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Chapter 6 Measure of Leverage

Chapter 6 discusses measures of leverage, focusing on the distinction between fixed and variable costs, and how leverage affects a company's earnings and risk. It outlines business risk, financial risk, and the impact of operating and financial leverage on net income and return on equity (ROE). The chapter also explains the concept of total leverage and breakeven points, emphasizing that high leverage increases both the potential for higher returns and the associated risks.

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16 views23 pages

Chapter 6 Measure of Leverage

Chapter 6 discusses measures of leverage, focusing on the distinction between fixed and variable costs, and how leverage affects a company's earnings and risk. It outlines business risk, financial risk, and the impact of operating and financial leverage on net income and return on equity (ROE). The chapter also explains the concept of total leverage and breakeven points, emphasizing that high leverage increases both the potential for higher returns and the associated risks.

Uploaded by

hoangyen1260
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 PDF, TXT or read online on Scribd
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Chapter 6: Measures of Leverage

Content
1. Introduction

The total costs of a company can be broken down into two parts: fixed costs and
variable costs. Fixed costs do not vary with output (the number of units produced
and sold), whereas variable costs vary with output.
Leverage is the use of fixed costs in a company’s cost structure. It has two
components:
• Operating leverage: Fixed operating costs such as depreciation and rent create
operating leverage.
• Financial leverage: Fixed financial costs such as interest expense create financial
leverage.

For highly leveraged firms, that is firms with a high proportion of fixed costs relative
to total costs, a small change in sales will have a big impact on earnings.
2. Leverage
• Leverage increases volatility of a company’s earnings and cash flows
and also increases the risk of lending to or owning a company. The
valuation of a company and its equity is affected by the degree of
leverage. The higher a company’s leverage, the higher is its risk, which
requires a higher discount rate to be applied in valuation.
3. Business Risk and Financial Risk

3.1 Business risk and its components


Business risk is the risk associated with operating earnings. All firms face the risk
that revenues will decline, which will, in turn, affect operating earnings. Business
risk consists of two components: sales risk and operating risk.
3.2. Sales Risk
• Sales risk is the variability in profits due to uncertainty of sales price and
volume (product demand and revenue uncertainty).
3.3. Operating Risk

Operating risk is the risk due to operating cost structure. It is greater when fixed
operating costs are higher relative to variable operating costs.
• Degree of operating leverage is a quantitative measure of operating risk. It is
the ratio of the percentage change in operating income to the percentage change
in units sold. It measures how sensitive a company’s operating income is to
changes in sales. For example, a DOL of 2 means that a 1 percent change in units
sold results in a 2 percent change in operating income.
3.4. Financial Risk
• Financial risk is the risk associated with how a company finances its
operations. A company may choose to finance using debt or equity. The greater
the use of debt, the greater is the company’s financial risk. This is because the
company takes on fixed expenses in the form of interest payments.
• Degree of financial leverage is a quantitative measure of financial risk. For
example, if DFL is 2, then a 5 percent increase in operating income will most
likely result in a 10 percent increase in net income.
Effect of Financial Leverage on NI and ROE
Higher leverage leads to higher ROE volatility and potentially higher ROE levels.
Example: Consider two firms with the same operating income (EBIT), but different
capital structures. While Firm 1 has no debt, the capital structure of Firm 2
comprises 50% debt and 50% equity.

_For lower levels of EBIT, NI and ROE are negative for the high leverage firm.
_Higher EBIT leads to potentially higher ROE levels, as seen in Firm 2 (high leverage
firm).
_ROE of firm 2 (high leverage firm) has a higher volatility and variability (-10% to
70%) relative to firm 1 (0 to 40%).
3.5. Total Leverage

Total leverage gives us the combined effect of both operating leverage and
financial leverage. Degree of total leverage (DTL) measures the sensitivity of net
income to changes in the number of units produced and sold.
3.6. Breakeven Points and Operating Breakeven Points
Operating breakeven point

• Operating breakeven point is the number of units produced and sold at which
operating income is zero.

• All else equal companies that have high operating and financial leverage will
have high break even points as compared to companies with low leverage.
The further away unit sales are from the breakeven point for high leverage
companies, the greater the magnifying effect of this leverage.

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