. Breakeven Analysis

Part One Outline 4.

5.
Operating Leverage
Financial Leverage
6. Total Leverage

Long Term Finance

 Leverage
Leverage refers to the effects that fixed costs have on the
returns that shareholders earn; higher leverage generally results
in higher but more volatile returns.
̶ Fixed costs are costs that do not rise and fall with changes in a
firm’s sales. Firms have to pay these fixed costs whether business
conditions are good or bad.
̶ Generally, leverage magnifies both returns and risks.
Capital structure is the mix of long-term debt and equity
maintained by the firm.
Long Term Finance
 Leverage
 Operating leverage is concerned with the relationship
between the firm’s sales and its earnings before interest and
taxes (EBIT) or operating profits.
 Financial leverage is concerned with the relationship
between the firm’s EBIT and its common stock earnings per
share (EPS
 Total leverage is the combined effect of operating and
financial leverage. It is concerned with the relationship
between the firm’s sales and EPS.

Long Term Finance

 General Income Statement Format and Types of Leverage

𝑃𝐷 = No. of shares of preferred stock outstanding × Annual dividend per share

Long Term Finance

 Leverage: Breakeven Analysis
 Breakeven analysis is used to indicate the level of operations
necessary to cover all costs and to evaluate the profitability
associated with various levels of sales; also called cost-
volume-profit analysis.
 The operating breakeven point is the level of sales necessary
to cover all operating costs; the point at which EBIT = $0.

Long Term Finance

 Leverage: Breakeven Analysis
̶ The first step in finding the operating breakeven point is to divide
the cost of goods sold and operating expenses into fixed and
variable operating costs.
̶ Fixed costs are costs that the firm must pay in a given period
regardless of the sales volume achieved during that period.
̶ Variable costs vary directly with sales volume.

Long Term Finance

 Operating Leverage, Costs, and Breakeven Analysis

Long Term Finance

 Leverage: Breakeven Analysis
̶ Rewriting the algebraic calculations in the previous Table as a
formula for earnings before interest and taxes yields:
EBIT = (P × Q) – FC – (VC × Q)
̶ Simplifying yields:
EBIT = Q × (P – VC) – FC
̶ Setting EBIT equal to $0 and solving for Q (the firm’s breakeven
point) yields:

Long Term Finance

 Example,
Assume that Cheryl’s Posters, a small poster retailer, has fixed
operating costs of $2,500. Its sale price is $10 per poster, and its
variable operating cost is $5 per poster. What is the firm’s breakeven
point?

Long Term Finance

 Breakeven Analysis

Long Term Finance

 Sensitivity of Operating Breakeven Point to Increases in Key
Breakeven Variables

Long Term Finance

 Example,
Assume that Cheryl’s Posters wishes to evaluate the impact of several
options: (1) increasing fixed operating costs to $3,000, (2) increasing
the sale price per unit to $12.50, (3) increasing the variable operating
cost per unit to $7.50, and (4) simultaneously implementing all three
of these changes.
1. Operating breakeven point = $3,000/($10 – $5) = 600 units
2. Operating breakeven point = $2,500/($12.50 – $5) = 333.33 units

3. Operating breakeven point = $2,500/($10 – $7.50) = 1,000 units

4. Operating breakeven point = $3,000/($12.50 – $7.50) = 600 units

Long Term Finance

 Leverage: Operating Leverage
Operating leverage is the use of fixed operating costs to
magnify the effects of changes in sales on the firm’s earnings
before interest and taxes.
̶ The figure on the following slide uses the data for Cheryl’s
Posters (sale price, P = $10 per unit; variable operating cost, VC =
$5 per unit; fixed operating cost, FC = $2,500).

Long Term Finance

 The EBIT for Various Sales Levels

Long Term Finance

 Leverage: Operating Leverage
The degree of operating leverage (DOL) is the numerical
measure of the firm’s operating leverage.

% ∆ 𝐸𝐵𝐼𝑇
𝐷𝑂𝐿 =
%∆𝑄
% ∆ 𝐸𝐵𝐼𝑇 = % ∆𝑄 × 𝐷𝑂𝐿

Long Term Finance

 Where,
𝐶𝑒𝑟𝑡𝑎𝑖𝑛 𝑙𝑒𝑣𝑒𝑙 𝐸𝐵𝐼𝑇 − 𝐵𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝐸𝐵𝐼𝑇
% ∆ 𝐸𝐵𝐼𝑇 = × 100
𝐵𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝐸𝐵𝐼𝑇

𝐶𝑒𝑟𝑡𝑎𝑖𝑛 𝑙𝑒𝑣𝑒𝑙 𝑄 − 𝐵𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝑄

%∆𝑄 = × 100
𝐵𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝑄

As long as DOL is greater than 1, there is operating leverage.

Long Term Finance

 Leverage: Operating Leverage
Applying the degree of operating leverage equation to cases 1
and 2 in previous Table yields the following results:

Long Term Finance

 Leverage: Operating Leverage
A more direct formula for calculating the degree of operating
leverage at a base sales level, Q, is the following:

𝑄 × 𝑃 − 𝑉𝐶
𝐷𝑂𝐿 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑠𝑎𝑙𝑒𝑠 𝑙𝑒𝑣𝑒𝑙 𝑄 =
𝑄 × 𝑃 − 𝑉𝐶 − 𝐹𝐶

𝑄 × 𝑃 − 𝑉𝐶
=
𝐸𝐵𝐼𝑇

Long Term Finance

 Leverage: Operating Leverage
Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 into
the previous equation yields the following result:

Long Term Finance

 Operating Leverage and Increased Fixed Costs
Assume that Cheryl’s Posters exchanges a portion of its variable
operating costs for fixed operating costs by eliminating sales
commissions and increasing sales salaries. This exchange results in a
reduction in the variable operating cost per unit from $5 to $4.50 and
an increase in the fixed operating costs from $2,500 to $3,000.

Long Term Finance

 Operating Leverage and Increased Fixed Costs

before

Long Term Finance

 Leverage: Financial Leverage
Financial leverage is the use of fixed financial costs to magnify
the effects of changes in earnings before interest and taxes on
the firm’s earnings per share.
̶ The two most common fixed financial costs are (1) interest on
debt and (2) preferred stock dividends.

Long Term Finance

 Example,
Chen Foods, a small Asian 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.
 The annual interest on the bond issue is $2,000 (0.10 × $20,000).
 The annual dividends on the preferred stock are $2,400
($4.00/share × 600 shares).

Long Term Finance

 The EPS for Various EBIT Levels

Long Term Finance

 Leverage: Financial Leverage
The degree of financial leverage (DFL) is the numerical
measure of the firm’s financial leverage.

% ∆ 𝐸𝑃𝑆
𝐷𝐹𝐿 =
% ∆ 𝐸𝐵𝐼𝑇

% ∆ 𝐸𝑃𝑆 = % ∆ 𝐸𝐵𝐼𝑇 × 𝐷𝐹𝐿

Long Term Finance

 Where,
𝐶𝑒𝑟𝑡𝑎𝑖𝑛 𝑙𝑒𝑣𝑒𝑙 𝐸𝑃𝑆 − 𝐵𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝐸𝑃𝑆
% ∆ 𝐸𝑃𝑆 = × 100
𝐵𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝐸𝑃𝑆

Whenever DFL is greater than 1, there is financial leverage.

Long Term Finance

 Leverage: Financial Leverage
Applying the degree of financial leverage equation to cases 1
and 2 in previous Table yields the following results:

Long Term Finance

 Leverage: Financial Leverage
A more direct formula for calculating the degree of financial
leverage at a base level of EBIT is the following:

𝑄 × 𝑃 − 𝑉𝐶 − 𝐹𝐶
𝐷𝐹𝐿 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑙𝑒𝑣𝑒𝑙 𝐸𝐵𝐼𝑇 =
1
𝑄 × 𝑃 − 𝑉𝐶 − 𝐹𝐶 − 𝐼 − 𝑃𝐷 ×
1−𝑇
𝐸𝐵𝐼𝑇
=
1
𝐸𝐵𝐼𝑇 − 𝐼 − 𝑃𝐷 ×
1−𝑇

Long Term Finance

 Note that ,
Note that in the denominator, the term 1/(1 – T) converts the after-
tax preferred stock dividend to a before-tax amount for consistency
with the other terms in the equation.

Long Term Finance

 Leverage: Financial Leverage
Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and the
tax rate (T = 0.40) into the previous equation yields:

Long Term Finance

 Leverage: Total Leverage
Total leverage is the use of fixed costs, both operating and
financial, to magnify the effects of changes in sales on the firm’s
earnings per share.

Long Term Finance

 Example,
Cables Inc., a computer cable manufacturer, expects sales of 20,000
units at $5 per unit in the coming year and must meet the following
obligations: variable operating costs of $2 per unit, fixed operating
costs of $10,000, interest of $20,000, and preferred stock dividends of
$12,000. The firm is in the 40% tax bracket and has 5,000 shares of
common stock outstanding.

Long Term Finance

 The Total Leverage Effect

Long Term Finance

 Leverage: Total Leverage
The degree of total leverage (DTL) is the numerical measure of
the firm’s total leverage.

% ∆ 𝐸𝑃𝑆
𝐷𝑇𝐿 =
%∆𝑄
% ∆ 𝐸𝑃𝑆 = % ∆ 𝑄 × 𝐷𝑇𝐿

As long as the DTL is greater than 1, there is total leverage.

Long Term Finance
 Leverage: Total Leverage
Applying the degree of total leverage equation to the data in
previous Table yields the following results:

Long Term Finance

 Leverage: Total Leverage
A more direct formula for calculating the degree of total
leverage at a given base level of sales, Q, is given by the
following equation:

𝑄 × 𝑃 − 𝑉𝐶
𝐷𝑇𝐿 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑠𝑎𝑙𝑒𝑠 𝑙𝑒𝑣𝑒𝑙 𝑄 =
1
𝑄 × 𝑃 − 𝑉𝐶 − 𝐹𝐶 − 𝐼 − 𝑃𝐷 ×
1−𝑇
𝑄 × 𝑃 − 𝑉𝐶
=
1
𝐸𝐵𝐼𝑇 − 𝐼 − 𝑃𝐷 ×
1−𝑇

Long Term Finance

 Leverage: Total Leverage
Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I =
$20,000, PD = $12,000, and the tax rate (T = 0.40) into the
previous equation yields:

Long Term Finance

 Leverage: Relationship of Operating, Financial, and
Total Leverage
 Total leverage reflects the combined impact of operating and
financial leverage on the firm.
 High operating leverage and high financial leverage will
cause total leverage to be high. The opposite will also be true.
 The relationship between operating leverage and financial
leverage is multiplicative rather than additive.
DTL = DOL  DFL

Long Term Finance

 Leverage: Relationship of Operating, Financial, and
Total Leverage
Substituting the values calculated for DOL and DFL, shown on
the right-hand side of the previous Table, into the previous
equation yields
DTL = 1.2  5.0 = 6.0

Long Term Finance

 1

Problem Example:
TOR most recently sold 100,000 units at $7.50 each; its variable operating
costs are $3.00 per unit, and its fixed operating costs are $250,000. Annual
interest charges total $80,000, and the firm has 8,000 shares of $5 (annual
dividend) preferred stock outstanding. It currently has 20,000 shares of common
stock outstanding. Assume that the firm is subject to a 40% tax rate.
a. Calculate the firm’s earnings per share (EPS) in tabular form at (1) the
current level of sales and (2) a 120,000-unit sales level.
b. Calculate the firm’s degree of operating leverage (DOL). Determine the
effect (in percentage terms) of a 50% increase in TOR’s sales from the base
level on its earnings before interest and taxes (EBIT).
c. Calculate the firm’s degree of financial leverage (DFL). Determine the effect
(in percentage terms) of a 10% decrease in TOR’s earnings before interest
and taxes (EBIT) from the base level on its earnings per share (EPS).
d. Use the degree of total leverage (DTL) concept to determine the effect (in
percentage terms) of a 50% increase in TOR’s sales from the base level on its
earnings per share (EPS).
Solution:
a. Calculate the firm’s earnings per share (EPS) in tabular form at (1) the
current level of sales and (2) a 120,000-unit sales level.

Operating
Leverage

Total
Leverage

Financial
Leverage
 2

b. Calculate the firm’s degree of operating leverage (DOL). Determine the

effect (in percentage terms) of a 50% increase in TOR’s sales from the
base level on its earnings before interest and taxes (EBIT).

Using the base sales level :

( )
( )
( )

( )
( )
( )

 Determining the effect (in percentage terms) of a 50% increase in

TOR’s sales from the base level on its earnings before interest and
taxes (EBIT)

If TOR’s sales increase by 50% from the base level, its EBIT will
increase by 112.5%
 3

c. Calculate the firm’s degree of financial leverage (DFL). Determine the

effect (in percentage terms) of a 10% decrease in TOR’s earnings before
interest and taxes (EBIT) from the base level on its earnings per share
(EPS).

Using the base level EBIT :

( )
( ) ( )

( )

( )
( ) ( )

( )

 Determining the effect (in percentage terms) of a 10% decrease

in TOR’s earnings before interest and taxes (EBIT) from the base
level on its earnings per share (EPS)

If TOR’s EBIT decrease by 10% from the base level, its EPS will
decrease by 37.5%
 4

d. Use the degree of total leverage (DTL) concept to determine the effect (in
percentage terms) of a 50% increase in TOR’s sales from the base level on
its earnings per share (EPS).

 Determining the effect (in percentage terms) of a 50% increase in

TOR’s sales from the base level on its earnings per share (EPS)

If TOR’s sales increase by 50% from the base level, its EPS will
increase by 422%